What does the RBA do when the economic facts change?


Stephen Miller

There is a quote that is popularly attributed to John Maynard Keynes that goes “when the facts change, I change my mind. What do you do sir?”.

Regardless of whether Keynes stated the above or not (some attribute it to that other quote magnet, Winston Churchill), it may well be a sentiment that the RBA Governor and Board heed when they meet tomorrow.

In so doing they will be acknowledging not only have they underestimated inflation but also its persistence. The same is true for nearly every other developed-country central bank. Perhaps it should also be acknowledged that there is no shame in this. It is not for nothing that economics is known as the “dismal science”. In economics the “facts” do change. While it is important to understand the nature and cause of the “fact” change, for policymakers it is most important to recast and recalibrate policy settings in the light of those new “facts”.

So, to invoke yet another quote magnet in V.I. Lenin: “what is to be done?”

First, the RBA should acknowledge that it will jettison what it has described as “emergency” monetary policy settings and that it should have contemplated that action earlier and perhaps should have thought about and communicated the circumstances where it would have done so. More persistent inflation has been visible for some time globally, while domestically, high vaccination rates and the end of lockdowns mean that the case for emergency settings was rapidly and clearly diminishing, particularly given the mounting costs of those settings in terms of inflating financial and real estate assets and the resultant financial stability concerns, not to mention the exacerbation of wealth inequality.

What the forgoing means in terms of any announcement tomorrow is:

  • walking back – or explicitly abandoning – the “central scenario” that the condition for a policy rate increase “will not be met before 2024”
  • confirming (even if it is somewhat perfunctory) the scrapping of the current yield-curve-control target of 0.10 per cent on the April 2024 bond
  • revisiting the pace of tapering so that the process effectively runs its course at some stage in the first half of 2022.

These developments are, however, of a more tactical nature.

There is in my mind a bigger strategic question and that is the utility of a move to ‘outcomes-based forward guidance’ (OBFG).

In essence, OBFG means that rather than be satisfied with a forecast that inflation will rise above a target (2-3 per cent in the RBA’s case), the central bank will await an outcome that they believe indicates persistent inflation above that target. Nor does the ‘outcome’ need to be inflation-based: it can be multi-pronged to encompass wage growth and / or employment objectives. The RBA has posited wage growth consistent with full employment (3 per cent wage growth with an unemployment rate around 4 per cent).

The problem is that OBFG is also potentially inflexible. It might unnecessarily constrain the central bank. For one thing it might mean the central bank only acts when the inflation genie is effectively out of the bottle. The pandemic induced supply shocks are coinciding with the reversal of structural trends that account for the deflationary tendency of the past three decades: viz; globalisation of labour supply (as well as that for goods and services) and baby boomer workforce participation. Add into that mix the secular rise in female workforce participation, and the result was a massive global labour supply shock and a decline in wage growth and a structural deflationary trend. That is ending. A move to OBFG might be a case of ‘fighting the last war’.

For another, the various ‘outcomes’ might be incompatible. For example, unemployment may remain relatively high because of geographic or skill mismatches. Keeping the monetary ‘pedal to the metal’ in these circumstances simply promotes inflation without any benefit to the unemployment rate. Put simply monetary policy can’t do much about structural rigidities that lead to unemployment. That is the bailiwick of structural or ‘supply-side’ policies. As the Bank of England Governor, Andrew Bailey recently commented “monetary policy can’t create more truck drivers”. What he didn’t say was that excessively accommodating monetary policy can make “transitory” supply-side inflation more persistent.

This is the lesson from the 1970s. Back then, by accommodating supply shocks, monetary policy ratcheted up inflation expectations putting pressure on limited supply leading to persistent inflation and a weakening economy. Little attention was given to structural approaches including, inter alia, assessments of the benefits of public and private infrastructure investments in physical and human capital.

The upshot for the RBA is that not only do the tactics need to change in the wake of new facts but that a holistic review of monetary policy strategy, including how it complements other arms of policy, may be required.

One that recognises that “facts” can and will change again and that monetary policy strategy needs the requisite flexibility to change when that occurs.

Keynes and Churchill would approve. Lenin might not.

By Stephen Miller, Investment Strategist

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