CAN MONETARY POLICY BE MADE
TO WORK IN THE NEW ECONOMY?
"SPEED LIMITS TO GROWTH:
Interest Rate Adjustments and the
Management of the Economy"
Economic Society of Australia, Canberra Branch Forum
Telstra Theatre, Australian War Memorial, 31 May 2000.m
by Des Moore
I am most grateful to Mr Saul Eslake, Chief Economist, ANZ Bank for comments and suggestions on an earlier draft of this paper. He should not be held responsible for any of the views herein.
This forum takes me back to the conference I organized at the Institute of Public Affairs in December 1991 under the title of Can Monetary Policy be Made to Work? Amongst the distinguished participants were New Zealand Reserve Bank Governor Don Brash and two who are presenting papers today, namely Professor Ian Harper and Mr Glenn Stevens. I thought it would be useful to start today by looking back to the uncertainties of 1991.
It is east to forget that, by December of that year, unemployment was still over 10 per cent and rising, while inflation had already fallen below 2 per cent (from 7 per cent a year earlier) and the CAD to around 3 per cent of GDP. The then Opposition had nonetheless bravely proposed that monetary policy should have a medium term objective of price stability, defined as an inflation rate of 0-2 per cent, but the then Governor of the Reserve Bank had suggested that such an inflation target could have adverse effects on the real economy. New Zealand, however, had recently adopted such a target though with exogenous price shocks explicitly excluded.
There was naturally considerable discussion of possible lessons from the 1980s. My own paper questioned the (then) recently published analysis by Assistant Governor Macfarlane that had appeared to suggest that the 20 per cent annual growth in credit between end 1983 and mid 1989, and the accompanying average inflation rate of 7 per cent per annum, could only have been prevented at the expense of "the overall macro-economic interests of the country". I argued that the reduction in Australia's inflation rate to around the OECD average of 4-5 per cent in 1984-85 could at least have been sustained if the Government had not, in effect, forced the Reserve Bank to accept an inflation rate that was effectively determined by wage levels agreed under the Accords with the union movement that sought to push the growth rate above the OECD average.
Interestingly, Governor Brash pointed out that an important benefit of his country's new policy had been illustrated when the head of the NZ Council of Trade Unions reacted that, while unions were totally opposed to the new monetary arrangements, they accepted they had no alternative but to gear wage settlements to those arrangements because unemployment would otherwise increase.
The New Zealand approach of having a (more) independent central bank with the sole objective of medium term price stability was favoured by most participants in 1991, although some thought Currency Boards might be better. Nobody objected to Governor Brash's statement that the experience of the 1980s indicated that the limitations on forecasting abilities, "including on our ability to forecast the power and speed of the effects of monetary policy", ruled out using monetary policy to dampen swings in the business cycle. However, while there was also agreement that monetary policy should not target the external account, Australia's CAD was seen as an on-going problem that could require monetary policy action to prevent external "crises".
Although a 0-2 per cent CPI target was favoured, there was no consensus on that. Some suggested greater regard to trends in asset prices but Glenn Stevens observed that "no-one can pin down how you use these things as indicators or even objectives of monetary policy". Nor was there any consensus on what mechanisms should be used to maintain price stability or on what departures from target might be allowed.
Fast forward from 1991 to the present and we find Australia also has a written agreement between the central bank and Treasurer which refers to the objective of maintaining full employment but emphasises the importance of price stability in achieving that. Interestingly, the objective of "keeping underlying inflation between 2 and 3 per cent, on average, over the cycle" (Statement on the Conduct of Monetary Policy, 14 August 1996) is stated as having been "adopted" by the Reserve Bank rather than agreed. This arrangement, which appears to have bipartisan support, gives the Reserve Bank more freedom than its counterpart in New Zealand, where (inter alia) the Government determines both the target and the extent to which deviations are acceptable.
Our Bank has indicated that, because of the time lag of 12 -18 months between changes in interest rates and activity, it adopts a pre-emptive approach in operating policy. This appears to mean that it changes policy when its forecasts indicate that inflation will otherwise exceed the target or fall below it. However, according to the Governor's statement to the Parliamentary Committee on Economics, Finance and Public Administration (EFPA) in December 1999, the Bank does not worry about small variations in inflation for short periods, viz "to trigger a change in policy would require a forecast which had inflation going clearly above 3 per cent or below 2 per cent and likely to stay there for a while". Moreover, by excluding the one-off price effects from the GST the Bank has highlighted that the focus of policy is on "underlying" inflation, which presumably means that the Bank will only take monetary action if there are second round effects from such one-offs.
How Fast Can We Grow Without Inflation?
As I have said elsewhere, we are lucky that the main argument today is not about how to get inflation down, but how to maintain medium term price stability without adversely impinging on growth. However, the question of what is sustainable growth raises issues that are relevant to both the implementation of policy and the interpretation of the target.
At the outset, I make it clear that, having spent a good deal of my time in the 1980s, first from within Treasury and then from outside it, pressing the Government and the Reserve Bank to take effective action to reduce inflation, I am not now about to urge a more "accommodative" approach to it. True, economic research still finds difficulty in proving substantial benefits from low inflation. But I take it as read that there is no longer any substantive argument that policy should seek to achieve trade-offs between inflation and unemployment. Further, while in 1991 Assistant Governor Macfarlane warned us to be careful not to continue to fight the last war against inflation, it would be wrong to assume that the inflation dragon is dead.
At the same time, however, it needs to be recognised that monetary policy is being conducted in a very different environment to the 1980s.
First, apart from a short "blip" in the mid 1990s that clearly required a tightening in policy, we have now experienced nearly nine years of below 3 per cent inflation accompanied by economic growth that has been consistently well above trend even in 1996-97 after the tightening. Significantly, the tightening produced the right reaction in inflation, possibly an over-reaction. Of course, unemployment has remained at relatively high levels, but the labour market is subject to many other influences. In short, while it would be foolish to declare victory, we now have some runs on the board in terms of keeping inflation down and some expectation, even with the GST, that that will be sustained.
Second, Treasury suggests in this year's Budget paper No 2 that productivity-enhancing reforms have lifted the trend rate of growth to 3.5 to 4 per cent per annum and "we have the prospect of sustained strong economic and employment growth which will lead to further inroads into unemployment". Unfortunately, this conclusion has not been supported by any detailed analysis and it would be highly desirable to have the back-up work published, if only to satisfy those of us who have been supporting reforms. It is also a little puzzling that the forward estimates use growth "projections" of 3.5 rather than 3.75 per cent. Does this simply reflect natural (and desirable) conservatism in constructing forward estimates or does it indicate some concern that the higher growth of recent years may partly reflect one-offs?
Some will say that uncertainty about the capacity to sustain higher growth without inflation emphasises the need to adopt a risk averse approach in operating monetary policy and that this is becoming increasingly important as unemployment comes down and we approach the NAIRU. However, nobody knows where the NAIRU is and estimates based on past experience are probably now of little value. It was particularly pleasing to hear Governor Macfarlane saying to EFPA on 22 May that the Bank puts no reliance on NAIRU estimates in making monetary policy decisions and it is well known that Chairman Greenspan adopts a similar attitude. Greenspan is reputed to put as much weight on the proportion of the work force that says it would like to work but is not actually in the labour force, as he does on the proportion unemployed. Of course, the US labour market is much more flexible. Even so, we cannot overlook that Australia's potential additional labour supply includes over one million not in the labour force but wanting to work, as well as about 650,000 unemployed.
A further important question that I would like to raise is whether, even if our medieval labour market institutions mean that we cannot reduce unemployment much further, we may still be able to sustain a higher rate of growth without exceeding the inflation target. There is no doubt that we now have a much more competitive economy and that this is limiting the scope for businesses to automatically pass on cost increases - and indeed for cost increases themselves to occur. I would particularly emphasise the importance in this regard of the effective transfer of responsibility for determining cost inflation from the union movement and the AIRC to the Reserve Bank. In 1997 the then Secretary of the ACTU, Mr Bill Kelty, recognised the significance of this when he accused the Reserve Bank of imposing "a prices and wages system that is more rigorous and more centralised than any we had during the Accord" and, in a debate I had yesterday with Professor Keith Hancock at an Economic Society meeting in Adelaide on labour market deregulation, he acknowledged that the Reserve Bank has made a successful take-over.
Accordingly, while it seems too early to be confident about any new trend rate of growth, there can be little doubt that there is enhanced potential for achieving higher growth on a sustainable basis. Indeed, given Australia's mediocre historical growth performance when properly measured in GDP per head adjusted for purchasing power parity, and the consequent scope for catch-up to US levels, it is not beyond the realms of possibility that Treasury has understated the potential improvement.
To my mind the key question now is - where should we strike the balance of risks in regard to inflation and growth? The experience of recent years, combined with the benefits from reforms, suggests that we should now be more prepared to test the limits to growth and to risk the possibility of higher inflation. By that, I do not mean that we should deliberately set out to push inflation above the target but, rather, that we should be more prepared to risk that happening and, if it does, we should not necessarily take monetary action.
The Target and its Interpretation
It is relevant that the monetary goal is stated as "medium-term" price stability and the underlying rate of 2-3 per cent is to be achieved on average over the cycle. My reaction to this is, at first blush, contradictory.
On the one hand, I believe that Australia would be seen to have a more credible anti-inflation posture if it abandoned the present target and opted for a straight 2-3 per cent one. It is in fact already evident that the Bank operates monetary policy on the basis of trying to keep inflation below 3 per cent and it would be far better to establish that definitively.
On the other hand, I also favour a flexible approach to allowing inflation to exceed 2-3 per cent without necessarily taking monetary action. The Bank will doubtless argue that, by allowing this to occur for 5 consecutive quarters in 1995-96, and by allowing growth of over 4 per cent per annum for a considerable period without tightening policy, they have been adopting a flexible approach that has tested the limits to growth. However, more recently the Bank seems to have got itself tied in knots over what to do if the rate goes above 3 per cent.
For example, in the Governor's opening statement to EFPA in December 1999 he initially indicated that, when "inflation is where we want it", there is "no need for policy action" unless it is forecast to go "clearly above 3 per cent or below 2 per cent and likely to stay there for a while". A little later in the statement he emphasised the importance of pre-emptive action and stated "to argue … that we should not act until our inflation forecast clearly exceeded 3 per cent would be to argue for a very stop-go monetary policy" (my emphasis).
There appears to be a contradiction between these two statements that serves to raise the question of how far the Bank is prepared to risk inflation going over 3 per cent. In particular, what would be judged to be "clearly above 3 per cent" and what would constitute staying there "for a while"?
This leads to a further question as to the circumstances in which pre-emptive action should be taken and the related question of the calculation of the underlying inflation rate.
Given the lags before monetary action takes effect, there is a strong theoretical case for taking pre-emptive action. However, the problem is - how to forecast inflation reasonably accurately twelve to eighteen months ahead? The Bank is so confident about its forecasts of underlying inflation that it does not publish any, which seems quite surprising given their apparent importance. The best it has come up with in the latest Semi Annual statement is that underlying inflation is expected to be around 2.5 per cent in mid 2000; and, assuming no second round effects from the GST, it is "projected" to be between 2 and 3 per cent, "though possibly towards the higher end of that range", in the second half of 2001. When he was asked at the most recent EFPA if this meant that, as inflation was projected to remain within target, we could expect no interest rate increases, the Governor rather remarkably described the question as "cheeky"!
The hazards of forecasts and the extent to which they should not be relied upon were well described by Glenn Stevens in his paper to the Economic Society's Victorian Branch Forecasting Conference (see Economic Forecasting and its Role in Making Monetary Policy, in Reserve Bank Bulletin, September 1999). It is difficult not to agree with his conclusion that "forecasts are not, and cannot be, simply accepted at face value by policy-makers. Instead, the policy-makers must be informed by the forecasts, by the discussion of risks around the forecasts and of the forces the forecasters see at work in producing them".
However, if we are to have a pre-emptive policy, the Bank surely has a responsibility to regularly publish some forecast of underlying inflation for, say, two years ahead and revise that whenever it takes monetary action. The Governor's statement at the December 1999 EFPA reinforces the need for such forecasts, which are offered by the RBNZ. How else can we be confident that, when the Bank takes monetary action, its inflation forecast is (in the Governor's words) "clearly above 3 per cent or below 2 per cent and likely to stay there for a while". The uncertainties could be covered by publishing a range.
It is relevant that Glenn Stevens pointed out in his forecasting paper that, while forecasts of US growth made in recent years have turned out to be much too low, forecasts of inflation have generally been close to the mark. The clear implication is that the US economy has been able to grow faster without inducing the higher inflation that would have been forecast if the faster growth had been forecast! Fortunately, Alan Greenspan has presumably been adopting the same approach as Glenn did in his conclusion!
The general idea of focussing on the underlying rate is that policy should not change because prices increase (or decrease) as a result of "one-off" events (such as the GST), events that do not reflect what has been happening in the domestic economy (such as petrol price changes) or because they are affected by temporary factors (such as seasonal fluctuations in fruit and vegetable prices). This approach seems appropriate. But is it clear as to what should be excluded in calculating the underlying rate?
Of course, there is widespread agreement that the first round net increase in prices from the introduction of the GST is a one-off that should not lead to a change in monetary policy. The Governor has confirmed that at the two recent meeting of EFPA, adding that the price effects on wage earners will be more than offset by income tax cuts. However, if wage earners were to obtain wage increases to also compensate for GST induced price increases, that would then almost certainly flow-on into higher ongoing inflation. Given that inflation would inevitably rise above the target, the Governor has also confirmed that the Bank would then have to increase interest rates.
However, while the GST situation may be reasonably clear, at least in principle, we do not know what the Bank is using to calculate the underlying rate. In practice, it seems to have taken complete discretion to itself in deciding whether and how to discount the headline rate, but without publishing any guide to its thinking. There is a question as to whether the Bank or the Government should exercise this discretion, and whether the calculation of the underlying rate should be undertaken by a body independent from the Bank, such as the ABS.
To illustrate the issue, it is worth spending some time considering a potential topical problem, viz whether any first round price increases resulting from exchange rate depreciations (or appreciations) should be excluded in calculating the underlying rate. This issue is also relevant to the question of whether the Bank should attempt to "defend" the $A by raising interest rates and the extent to which Australia can operate an "independent" monetary policy ie do we have to follow the US?
In the past, the Bank has indicated that, apart from intervention in the foreign exchange market when it has judged those markets have become "disorderly," it does not target the exchange rate and, hence, does not try to influence it by changing monetary policy; and that movements in the exchange rate are primarily relevant to their potential influence on inflation ie the implication is that, if the inflationary effects of a depreciation were to push inflation above the target range, then the Bank would have to tighten monetary policy.
While the statement of 3 May announcing the increase in cash rates caused some confusion as to whether or not the exchange rate is being targeted, the Governor made it clear at the recent EFPA that it is not doing so and that Australia has the capacity to operate an independent monetary policy. Unlike in the 1980s, we ought to be to do so now because we are pursuing a monetary policy that is clearly aiming to keep inflation under control and a budgetary policy that is at least seeking to balance the budget over the cycle. In short, so long as macro-policies are in order we should not become concerned at the size of the CAD. While this does not rule out intervention in foreign exchange markets when trading becomes "disorderly", the Bank should not raise interest rates to "defend" the $A and it appears to accept that.
But there is a further question relevant to the potential inflationary effects of depreciations and the monetary policy implications. The Bank's Semi-Annual statement suggests that, with the latest depreciation, the "pass through into consumer prices could be stronger than it was in 1997 and 1998 when more competitive conditions, both domestically and internationally, contained price rises which would otherwise have flowed from a weak exchange rate." This is probably correct.
But what if it is stronger? And has that possibility already been taken into account in the Bank's "projections" of inflation? If so, how much has been allowed? And how is the eventual effect (if there is such a thing) going to be calculated? There are important questions on which we should have some guidance.
Such questions are relevant to the issue of the extent to which the latest depreciation should be regarded as a one-off. The first round inflation effects from increased import prices flowing from the recent $A depreciation are one-offs comparable to the GST - from one perspective all depreciations are a tax - but levied by foreigners! Further, on this occasion the depreciation is basically unrelated to developments in demand in the domestic economy and, prima facie, does not therefore suggest any need to adjust macro settings.
The depreciation is also a one-off in the sense that there is no reason to suppose any further substantial fall, given that the real effective exchange rate is below its long-term average. Whether it is a "permanent" structural change remains to be seen, but it is far from impossible that the recent depreciation could be substantially reversed over the next 18 months if the world economy strengthens as forecast.
In short, even if the latest depreciation causes inflation to move "clearly" above 3 per cent "for a while", there is a case for not taking pre-emptive action and waiting to see if the increase in prices is modified either by natural competitive forces responding to higher import prices through substitution of domestic goods at lower prices or by a reversal of the depreciation. If the depreciation is not reversed, the first round increase in prices can be regarded as sending appropriate restructuring signals and the policy reaction should depend on whether it appears likely to lead to an increase in the rate of ongoing inflation, as distinct from the level.
My concern is that in the operation of monetary policy, in what is clearly a very different economy than the 1980s, we do not weight the balance of risks against growth. The changes in the economy over recent years, particularly in regard to improved competitiveness and greatly reduced capacity for cost inflation, are conducive to sustaining high growth and low inflation.
At the same time, it is both desirable and appropriate for monetary policy to continue to target price stability over the medium term. However, it would be preferable to change the target to 2-3 per cent, without the averaging proviso but with an accompanying requirement that any policy action to keep inflation within the target, or bring it back within target (from either direction), would be accompanied by a published assessment by the Bank showing why there has been, or is going to be, a permanent departure that will not be self-correcting.
Further, given that changes in monetary policy take effect with a 12-18 months lag, the Bank should be required to publish a regular forecast on underlying inflation two years ahead and the revision to that whenever policy action is taken should form part of permanent departure assessment.
Finally, as a separate but related exercise, the Bank should publish a detailed assessment of how it interprets underlying inflation, including an examination of the factors that should be taken into account in calculating underlying inflation, and the circumstances in which such factors should be regarded as one-offs. Particular regard should be paid to exogenous shocks such as major changes in the terms of trade and changes in the exchange rate that are externally driven.