The mountain has laboured and brought forth a mouse. After a lengthy process, the review of the Reserve Bank of Australia has produced a report saying that our existing monetary policy framework represents the best of all possible worlds. The only significant change proposed is to bring the RBA into line with other central banks by establishing a specialist committee to set the cash rate.
The central conclusion, shared by other central bankers around the world, is that there is no need to change the system of inflation targeting or even to adjust the targeted range of 2-3%. The global failure of inflation targeting to reach its stated goals, or to make the global financial system work properly, has been ignored.
Although it seems to many as if inflation targeting has always been the basis of monetary policy, the system is only 30 years old. And the rationale for the target range is an accident of history, rather than the result of an analysis of costs and benefits. As Australia and other countries emerged from the recessions of the 1980s, inflation rates fell to around 2%. The target range was adopted with the aim of locking in the hard-won reduction in inflation.
But the inflation-targeting system promised more than that. The claim was that low and stable inflation would yield an end to the financial chaos of the 1970s and 1980s and ensure stable growth and low unemployment. By the early 2000s, central bankers were proclaiming a “great moderation” in which deregulated financial markets and independent central banks would put an end to the cycle of boom and bust.
But as some analysts (notably including future RBA governor Philip Lowe, and, less notably, myself) had warned, low and stable inflation came with the risk of asset price bubbles. These predictions came to pass with the global financial crisis, which saw the financial system come to the edge of collapse.
The primary response to the GFC in Australia and elsewhere was massive fiscal stimulus. The power of conventional monetary policy was quickly exhausted as central bank interest rates in most countries were cut to zero. Instead monetary policy relied on direct purchases of government bonds and other securities. This wasn’t a new policy: in the 1970s and 1980s it went under the name “open market operations”. But as an emergency exception to reliance on interest rate adjustments, the policy has been referred to as “quantitative easing”.
After the GFC, central banks made strenuous attempts to restore pre-crisis “normality”. In most countries, austerity policies aimed at reversing fiscal expansion produced long and deep recessions. Interest rates remained at the zero lower bound. Occasional attempts at raising rates were quickly reversed.
Australia did less badly than most, thanks to the rejection of austerity (notably with the failure of Tony Abbott’s 2014 budget). But inflation remained stubbornly below the 2-3% target range. As a result, the RBA cash rate fell consistently from 2010 onwards, reaching 0.75% just before the onset of the pandemic.
The result was that, when the pandemic hit, there was virtually no room left for interest cuts to stimulate the economy. As in the GFC, the burden was taken by fiscal policy and open market operations.
Given the buildup of household cash balances during lockdowns and impact of global supply shocks, an upsurge in inflation was inevitable. It is not the fact of rising prices but the failure of wages to keep up that has turned this episode into a “cost of living” crisis.
But rather than allow the resulting price increases to work their way through the system and maintain the real purchasing power of wages, the RBA has once again sought to restore the discredited 2-3% inflation target.
How should we run macroeconomic policy if not through inflation targeting? First, we need a target that takes account of real income growth as well as changes in prices. As part of this, we need to accept that the arbitrary choice of a 2-3% inflation target is no longer appropriate and accept an average rate of 4% or so.
Finally, we need to abandon the idea of an all-wise central bank keeping spendthrift governments in check. Monetary and fiscal policy should work together as happened during the GFC and pandemic emergencies and as was the norm before the shift to strong forms of central bank independence in the 1990s.
