Monetary Policy According to the Reserve Bank of Australia

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A report on the unique aspects of inflation-targeting by the Reserve Bank of Australia.

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Monetary Policy According to the Reserve Bank of Australia

  1. 1. ECE DepartmentMonetary Policy According to theReserve Bank of AustraliaJonathon Flegg and Mieke Klanker 0 j.c.flegg@nus.edu.sg | mieke.klanker@sciences-po.org
  2. 2. Contents1. Introduction .......................................................................................................................................................22. Inflation-Targeting Pioneer .................................................................................................................................2Institutional Development and the Australian Economy ....................................................................................................... 2Reserve Bank Finds its Independence .................................................................................................................................... 4Board Structure and Current Independence .......................................................................................................................... 63. Inflation-Targeting Framework ...........................................................................................................................8A Flexible Target ..................................................................................................................................................................... 9The Operational Target ........................................................................................................................................................... 9Credibility and Transparency ................................................................................................................................................ 104. Inflation-Targeting Success ............................................................................................................................... 11Hitting the Target.................................................................................................................................................................. 11Reducing Inflation Volatility.................................................................................................................................................. 13Anchoring Inflation Expectations.......................................................................................................................................... 13A Macroeconomic ‘Free Lunch’ ............................................................................................................................................ 155. Not an Inflation-Targeting ‘Nutter’ ................................................................................................................... 15Output and Employment Gaps ............................................................................................................................................. 16Asset Price Bubbles ............................................................................................................................................................... 176. Concluding Remarks ..................................................................................................................................................... 187. Bibliography ................................................................................................................................................................. 20 1
  3. 3. 1. IntroductionSince 1993 there has been a silent revolution in way the Reserve Bank of Australia (RBA) conducts monetarypolicy. In that year without any fanfare or public pronouncements the RBA quietly moved to developing a newframework of inflation-targeting. New Zealand was the first country to initiate a similar regime but that had onlybeen initiated a short three years earlier and operationally was very different to anything being discussed acrossin Australia. Certainly in advanced economies just coming out of stagflation the verdict on central banks targetinginflation was still open.Now in 2011 the RBA and its framework for targeting inflation are still going strong. The unique framework thatthe RBA has developed over time can most aptly be described by three core characteristics: credibility,transparency and flexibility. The target is distinctive internationally for its flexibility: 2 to 3 per cent inflation, onaverage, over the business cycle. What is surprising however is that this amount of flexibility afforded to the RBAin meeting this medium-term target coexists with a comparatively low-level of political independence. If the RBAhas an Achilles’ heel it is certainly the lack of institutionalised independence from the Government it currentlyoperates with. Ultimately though it is likely that the three characteristics described above are its great strength,and maintaining them has afforded the RBA the capacity to steer the real economy through some difficult times.In this assessment of the RBA’s practice of monetary policy we will first discuss the pioneering days when the RBAwas feeling its way into inflation-targeting, and how and why the framework developed, politically andexperientially, into the distinctive form we observe today. In the next section we will explain the mechanics of thehow the RBA operationalises inflation-targeting, and if given its short history we can regard it as a success. And tofinish we will demonstrate how the unique characteristics of the framework, its focus on credibility, transparencyand flexibility, allow the RBA to also focus on achieving a number of secondary policy objectives.2. Inflation-Targeting PioneerInstitutional Development and the Australian EconomyPrior to the Reserve Bank Act of 1959, the government-owned Commonwealth Bank of Australia possessed thefunctions of both a central and commercial bank. The Australia Government, judging that these dual roles wereinconsistent, created a new statutory body called the Reserve Bank of Australia, which relieved theCommonwealth Bank of its duties as a nation’s central bank.Section 10(2) of the Act specifies the ‘Charter’ of the RBA as: It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and 2
  4. 4. that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to: a. the stability of the currency of Australia; b. the maintenance of full employment in Australia; and c. the economic prosperity and welfare of the people of Australia. While the ‘Charter’ is clearly loaded with the economics of Keynesian times, actual policy is for the most part free to be operationalised by the Government of the day, and in more recent times, the RBA itself. Open to interpretation is the meaning of “stability of the currency”. While it could be understood as exchange rate or price stability, the RBA now chooses to have the Charter find “practical expression” in the current inflation-targeting regime (RBA, 2011). Figure 1: Real Exchange Rate and Terms of Trade (Battellino and Plumb, 2009: 11) The Australian economy is as a small and open economy with a high-level of income per capita. However its strong dependence on export commodities has led it be susceptible to extreme fluctuations in its terms of trade. The Bretton Woods system of pegged exchange rates left the Australian economy vulnerable to debilitating booms and busts. In fact the inflexibility of exchange rates was one of the major reasons why Australia was one of the only major international economies not to join the IMF when it was established in 1944 (Henry, 2003)1. It was little surprise then that Australia was not far behind the United States in moving to a floating currency in 1983. The event was a culmination of first switching the peg from the British Pound to the US Dollar in 1971, then to a trade-weighted exchange rate index in 1974, followed by periodic valuation in 1976. The current floating exchange rate dampens the impact of commodity booms and busts on the economy. When exports in Australian1 The other major economy that refused to join the IMF was Russia. Prime Minister Chifley was successful in reversing Australia’sdecision not to join in 1947. 3
  5. 5. commodities are booming, the Australian Dollar appreciates to provide some dampening to inflation (note theparticularly robust relationship since 1983 in Figure 1)2.The floating of the exchange rate was an important reform that now assists the RBA to dampen inflation. Becauseof its high volatility the Australian Dollar is now commonly referred to by Australians as the “little Aussie battler”.Floating the currency also allowed for the foreign exchange controls in Australia to be liberalised, leading to the‘internationalisation’ of the dollar. It now ranks as the sixth most traded currency globally (Battellino and Plumb,2009: 5).Abandoning the peg produced its own challenges for monetary policy however. Monetary targeting was adoptedfirst and then abandoned by 1985, when it had become clear that resulting from financial liberalisation andinnovation the monetary aggregates no longer bore a stable relationship to prices or nominal incomes. In theperiod that followed, the approach to monetary policy was could best be described as an ad hoc “checklist” ofindicators (Edey, 2005:3). The Government’s preferred position was to target the Current Account Balance (Bell,2004), while many at the RBA realised that Australia’s status as a commodity exporter made targeting an externalposition infeasibility difficult. This gulf in attitudes set the scene for independence.Reserve Bank Finds its IndependenceWithin the Australian media it is an often-repeated maxim that the RBA is independent of the Government. Inpractice what is meant is the RBA enjoys de facto independence, a kind that should not be confused with the typeof institutionalised independence we might ascribe to the European Central Bank. The RBA’s de factoindependence was the not a consequence of conscious institutional design, but rather it was the product of aseries of political events culminating in the 1996 Statement on the Conduct of Monetary Policy (RBA, 1996). Priorto that agreement the status quo, according to the former Governor Ian Macfarlane (in Bell, 2004: 110), was thatthe “Treasurer made monetary policy on the advice of the Reserve Bank and the Treasury” indicating a lack ofindependence. Prime Minister Keating jealously guarded this arrangement, and once ignited a firestorm in 1990by boasting to the Federal Press Gallery: I have Treasury in my pocket, the Reserve Bank in my pocket, wages policy in my pocket, the financial community both here and overseas in my pocket (Keating in Bell, 2004).The RBA’s credibility suffered greatly as a result of this comment. To maintain the Government’s control overmonetary policy, PM Keating appointed a trusted colleague and former Treasury Secretary, Bernie Fraser, to theposition of RBA Governor in 1989. However once appointed Fraser came to the view, along with many others atthe RBA, that Australian monetary policy should be primarily focused on targeting inflation rather than the2 This occurs through greater substitution of imported goods and services for domestically-produced ones and through thedeparture of liquidity. 4
  6. 6. current account deficit, a position upheld by the Government (Bell, 2004: 63). Inflation-targeting had been introduced relatively recently in a number of other small and open economies, such as New Zealand and Canada, and had been shown to be performing well. The decision by Fraser and the RBA to contravene explicit Government policy enraged Keating, at a time when his political fortunes were fading3. The inflation-targeting policy was a bureaucratic declaration of independence at a time in the political cycle most conducive to such a manoeuvre. Keating confessed in his memoires that going into the 1996 election: The option for me, near a difficult election, was to have an open brawl with the Bank and [Governor] Bernie Fraser. Further away from an election, I would have dealt with the Bank’s unreasonable intransigence in much sterner and more decisive terms (Keating in Bell, 2004: 127). The incoming Liberal-National Government led by Prime Minister John Howard recognising the strength of operational independence and inflation-targeting over the preceding three years, and decided to acknowledge the RBA’s independence in the joint Statement on the Conduct of Monetary Policy (RBA, 1996). Like a peace treaty it was signed and issued jointly by two equal representatives of both sides of the conflict, the Federal Treasurer and the Governor of the RBA. The unique evolution of independence for the RBA serves to illustrate a number of characteristics of the Australian system of setting monetary policy. Firstly, the RBA does not neatly follow the intuition that independence and flexibility go hand-in-hand. The RBA developed as one of the less formally independent central banks, yet enjoys a considerable degree of flexibility in achieving its final target. Secondly, this anomaly to some degree can be explained by the fact that the introduction of inflation-targeting was entirely bureaucratic-led rather than government-imposed. The system that the RBA developed without the blessing of the Government is inherently flexible and provides the Board with considerable discretion in how they reach the target. It was always within the interests of the RBA to conduct a system that ‘bound their hands’ as little as possible and even allowed them to decide on what other macroeconomic goals to focus. However, the independence that allowed the RBA to develop inflation-targeting was not bestowed upon them but was because it occurred at a unique point in the political cycle when the Government was weak.3 By the 1993 Federal Election the Labor Government, credited with the floating of the Australian Dollar in 1983, was struggling tomaintain public support. While inflation was lower, so was Prime Minister Keating credentials on the economy, given the size of theGovernment’s deficit and high interest rates. The Liberal-National Coalition failed to secure an election victory in 1993 mainlybecause of public concerns about their most well-known policy was to introduce a Goods and Services Tax. However by the 1996election the Liberal-National Coalition, led by a new leader John Howard, had publicly scrapped the GST policy and went on to win astrong majority in Parliament. 5
  7. 7. This is linked to a final point, the RBA’s independence can hardly be considered institutionalised. While the Statement is an agreement between the two parties that has gained acceptance through time, ultimately the RBA enjoys its freedom because of its support by from the Government, not despite it. In a way the Government can be considered to currently benefit from the political cover for never being directly responsible for raising interest rates, but conversely being able to claim responsibility for ‘creating a strong economic environment’ when rates remain low. However the strongest source of support of maintaining RBA independence remains their on-going perceived performance rather than correct institutional procedure. As Coleman (2004) warned that in different economic times and with different political figures the threat of government ‘capture’ still remains at the RBA. Board Structure and Current Independence The Reserve Bank Board consists of nine members all appointed by the Government: Three executive and six non- executive members. The three executive members consist of the Governor, Deputy Governor and the Treasury Secretary. The Governor and Deputy Governor are appointed by the Government Treasurer for an eight year term, and both are eligible for reappointment and termination. The non-executive members are also appointed by the Treasurer. Most non-executive appointments are made from the within the corporate community, and there is a tradition of placing one academic on the Board (Bell, 2004)4. To protect anonymity within the Board’s membership, neither member-votes nor minutes are publicly reproduced. Moderately Low Policy Independence Comparatively High High Financial Low Overall Instrument Independence Independence Independence Low Personnel Independence Figure 2: The RBA according to Cukierman’s (1992) Central Bank Independence Index The current RBA’s separation from Government can be understood along the four dimensions of independence determined by Cukierman (1992): policy, instrument, personnel, and financial independence. The RBA has high instrument independence, but unlike some other inflation-targeting central banks has minimal ability to change4 To protect the Board from political ‘capture’ Coleman (2004) has suggested reforming appointments along the lines of the Bank ofEngland Board to include more economists and public sector representatives from institutions such as the Productivity Commissionor ACCC. 6
  8. 8. the policy framework without the agreement of the Government5. However as we have seen the system is quite flexible, and for the most part was a framework designed by the RBA themselves between 1993 and 1996. RBA’s personnel independence is quite low because all members of the Board are government-appointed, but it is responsible for its own budget, giving it substantial financial independence (RBA, 1994: 7; Arnone et al, 2006). Compared with other inflation-targeting regimes, the RBA’s overall independence is usually rated as quite low. In an assessment of the personal, political and financial independence of central banks, Sousa (2002) placing the RBA’s independence second only to the Bank of Canada (see Figure 3). According to a cross-country IMF study by Arnone et al (2006), the RBA was the only central bank where political independence diminished between 1991 and 2003 because of the loss of some “legal protections that strengthen the central bank’s position in the event of a conflict with the government” (2006: 5). Figure 3: Accountability versus Independence within inflation-targeting central banks (Sousa, 2002) The converse of a lack of independence compared with other central banks is that the RBA is quite accountable to Government, and indirectly responsible to the Australian people. This accountability is maintained not only through the Board’s appointment system but also through the executive and senior staff appearing at least twice a year before the House of Representatives Standing Committee on Economics. However accountability must be weighed against the vast literature that has emerged on the positive relationship between central bank independence and economic performance 6. The continued rise in home ownership in Australia has only strengthened the powerful incentives for politicians to prefer downward-biased interest rates in the short-term. This potential political pressure makes the institutionalisation of the RBA’s independence even more vital.5 Policy independence refers to the capacity of the central bank to determine its own policy goals and processes, while instrumentindependence is a measure of its control over the use of the policy instrument, the short-term official interest rate.6 See Bofinger (2001: 216-20) for a summary of the evidence. 7
  9. 9. 3. Inflation-Targeting FrameworkThe principal objective of the RBA’s inflation-targeting framework is to achieve price stability through achieving apredetermined inflation target. In the 1996 Statement the Governor and the Treasurer agreed that theappropriate official target for monetary policy was a consumer price inflation rate of “2-3 per cent, on average,over the cycle” (RBA, 1996). The design of the framework allowed “for the natural short run variation inunderlying inflation over the cycle while preserving a clearly identifiable benchmark performance over time”(RBA, 1996). This line made clear from the beginning the Australian framework was at the flexible end of thespectrum of inflation-targeting central banks. The distinct characteristics of the Australian inflation-targetingframework are credibility, transparency and flexibility. Figure 4: Key Characteristics of the RBA’s Inflation-targeting FrameworkThe 2-3 per cent target was defined based on the best average performances since WWII which were in the “twopoint something” region with quite a wide degree of variation around that average (Stevens, 2003:20). Accordingto Governor Stevens (2003:20) the Bundesbank was also a lead example in defining this target. The RBA’s targetwas quite different to what Greenspan was suggesting at the time as an optimal target for the Federal Reserve: “Iwould say the number is zero, if inflation is properly measured.”(in FOMC, 1996). Summary of the RBA’s Inflation-targeting Framework Measure of inflation Headline CPI Target band and horizon Average of 2-3% over the medium term Policy timeline No explicit timeline for corrections Policy rate Overnight cash rate Table 1: Summary of the RBAs Inflation-targeting FrameworkThe inflation target is expressed in terms of the average rate of increase in the consumer price index (CPI).Although the ultimate objective for the RBA is specified in terms of headline CPI, an important input intoforecasting inflation are measures of underlying inflation which attempt to abstract from the short-term volatilityin some prices (Richards and Rosewall 2010:7). The measure of underlying inflation most used by the RBA is thetrimmed-mean rate of inflation, the average rate of inflation after ‘trimming’ away a certain percentage of the 8
  10. 10. distribution of price changes at both ends of that distribution (Richards and Rosewall, 2010:8). In a recent studyBrischetto and Richards (2006) found that trimmed measures tend to out-perform headline and exclusionmeasures, which are used by other central banks, on a range of different criteria. In practice, the RBA has tendedto focus on two particular trims: the 15 per cent trimmed mean and the weighted median, which trims 50 percent of the distribution from both ends (Richards and Rosewall, 2010:8).A Flexible TargetThe Australian inflation-targeting regime differs in two ways from conventional regimes which are both related tothe definition as “2-3 per cent, on average, over the cycle”. Firstly, unlike other inflating-targeting central banks, isthe RBA is not faced with an explicit timeline to correct deviations from the target band. This allows the ReserveBank the flexibility to pay attention to the state of the economy, as measured by output or unemployment, in itsdeliberations about the stance of monetary policy.Secondly, the 2-3 per cent range was not intended to specify outer limits, but rather to convey the idea of anapproximate central tendency, or “thick point”, as Debelle and Stevens (1995: 3) have referred to it. Though otherearly adopters of inflation-targeting have a point target (such as the Bank of England), or a range (in New Zealandand Canada), the RBA had observed that inflation was hard to control in a precise way and attempts to do so overshort periods risked are aggravating the economic instability the RBA is trying to reduce (Stevens 2003:20). Thusthe formulation of the inflation target of the RBA allows for the inevitable uncertainties that are involved inforecasting and lags in the effects of monetary policy on the economy.The Operational TargetThe formal policy rate is the target cash rate, or the overnight rate, which is a market interest rate (Ho, 2009: 4).Changes in monetary policy by the RBA entail a change in the operating target for the cash rate, and hence a shiftin the interest rate structure prevailing in the financial system. The two main instruments used by the RBA arerepurchase agreements and discretionary operations. Repurchase agreements are of the deposit facility type witha ceiling and floor differing with 25 basis points from the prevailing policy rate. Discretionary operations aremainly repo and reverse repo as well as outright transactions and foreign exchange swaps (Ho 2009). Unlike manyother central banks, such the Federal Reserve, the reserves at the RBA are only used for settlement in thepayments system and not for reserve requirements.The close relationship between the cash rate and other money market interest rates is demonstrated in Figure 5.According to Ho (2009: 10), this low volatility is typical for central banks that are targeting the overnight rate. TheRBA has taken up a proactive stance by providing the right amount of liquidity through its discretionaryoperations which has made the overnight rate seldom venture towards the boundaries. Furthermore, the RBA has 9
  11. 11. defined a narrow corridor around the formal policy rate which also serves to dampen short-term market rate volatility (Ho 2009: 20). Figure 5: Short-term Interest Rates (RBA, 2011) Credibility and Transparency Critical to the RBA’s current strategy is establishing and maintaining credibility and transparency in their relationship with the private sector. Compared with previous decades this has managed to solidly anchor expectations around the top of the target band. It is important not to understate this achievement. According to Governor Stevens (2003:18), after decades of high inflation Australians were suffering from “inflation psychology”. The erosion of the value of money that had become a permanent feature for an entire generation of Australians was now reversed. The RBA is considered to be one of the most transparent central banks in the world. Openness is maintained by a regular dialogue with the public, through media releases, speeches and their comprehensive website. Monthly decisions pertaining to the cash rate are associated with an explanation of the reasons behind their action or inaction. Fracasso et al (2003) , in an comprehensive analysis of the quality and accessibility of information provided by inflation-targeting central banks, argue while the RBA’s written inflation reports remain relatively concise they rely more heavily on their disseminating data regularly through their website. Quarterly the RBA also releases an exhaustive Statement of Monetary Policy which includes detailed forecasting of international and domestic market conditions7. Inflation forecasts are a vital part of this statement and thus of the RBA’s communication strategy. Forecasts of inflation and GDP growth are point estimates over a 1-2 year period and7 See the RBA website (http://www.rba.gov.au/) for records of previous Statements on Monetary Policy. 10
  12. 12. crucially assume no change in the instrument (Edey, 2005: 12). There has been some discussion of changing the ‘no policy change’ assumption, as it could be misinterpreted by the private sector for expectations of inflation8. Credibility is considerably more difficult to establish than transparency, as it presumably requires the private sector to develop trust in the RBA’s record of hitting the target over time. Unlike monetary aggregate targeting where the private sector can immediately see the proof of the central bank performance, inflation-targeting involves a considerable lag before the target is realised. Hence being credible is critical to performance otherwise wages can easily get out of control. As mentioned above during the early 1990s the RBA suffered a lack of credibility given a string of comments made by Prime Minister Keating. Surprisingly though with the advent of inflation-targeting, expectations were quite quick to revert to the target band, and since then have stayed relatively stable. Although prior to the Global Financial Crisis it appears that the Australian public suffered from some second thoughts about the ability of the RBA to maintain inflation, overall the credibility of the current framework and the faith in the competency of the Board’s leadership is quite strong. 4. Inflation-Targeting Success There are several approaches we can employ in evaluating the success of the RBA’s inflation-targeting. Assistant Governor Debelle (1995) noted that it might be as simple as, “if, some years hence, we can look back and observe that the average rate of inflation has a ‘2’ in front of the decimal place that will be regarded as a success”. First, we will look at whether the RBA has achieved the target it has set for inflation. Secondly, it is assessed whether inflation-targeting has led to lower inflation volatility. Thirdly, the issue of inflation expectations will be dealt with by examining whether the inflation ‘psychology’, ubiquitous until the early 1990s, has left Australian mindsets. The last section will go into detail on whether IT has been associated with any cost to growth or unemployment. Hitting the Target For RBA Governors the flexibility of the target makes it not only easier to achieve, but also convenient for claiming success. In 2003 Governor Stevens (2003: 21) noted that after ten years of inflation-targeting the average inflation rate over the 38 quarters up to December 2002 was 2.4 per cent. In this way, he explained, the inflation target had been achieved. Truman (2003) does not view this as much of a surprise. He categorises Australia as a “maintainer”, a country that had already achieved its low-level target inflation prior to inflation-targeting being adopted. Figure 6 shows that if Australia’s target were strict rather than flexible the results would not be encouraging. CPI was only in line with the target in the period 2002-2006 and showed deviations (mainly above the 3 per cent8 In reality it rarely the case there is no change in the instrument over the timeframe of a 1-2 year forecast, so in this sense forecastinflation should not be confused with an inflation expectation, because rational actors would expect the RBA to move theinstrument in the event of a forecast outside the target band. Possible reforms might include releasing a probability distribution fanchart or an endogenous instrument change forecast (such as is done by the Bank of England). 11
  13. 13. upper band) during the remaining periods. It is noteworthy that the deviations from the inflation targets have notbeen symmetric; while there have been breaches both on the upside and the downside, most have been on theupside. Australian Consumer Price Index 7.0 6.0 CPI (annual % change) 5.0 4.0 lower band 3.0 upper band 2.0 1.0 Consumer price index 0.0 Mar-1993 Mar-1994 Mar-1995 Mar-1996 Mar-1997 Mar-1998 Mar-1999 Mar-2000 Mar-2001 Mar-2002 Mar-2003 Mar-2004 Mar-2005 Mar-2006 Mar-2007 Mar-2008 Mar-2009 Mar-2010 -1.0 Figure 6: CPI inflation, headline from 1993 to 2011 (Source: RBA, 2011)As the RBA has defined the inflation target as “on average, over the cycle”, it is of interest to take a closer look atthe performance of the main underlying indicator, the weighted median, in terms of its average over the cycle.Table 2 clearly shows that compared with the pre-period, inflation over the cycle has diminished towards thetarget as set by the RBA. However, the most recent cycle shows an upward deviation, partly caused by increasedinflation during the global financial crisis. Though this does not seem to be part of a long term trend, the trimmedmean CPI of 2010 indicates that inflation has come back to its previous path with an average of 2.6 per cent overthe year. On the whole, the RBA’s flexible inflation target seems to have been achieved by the RBA for the periodof 1993-2010. CPI inflation, weighted median (on average over the period, in %) 1985-89 1990-94 1995-99 2000-04 2005-09 2010 7.7 3.3 2.2 2.6 3.4 2.6 Table 2: 5 Year averaged CPI inflation, trimmed mean (Source: Edey, 2005; and authors’ own calculations) 12
  14. 14. Figure 7: CPI inflation volatility from 1984 to 2008 (Source: Lim, 2009)Reducing Inflation VolatilitySuccessful inflation-targeting should not only constraint the level of inflation, but should also reduce its volatility.Lower inflation volatility would increase credibility and consequently strengthen lower inflation expectations(Filardo and Genberg 2009: 13). Figure 7 shows that prior to the implementation of the inflation-targetingframework in 1993, the volatility of CPI decreased considerably. The standard deviation over 5 year periods inTable 3 shows a similar trend. CPI inflation, weighted median (standard deviation, in %) 1985-89 1990-94 1995-99 2000-04 2005-09 2010 1.1 1.8 0.4 0.3 0.8 0.4 Table 3: 5 Year standard deviation in CPI inflation, trimmed mean (Source: Edey, 2005; and authors own calculations)Anchoring Inflation ExpectationsOne of the reasons behind adopting the inflation-targeting framework was it was hoped its credibility wouldeventually rein in the nation’s high expectations of future inflation. As Figure 8 shows, inflation expectations inAustralia have decreased greatly with the adoption of inflation-targeting in 1993. This shows that the RBA hadsent out a strong signal that inflation control was a priority. The policy had been well communicated with peopleexpecting and acting on the prospect of stable prices. The benefit of controlling inflation expectations is it anadditional ‘soft’ method of controlling actual inflation compared with the ‘hard’ cash rate instrument. To theextent that the economy is ‘self-controlling’ when it comes to inflation, the instrument becomes more available torealise other secondary goals (Bofinger, 2001: 113; Bernanke, 2004). 13
  15. 15. Figure 8: Inflation expectations from 1975 to 2003 (Source: Stevens, 2003)Figure 9 shows the high correlation between the actual underlying inflation and consumer inflation expectations.Since introducing inflation-targeting, inflation expectations have been on the upper side of the range defined by theRBA as shown in Table 4. It seems that there continues to be a significant proportion of households anticipatinginflation higher than defined by the RBA. Particularly in the period leading up to the financial crisis, betweenDecember 2006 and June 2008, inflation expectations exceeded the CPI, and during the global downturn inflationand inflation expectations both significantly exceeded the target band. This may indicate that the RBA’s credibilitywas tested while moving the through the uncharted waters of the crisis. Consumers inflation expectation (average, in %) 1995-99 2000-04 2005-09 2010 2.5 3.1 3.5 3.1 Table 4: 5 Year consumer inflation expectation (Source: RBA, 2011: and authors own calculations) Inflation Expectations and CPI 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Jun-1993 Jun-1995 Jun-1997 Jun-1999 Jun-2001 Jun-2003 Jun-2005 Jun-2007 Jun-2009 -1.0 Consumers inflation expectation Consumer price index Figure 9: Inflation Expectations and CPI from 1993 to 2010 (Source: RBA, 2011) 14
  16. 16. Taking a long-term perspective, Finlay and Wende (2011:13) hold that 1-year-ahead inflation expectations aremuch more volatile than 5- and 10-year-ahead expectations and are strongly influenced by current inflation.Longer-term inflation expectations appear to be well-anchored within the 2 to 3 per cent target range.A Macroeconomic ‘Free Lunch’Some authors, such as Truman (2003), have argued that inflation-targeting can reduce inflation withoutnegatively effecting output growth or employment in the real economy, the equivalent of a macroeconomic “freelunch”. Figures 10 and 11 demonstrate that the lower average level of inflation and the decreased volatility havenot come at the expense of slower or more variable output growth. On the contrary, unemployment is lower andoutput variability has decreased.The conclusion that this is a causal relationship must be taken with a grain of salt though. Global economicconditions since 1993 have been quite conducive to economic growth and countries that do not target inflation aspart of their monetary policy have seen similar improvements in economic conditions (Filardo and Genberg,2009). The period also overlaps with the longest resources boom in Australian history. Figure 10 and 11: GDP Growth Rate and Unemployment Rate from 1984 to 2008 (Source: Lim, 2009)5. Not an Inflation-Targeting ‘Nutter’In 1997 the then Chief Economist of the Bank of England, Mervyn King, coined the term, “inflation nutter” to referto the burgeoning number of central banks who appeared to be operating as strict inflation-targeters. The RBA iscertainly not a strict inflation-targeting “nutter”. The combination of being credible and transparent with thepublic strengthens low and stable inflation expectations, while the flexibility the RBA enjoys in hitting its medium-term inflation target, gives considerable ‘room’ in the short-term. The combination of all these attributes permitsthe RBA the capacity to also focus on secondary policy objectives, particularly in the short-term. It should be 15
  17. 17. remembered that the framework affords the RBA the capacity to also focus on secondary policy objectives, butdoes not compel them to do so. However since 1993 there is strong evidence that the RBA has made use of thiscapacity by targeting short-term output and employment gaps, and more controversially asset price bubbles. Figure12: How the RBAs Policy Framework Affords Secondary Policy Objectives Beyond InflationOutput and Employment GapsIf the Reserve Bank Board is in a position to compare two “paths” to the medium-term target, the Pareto-optimal“path”, as far as welfare is concerned, is the one that causes the least amount of volatility to the real economy. Atypical decision might be to “go hard” now against rising inflation or to “go hard” later. Faced with such adecision, the Board may decide to use the short-term Phillips Curve to generate ‘surprise’ inflation in order toachieve the least amount of volatility to output and employment gaps (Debelle, 1995). Or as Bernanke (2004) putsit, “well-anchored inflation expectations may afford the central bank more short-term flexibility to respond toeconomic disturbances that affect output and employment”. Figure13: Inflation and Unemployment Gaps and Non-Zero Official Cash Rate Changes from 1993 to 2007 (Source: Lim, 2009) 16
  18. 18. The evidence since 1993 suggests the RBA frequently has often decided to use this flexibility to target real gaps in the economy. Figure 13 shows all non-zero interest rates changes against the inflation and employed gap, with black representing positive movements and the white for negative ones. A simple interpretation of the policy of strict inflation-targeting should produce positive interest rates changes with positive inflation gaps and vice versa for negative inflation gaps9. In about half the Board’s decisions when inflation was high and unemployment was high they decided to respond to unemployment by cutting rates. A similar pattern of exceptions to strict inflation- targeting can be noticed when interest rate decisions are plotted against the output gap. Asset Price Bubbles A more controversial notion is that the RBA uses monetary policy to combat perceived asset price bubbles. This practice has been likened by Posen (2009) to be a case of, “When the only tool you have is a hammer, it is tempting to treat everything as if it were a nail”. There is strong evidence during 2002-04 that this is exactly what the RBA did. Concerns built throughout 2002 and 2003 that a property bubble was developing in Australia due to the introduction of the first home-buyer grant in 2000 and changes to capital gains exemptions in 1999. In the five years following 1997 housing prices doubled, increasing by 40 per cent over 2002 and 2003 alone (Bloxham et al, 2010: 2). In response the RBA during 2002 to 2004 ‘chased the bubble’ by tightening interest rates. This occurred in contrast to increasing interest rates in every other developed economy, and most large developing economies during the same period. Figure14: Average Nominal House Prices, Australia and the United States (Source: ABS, Datastream)9 This analysis only considers the inflation gap at the time of the interest rate decision, and does not assess projected inflation,which would be a more appropriate form of analysis. For example, while a current inflation gap might be positive, the trend mightbe receding with projected inflation expected to be on or below target. In this case an interest rate reduction might be warranted tomaintain the inflation target. 17
  19. 19. As an additional tool the RBA implemented a campaign of ‘open mouth operations’ in an attempt dampen the property market, involving repeatedly explanating that monetary policy was actively being used to combat “overheating in the property market”10. The most elucidating comment by Governor Stevens that the RBA believed in actively targeting the property bubble was, “… a case might be made, on rare occasions, to adopt a policy of ‘least regret’ so far as asset prices are concerned, if financial and macroeconomic stability were thought to be at risk” (Stevens, 2003). The use of monetary policy was remarkably successful in completely halting the growth of the bubble (see Figure 14), however it is unknown as to what cost to the real economy these interest rate rises came. An interesting ex post comparison can be made with the United States, where loose monetary policy is blamed by some for fuelling the property boom that culminated in the sub-prime mortgage crisis of 2007 (Taylor, 2009). Now many commentators believe Australia is in the midst of another housing bubble, with The Economist (2010) concluding that housing prices are currently on average 63 per cent over-valued. 6. Concluding Remarks The pioneering and flexible inflation-targeting of the RBA can be regarded, so far, as a success. However two notes of moderation must be trumpeted before we herald the end of Australian monetary history. Firstly, the onset of inflation-targeting in Australia has also coincided with the longest commodity boom in Australian history. As a result attributing the gains in the real economy during this period to the new monetary framework is problematic. However the fact that the framework has largely caged Australia’s decades of post-war inflation is not too much of a stretch to suggest. Secondly, the flexibility of the target itself has permitted subsequent Governors to rhetorically get away with a fuzzier version of what actually counts as success, compared with stricter frameworks. The design of an inflation-targeting framework that focuses on maintaining the triumvirate of credibility, transparency and flexibility is a pragmatic way of conducting monetary policy that allows the RBA not to fall into a monofocal obsession with simply the monetary phenomenon of inflation. Transparency is a relatively easy reform to introduce, one the RBA has achieved through publishing comprehensive volumes of timely explanations of its use of the cash rate instrument and forecasts of future inflation and other economic indicators. Credibility is considerably harder and involves gaining the private sector’s trust that the economy will, more or less, hit the inflation-target. While inflation expectations did get out hand in the period just prior to the Global Financial Crisis, overall10 th For example on 8 May 2002 a RBA media release stated, “To persist with a strongly expansionary policy setting … could fuelother imbalances such as the current overheating in the housing market, potentially jeopardising the economy’s continuedexpansion”. The quarterly Statement on Monetary Policy in February 2003 reaffirmed to risk of the asset price bubble, “… therun-up in housing prices and associated expansion in housing related debt were a source of concern for most of the past year,given the potential of such a process to remain disconnected from fundamentals and develop into a significant imbalance overtime.” 18
  20. 20. expectations have generally sat nicely around the top of the target band since 1993. The younger generations ofAustralians appear no longer afflicted by Steven’s (2003: 18) “inflation psychology”.Flexibility is the final ingredient that possibly makes the RBA’s framework attractive as a model for other countriesconsidering reforming monetary policy to emulate. Target flexibility may permit a prudent Reserve Bank Board tooutperform stricter frameworks by also smoothing the volatility felt by the real economy en route to the inflationtarget. The policy flexibility the RBA enjoys and its considerable instrument independence is also balanced by a highdegree of accountability to the nation’s democratic government. However this fact may also conceal its greatestweakness, given that the current institutional arrangement does not protect the RBA’s independence from capturefrom a more domineering future Government. 19
  21. 21. 7. BibliographyArnone, M., Laurens, B. J. and Segalotto., J.F. (2006). "The Measurement of Central Bank Autonomy: Survey of Models, Indicators, and Empirical Evidence“. IMF Working Paper No. 06/227.Battellino, R. and M. Plumb (2009). “A Generation of an Internationalised Australian Dollar”. Address to BIS/Bank of Korea Seminar on Currency Internationalisation, Seoul. Retrieved from: http://www.bis.org/ .Bell, S. (2004). Australia’s Money Mandarins: The Reserve Bank and the Politics of Money. Cambridge: Cambridge University Press.Bernanke, B. (2004). “Central Bank Talk and Monetary Policy”. Retrieved from: http://www.federalreserve.gov/boarddocs/speeches/2004/200410072/default.htm/ .Bloxham, P., Kent, C. and Robson, M. (2010). “Asset Prices, Credit Growth, and Monetary and Other Policies: An Australian Case Study”. Reserve Bank of Australia Research Discussion Paper 2010-06.Bofinger, P. (2001). Monetary Policy: Goals, Institutions, Strategies, and Instruments. Oxford, Oxford University Press.Brischetto, A. and Richards, A. (2006). The Performance of Trimmed Mean Measures of Underlying Inflation. RBA Research Discussion Paper, December 2006. Retrieved at: http://www.rba.gov.au/ .Coleman, W. (2004). “How the Bank Got Its Groove Back”. Retrieved from: http://epress.anu.edu.au/.Cukierman, A. (1992). Central Bank Strategies, Credibility, and Independence: Theory and Evidence. Cambridge, MA: MIT Press.Economist, The (2010, Oct 10). “Global House Prices: Floor to Ceiling”. Retrieved from: http://www.economist.com/.Edey, M. (2005). “An Australian Perspective on Inflation-targeting, Communication and Transparency”. BIS Paper 31, Monetary policy in Asia: approaches and implementation: 3-24.Federal Open Market Committee (FOMC) (1996). “Meeting of the Federal Open Market Committee, 2-3, 1996”. Retrieved from: http://www.federalreserve.gov/.Filardo, A. and Genberg, H. (2009). Targeting Inflation in Asia and the Pacific: lessons from the recent past. BIS Working Paper 52. 20
  22. 22. Finlay, R. and Wende, S. (2011). “Estimating Inflation Expectations with a Limited Number of Inflation-indexed Bonds”. RBA Research Discussion Paper 2011-01.Fracasso, A., Genberg, H., and Wyplosz, C. (2003). “How do Central Banks Write? An Evaluation of Inflation-targeting Central Banks”. Geneva Reports on the World Economy Special Report 2.Fraser, B. (1994). “Central Bank Independence: What Does It Mean?” Reserve Bank of Australia Bulletin December 1994: 1-8.Henry, K. (2003). “Australia and the international financial architecture — 60 years on”. Retrieved from: http://www.treasury.gov.au/.Ho, C. (2009). Implementing monetary policy in the 2000s: operating procedures in Asia and beyond. BIS Working Paper 253.Lim, G.C. (2009). “Inflation-targeting”. Australian Economic Review, vol. 42(1): 110–118.Posen, A. S. (2009). “Finding the Right Tool for Dealing with Asset Price Booms”. Speech to the MPR Monetary Policy and the Economy Conference, London. Retrieved from: http://www.iie.com/publications/papers/posen1209.pdf .Rasche, R.H. and Thornton, D.L. (2006). “Greenspan’s Unconventional View of the Long-Run Inflation/Output Trade-off. Monetary Trends”. Monetary Trends. Retrieved at: http://research.stlouisfed.org .Reserve Bank of Australia (RBA) (1996). Statement on the Conduct of Monetary Policy. Retrieved from: http://www.rba.gov.au/monetary-policy/framework/stmt-conduct-mp-1-14081996.html . (2011). “About Monetary Policy”. Retrieved from: http://www.rba.gov.au/monetary- policy/about.htmlRichards, A. and Rosewall, T. (2010). “Measuring Underlying Inflation”. In: RBA Statement on Monetary Policy March 2010. Retrieved at: http://www.rba.gov.au/ .Sousa, P. (2002). Central Bank Independence and Democratic Accountability. Portucalense University, Mimeo.Stevens, G. (2003). “Inflation-targeting: A Decade of Australian Experience”. Reserve Bank of Australia Bulletin April 2003.Stevens, G. and Debelle, G. (1995). “Monetary Policy Goals for Inflation in Australia”. In A.G. Haldane (ed.), Targeting Inflation: 81-100. London: Bank of England. 21
  23. 23. Taylor, J. B. (2009). “The financial crisis and the policy responses: An empirical analysis of what went wrong”. NBER Working Paper 14631.Truman, E. (2003). Inflation-targeting in the World Economy. Washington, DC: Institute of International Economics. 22

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