Jun 29, 2020

Stephen Kirchner on Australian Monetary Policy in the Wake of the Great Recession

Australia has been consistently undershooting its inflation target, and this may be cause for a new monetary framework.
David Beckworth Senior Research Fellow , Stephen Kirchner

Hosted by David Beckworth of the Mercatus Center, Macro Musings is a new podcast which pulls back the curtain on the important macroeconomic issues of the past, present, and future.

Stephen Kirchner is a program director for trade and investment at the United States Center at the University of Sydney, and he was written widely on financial markets and economy policy in Australia. Stephen joins Macro Musings to talk about the journey of monetary policy in Australia that has transpired throughout the last few decades. Specifically, David and Stephen discuss the structure of the Reserve Bank of the Australia, the history of its inflation target, how Australia was able to avoid the worst of the Great Recession, and the actions they have taken to in response to the COVID crisis.

Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

David Beckworth:  Stephen, welcome to the show.

Stephen Kirchner: Thanks for having me, David.

Beckworth:  Well, it's great to have you on. We've interacted online a lot. And you, yourself, have written on nominal GDP targeting, and you have a lot of interesting work. We're going to cover some of that today. We're going to spend our time thinking about, and trying to grapple with what Australia has done that has led to such an amazing journey over these past few decades. Now, Australia, like most countries, has succumbed to the COVID-19 shock. And I believe this is the first recession in a number of years. Is that right?

Kirchner: Yes, it will be the first recession really since the early 1990s.

Beckworth:  Yes. So that's an amazing run. And on top of that, Australia fared the great recession relatively well. Some attribute it to luck, some attribute it to better policy. And we'll come back to that question later. Another fascinating fact about Australia is that it's run current account in deficits for a long, long time as well.

Beckworth:  And you often warn against doing that, yet Australia has fared relatively well. So Australia has a lot of interesting features about it. It's been relatively recession-proof, at least until recently. The central bank, the Reserve Bank of Australia, the RBA has done relatively well as one of the early adopters of inflation targeting. Just a lot of interesting features. And we'll try to get to as much as we can during the show. Before we do that though, Stephen, tell us a little bit about yourself, and what you do there at the University of Sydney.

Kirchner: I was always very interested in the intersection of politics and economics, and studied both as an undergraduate at the Australian National University in the mid to late 1980s. Economics in ANU at the time had a very strong classical orientation. It was sometimes called the Chicago of the south because it had a lot of Chicago-trained or Chicago-influenced economists. The economics faculty there at the time were also very engaged with public policy in various ways, including through think tanks.

Kirchner: And so that was a very strong influence on me. My first class in Economics 1 was with professor Ian Harper is now on the board of the Reserve Bank. The faculty also included people like Geoff Brennan, who was one of James Buchanan's co-authors. So I was fortunate enough to have Geoff for Economics 2. After graduating, I worked as an advisor for two Liberal Party members of the Australian Federal Parliament. The Liberal Party being the main conservative party in Australia, to put that in American terms.

Kirchner: And the Liberal Party took a supply side reform package to the 1993 federal election, in which they lost. But part of that package was a proposal to put the Reserve Bank of Australia on a more independent footing, and to give the bank an inflation target, which was one of the things that got me interested in monetary policy. That proposal was considered hugely controversial at the time, it was strongly opposed by the then-governor of the bank, Bernie Fraser. After the 1993 election, I did a master's degree in economics and subsequently, worked in financial markets with Standard & Poor's Institutional Market Services, and I was based in both Sydney and Singapore.

Kirchner: And a large part of that job was central bank watching. In my case, the RBA, the RBNZ and the BOJ. I subsequently the market scene in 2003 to do a PhD in economics, and since then I've mostly worked in academia and think tanks. Although I also did a three-year stint as the chief economist with the Australian Financial Markets Association, which is the big industry body for market participants. And a large part of that role was dealing with the RBA on various regulatory issues.

Kirchner: So since 2018, I've been at the US Studies Center at the University of Sydney, running the trade and investment program. One of the things we are interested in is the determinants of investment in Australia and the US, and cross-border investment between the two economies. And monetary policy obviously plays a large role in that. So most of my career has touched upon monetary policy from various perspectives.

Beckworth:  Yes. And again, Australia has a rich history and fascinating history. And it was interesting to hear you say that the RBA was initially opposed to the move to inflation targeting in the early '90s because nowadays, it's heralded as one of the early adopters, one of the pioneers. Right? But it's fascinating that it actually got resistance from the central bank itself. So we'll come back to that a little bit later. We'll talk about the history of inflation targeting in Australia. But I want to come back to this point that Australia has been relatively resilient to recessions that the rest of the world has gone through, at least what the US has endured.

Beckworth:  So in 1990s was the last recession that it really endured. It missed the other two that followed, 2001, of course the Great Recession in 2008. And I want to walk through the Great Recession or the Great Financial Crisis of 2007, 2009 and 2008 period there. And give us your account of what happened because there's many stories told. I've told the story that in part, due to monetary policy doing a good job, but there's also a luck story, there's a commodity export story closely tied to China. A lot of moving parts there. So why don't you give us your take on what happened during the Great Recession. Or let me rephrase me that, why wasn't there a Great Recession in Australia that we experienced in the rest of the world during that time?

How Did Australia Largely Avoid the Great Recession?

Kirchner: Yes. You often get the impression offshore, the discussion offshore often goes along the lines of, well, Australia hasn't had a recession since the early 1990s, and so we must have some secret sauce or secret formula as to how we managed to avoid recession. And it's not uncommon for people to attribute that to monetary policy. And I think monetary policy is implicated, although not in the way that many people would think. It's certainly not the case that we've escaped the business cycle.

Kirchner: We still have had very serious downturns in the Australian economy since then. The 2008 crisis did lead to a downturn in Australia. We had a two percentage point increase in the unemployment rate during that episode. What we avoided, of course, was the conventional definition of a recession which is two consecutive quarters of negative growth. And I think policy certainly played a role about monetary and fiscal, in terms of smoothing out the cycle such that we managed to avoid that somewhat arbitrary definition of a recession. But it's certainly the case that we experienced a downturn.

I think monetary policy is implicated, although not in the way that many people would think. It's certainly not the case that we've escaped the business cycle. We still have had very serious downturns in the Australian economy since then.

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Kirchner: I think part of the success of the Australian economy since the early 1990s has been that many of the shocks that have hit the global economy since then have been somewhat tangential to the Australian economy. It used to be the case, up until the early 2000s that the Reserve Bank, for example, would model the Australian economic growth rate in terms of a long-run equilibrium relationship with the United States.

Kirchner: So if the United States turned down, we would turn down as a matter of course. And that relationship really broke down from the early 2000s, particularly with the 2001 recession. And I think that was partly the Australian economy was not that exposed to the ICT goods producing sector in the way that the US was. So we are a net consumer and importer of ICT, rather than a net producer.

Beckworth:  When you say ICT, you mean information and communication technology? Okay.

Kirchner: Yeah. Yeah. So the tech sector downturn in the US in 2001 was not something that really impacted the production side of the Australian economy. And certainly, with the crisis in 2008, the Australian financial system really had very little exposure to US mortgage backed securities. It just wasn't a big part of their business models. And so we didn't have the fall-out for the financial system in Australia that we had in the United States. There were some financial institutions that got into trouble in Australia, but we didn't have the wrath that we saw in the US, UK and Europe.

We didn't have the fall-out for the financial system in Australia that we had in the United States. There were some financial institutions that got into trouble in Australia, but we didn't have the wrath that we saw in the US, UK and Europe.

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Kirchner: And of course, that brings us today with the COVID pandemic. Of course, the COVID pandemic is a shock that we just couldn't avoid. And so we will certainly experience a recession in the first half of this year. But in terms of macroeconomic policy and the contribution it made to avoiding a recession over this period, I don't think it's coincidental that we moved in the direction of inflation targeting from the early 1990s.

Kirchner: After the 1993 federal election, the RBA started to target the inflation rate implicitly, and then explicitly from 1996. And so this was the first time that monetary policy in Australia really had a firm nominal anchor. So the RBA decided on a singular objective, and pursued that objective with a singular policy instrument, which was the official cash rate. And I think that focus on inflation really for the first time in the RBA's history certainly meant that monetary policy was conducted in a way that was more stabilizing than it had been before. So I think you can argue that policy contributed in that sense.

Kirchner: I don't think the RBA was doing anything that other central banks weren't doing. So its approach to inflation targeting was pretty conventional, it was not really that different from the approach being adopted in many other economies at the time. And the RBA was looking at this in a broadly new Keynesian Taylor Rule type framework. So I think their thinking about monetary policy was very similar to that of foreign central banks. But when you combine that with a macro environment in which the shocks that the world economy was experiencing, were somewhat tangential to the Australian economy, then I think the combination of those two things was a recipe for a continuous expansion, at least in terms of not having two consecutive quarters of negative growth.

Beckworth:  Let me go back to that period a little bit. So some commentators, I think you're alluding to this, mentioned the commodity prices going up in 2008 is one reason Australia didn't do as bad as the rest of the world. Now, you gave other reasons. It wasn't as exposed to some of these financial derivatives, the run on a shadow banking system didn't hit Australia as hard, or at all, as it did in the US. But the commodity shock story is a double-edged sword. Right? The commodity prices did eventually fall in 2009.

Beckworth:  But that story is often given as the good luck; they just got lucky. And I think if you want to make a luck story... This is a point you raised before, is that Australia went into the recession, into this crisis with comparatively high inflation and nominal GDP growth. So it had more room to cut interest rates. It never hit the zero lower bound. So maybe that's the luck story, is that it just came in with above trend inflation. Is that a fair assessment?

Kirchner: Commodity prices certainly play a role. The way I look at it is, Australia experienced a huge terms of trade boom starting in 2003. And by 2008, the Australian economy was really running red hot. I mean, we had nominal GDP growth at an annual rate in double digits, we had a CPI inflation rate running 5%, the unemployment rate hit 3.9% which was the lowest since the early 1970s.

Kirchner: And so we went into the financial crisis with a huge nominal and real buffer. And in fact, I think in some ways, the financial crisis did the RBA an enormous favor because it was in a situation in 2008 where in the absence of a global shock, the Australian economy was running well above capacity, and inflation was becoming unanchored. Inflation expectations were becoming unanchored as well. So the global shock did some of the RBA's work for it, in terms of putting a brake on what, in many ways, was a runaway economy at that time. So it was just a case of going in the crisis in a hugely strong position, which meant that they had a lot of room to do things in terms of monetary policy.

The global shock did some of the RBA's work for it, in terms of putting a brake on what, in many ways, was a runaway economy at that time. So it was just a case of going in the crisis in a hugely strong position, which meant that they had a lot of room to do things in terms of monetary policy.

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Kirchner: Australia also had a negative net debt position at the time. We were running very large budget surpluses. The Commonwealth government was accumulating assets through a sovereign wealth fund. And so in terms of both monetary and fiscal policy, there was certainly a lot of firepower they could bring to bear, in relation to the crisis. But they were also worried about the fact that the downturn for Australia was really a function of what was happening offshore, it wasn't a matter of the Australian economy having systemic weaknesses.

Beckworth:  Yeah. Well, I just want to highlight though, that Australia may not have been exposed to these mortgage backed securities, CDOs, these financial derivatives, it did have however highly leverage households. I mean, compared to the US, a lot of household debt, high household prices. And one of the standard stories told is that it was the housing sector that really gave rise to the crash in the US economy. And I think Australia provides an interesting counter-example. I mean, again, they got lucky in the sense that they came into the crisis with lots of high nominal income growth, which means they can maintain...

Beckworth:  Nominal income growth is essential to paying those mortgages, meeting your financial obligations, higher inflation... And so to me, again, a takeaway is they didn't hit the zero lower bound, they still had relatively decent nominal income growth through 2009, compared to other places who similarly had lots of household leverage. So household leverage was not a sufficient condition in Australia to generate a severe contraction.

Kirchner: We certainly have had very pronounced cycles in house prices. In many ways, even more pronounced than the US. And this is just a function of a very rigid supply side of the housing market combined with a demand side that can shift very quickly. So demand changes takes a while for a supplier to catch up and... So these are very pronounced cycles. Certainly true. The household sector has been increasing its leverage more or less continuously since deregulation of financial markets in the early 1980s.

Kirchner: And I think in many ways, that the household sector has really just been reaching for a new equilibrium in terms of its balance sheet, so the mix of household debt and assets. You have to remember that before financial deregulation in the 1980s, there was a lot of financial repression in the Australian financial system. So mortgage interest rates, for example, were subject to a price ceiling, we had credit rationing. And so I think, in many ways, households were prevented from borrowing as much as they would have liked. So as those constraints have come off, the household sector has increased its leverage.

Kirchner: But I don't think that leverage has been a problem from a macroeconomic point of view. I think if you look historically at Australia, the two sectors that have gotten into trouble in terms of leverage and over-extending themselves have been either the corporate sector or the government sector. The household sector has not really been a source of macroeconomic stability in Australia, historically. So in the late 1980s, for example, the corporate sector over-extended in terms of leverage, particularly in relation to commercial property.

I don't think that leverage has been a problem from a macroeconomic point of view. I think if you look historically at Australia, the two sectors that have gotten into trouble in terms of leverage and over-extending themselves have been either the corporate sector or the government sector.

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Kirchner: The government sector has over-extended itself in terms of running large budget deficits at various times in its history. But by comparison, I'd say the household sector has been fairly prudent. Now as the household debt to income ratio has increased, policymakers in Australia have become increasingly concerned with whether the sector's taking on too much leverage. And that has seen financial stability concerns get a little bit larger in terms of both monetary policy and prudential policy. But it's hard to say to what extent this is a problem. Certainly, even within the RBA, they debate the question of whether or not this is an equilibrium phenomenon.

Kirchner: So if equilibrium interest rates are falling, we're doing less financial repression than we did historically, maybe this is an equilibrium phenomenon which policy should accommodate. But they're also wary of some of the dangers of an over-leveraged household sector. I think part of this recently has just been fighting the last war, that they're very conscious of what happened in the US and don't want to repeat that experience here. But I think part of what happened in the US was just a very fragmented regulatory system, a lot of things fell between the regulatory cracks, which has not happened so much in Australia because we have a more unified and coherent system of financial regulation.

Beckworth:  But going back to your point about housing, there was some correction in 2008 you noted, but it didn't lead to the massive contraction we had in the US. In other words, both economies had highly leveraged households, both economies had cities with really roaring housing prices, rapid growth. Both economies had a correction in housing, but only one experienced a Great Recession. Right? And so I guess, one of the takeaways I get out of Australia is that housing, highly leveraging households by itself is not a sufficient condition for sharp recessions.  There have got to be some other pieces of the puzzles you got to put on there. Now, I think in the case of the US, two big differences. One is the run on the shadow banking system definitely exacerbated matters. And you've already alluded to and mentioned that that wasn't the case there.

Beckworth:  Second thing is just the lack of policy space that [the US] had to work with. So again, there is some luck there, there's also just different dynamics at play. But I think that's an important lesson for us to consider. And I know we're in a very different crisis today; different things that we look at. But let's do this. Let's move onto the structure, the design, the differences in the RBA versus the Fed because here in the US, the Federal Reserve is well-known. Most of my listeners are in the United States. I know there's a number around the world...

Beckworth:  I mean, you're in Australia, for example. I know you listen, and people in Europe have told me they listen, in Canada and other places. But I suspect many of the listeners aren't as familiar with the structure of the Reserve Bank of Australia. So maybe you can walk us through the mandates, maybe the governance, and maybe the history of its inflation target.

The Reserve Bank of Australia and Its Inflation Targeting History

Kirchner: Sure. So the statute for the Reserve Bank of Australia is a 1959 piece of legislation. And the legislation gives the RBA a mandate that has three components to it. So the first component is the stability of the currency, which is conventionally being read as a price stability mandate.

Kirchner: The second element is a full employment mandate. And the third element is this open-ended promote the welfare of the people of Australia mandate. And it's the third element of the mandate which sometimes causes people to puzzle. So you have to remember that when the Reserve Bank Act was written in the late 1950s and reflected previous legislation for its predecessor institution, when that legislation was written, price stability and full employment were seen to be a much greater tension than we would accept today.

Kirchner: This is pre-rational expectations revolution... And so in giving the RBA a price stability and full employment mandate, there was debate as to how you would reconcile those two things. And if you look at the biography of H.C. Coombs who was the first governor of the Reserve Bank from 1960, he said that the third element of the mandate to promote the welfare of the people of Australia was really just an attempt to fudge or reconcile those two.

Kirchner: So I think one way of interpreting this would be to say, however you manage a trade-off between price stability and full employment, do it in a way that's welfare maximizing.

Beckworth:  So the RBA had a dual mandate back in the '60s? I mean, starting in 1959?

Kirchner: Yeah. The RBA has always been seen to have a dual mandate for price stability and full employment. But more recently, the third element of the mandate has been used by the current governor, Governor Lowe, to infer a statutory basis for a financial stability mandate. Because Governor Lowe would argue that to the extent that financial stability potentially poses a threat to the welfare of the people of Australia, then you can read into that third element of the mandate, a financial stability mandate. And I think the problem here, of course, is that you can read almost anything into the objective of promoting the welfare of the people of Australia. So potentially, this becomes a way in which you could smuggle additional objectives into the statutory mandate of the bank.

I think the problem here, of course, is that you can read almost anything into the objective of promoting the welfare of the people of Australia. So potentially, this becomes a way in which you could smuggle additional objectives into the statutory mandate of the bank.

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Beckworth:  How has the RBA fulfilled those mandates historically? So has it lived up to the dual mandate? Has it done a good job balancing the two?

Kirchner: Well, you have to recall that up until 1983, the Reserve Bank... Well, Australia had a fixed exchange rate regime. So we didn't really have an independent monetary policy for the three, we had various types of fixed or managed exchange rate regime either to the British pound or to the US dollar. And that exactly the consequences that Milton Friedman predicted it would have, which was that the exchange rate became the tail that wagged the dog of the economy. And for a small, open economy like Australia, it was very much a sub-optimal regime.

Kirchner: Prior to 1982, it was also the case that the central bank would sometimes finance the federal government's budget, who was running a deficit. So the government would borrow directly from the central bank. So before 1983, you had a fixed exchange rate or a managed exchange rate and a central bank that was accommodating fiscal policy a lot of the time.

Kirchner: So we didn't really have an independent monetary policy. You could argue that the price level's effectively been determined by fiscal policy and the occasional change in the exchange rate regime. So in many ways, this looked like the sort of world that the MMT people advocate because you have monetary financing, you have the budget deficit, and you had extensive wage and price controls in an effort to try and manage the inflationary consequences of that.

In many ways, this looked like the sort of world that the MMT people advocate because you have monetary financing, you have the budget deficit, and you had extensive wage and price controls in an effort to try and manage the inflationary consequences of that.

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Beckworth:  Oh, that's interesting. Did it work out all right?

Kirchner: Yeah. So it's really only after 1983 that the Reserve Bank really gains control of the monetary policy. And for most of the 1980s, the Reserve Bank was really wrestling with the pursuit of a number of different macroeconomic objectives simultaneously, and using a number of different operating instruments as well. So for most of the '80s, there was a focus on quantitative policy instruments, mostly restrictions on bank lending and credit formation. In the late 1980s, we had what was called the checklist which was basically a laundry list of macroeconomic objectives that the RBA was initially trying to target.

Kirchner: But it was a classic case of too many policy objectives being pursued with too many policy instruments. And so it's really only in the early 1990s when the RBA moves in the direction of inflation targeting that it has firstly a clear objective of policy. And in 1990, it started announcing changes to the official cash rate as its main operating instrument. And so we finally had a single policy objective and a single policy instrument, which to pursue that objective. And that's where monetary policy comes into its own.

Beckworth:  Okay. Now my understanding is that the inflation rate has been below target since 2014, 2015. Is that right?

Kirchner: Yes, since the end of 2014.

Beckworth:  Yes. It's been persistently under target, which is very similar to what we've had in the US up until the crisis, and still do today. I mean, obviously the current crisis is a different story. But the RBA was facing the same struggle that the Federal Reserve is facing, that the ECB was facing, Bank of Japan. Inflation was undershooting, persistently, its target during that time. And you discussed how they were telling very similar stories, RBA officials were telling similar stories, to the Fed officials that one-off shocks from this sector, from this development, supply side distortions, a number of non-monetary stories. So walk us through that, and tell us what you think really happened. Why did the RBA fail to hit its inflation target from that period on?

The RBA's Inflation Undershooting Problem

Kirchner: We should probably say a little bit about how the RBA formulates and thinks about its inflation target, at least historically.

Kirchner: So since 1993, the RBA has talked about inflation targeting in terms of inflation averaging between 2% and 3% over time. And the over time is the ambiguous element. The way the RBA would define success in terms of its inflation targeting regime would be to say, if over a significant period of time, and we're probably talking anywhere from 5 to 10 years, the inflation rate were to average two point something, then they would deem that to be hitting the inflation target.

Kirchner: So it's a medium-term, flexible inflation target. It's expressed that way because it's designed to accommodate things like supply shocks. So an overshooting or an undershooting of the central tendency of the inflation target due to a supply shock is something that the RBA would look through, so treat that as a temporary deviation, not something that policy has to immediately respond to.

Kirchner: As long as the central tendency for inflation is around about 2.5, then that would be considered to be a success in terms of the inflation targeting regime. So you can think of it as average inflation targeting. So if you look at the RBA and Governor Macfarlane from 1996 to 2006, and then under Governor Stevens from 2006 to 2016, if you look at the average inflation rate under both those governors, it is bang on 2.5%.

Beckworth:  Wow.

Kirchner: So the RBA did exactly what it said it would do, which is target the central tendency of that 2% to 3% range. So more recently, the RBA, as you've noted, has been undershooting its inflation target. So inflation falls below target at the end of 2014, and has been either below target or at the very bottom of the range more or less continuously since then. So going on six years. So this is really stretching the ‘over time’ part of the RBA's agreement with the government on inflation. If we look at the RBA's forecast, their forecast horizon goes out two years. They're expected to continue to undershoot over the next couple of years.

Kirchner: So you're really looking at an eight-year undershoot of the inflation target. And I would argue that there's two elements to this undershooting. First is a policy mistake, and that policy mistake was exactly the mistake that the Fed made in the US, which is that the RBA underestimated the NAIRU. So just as US Fed was reluctant to ease monetary policy for fear that a falling unemployment rate would lead to a take-off in inflation, the RBA has not had much the same concern. And they've only very recently, in the last year or so, conceded that the NAIRU is actually a lot lower than they previously thought.

You're really looking at an eight-year undershoot of the inflation target. And I would argue that there's two elements to this undershooting. First is a policy mistake, and that policy mistake was exactly the mistake that the Fed made in the US, which is that the RBA underestimated the NAIRU.

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Kirchner: So they had been thinking of the NAIRU as sitting at an unemployment rate of around 5%. And the unemployment rate has been very close to five percent, at least before the pandemic. So before the pandemic hit, the last previous year or two, the RBA thought, "Well, if unemployment rate's down at around 5%, then the inflation rate will have to take off." And they've been sitting on their hands, waiting for the attack and of course, it didn't occur. And so this led them to revise the NAIRU down to four and a half. The other element was not a policy mistake, but a policy choice.

Kirchner: I mean, Governor Lowe assumed office in 2016. He got the government to agree to changes to the statement on the conduct of monetary policy that really defines how the RBA goes about inflation targeting. Previous statements on monetary policy, up until 2010, had not contained any references to financial stability concerns. With the 2010 agreement after the financial crisis, there was a new section they added, discussing financial stability. But that section made the financial stability explicitly subordinate to price stability. So the relevant section reads, “without compromising the price stability objective, the RBA should reference financial stability concerns in this conducted policy.” The 2016 agreement when Phil Lowe became a governor, inverted that relationship.

Kirchner: So it explicitly allowed for short-term deviations from the inflation target, in pursuit of other objectives. And the only other objective that was explicitly mentioned was financial stability. So now the agreement was effectively giving the RBA a license to lose the inflation target if it had financial stability concerns, which under Governor Lowe, it has. So since Philip Lowe became governor, the RBA has started to very explicitly trade off the inflation target, and the full employment mandate against these financial stability concerns. And so for the first few years in which Philip Lowe was governor, there was no change in monetary policy.

It explicitly allowed for short-term deviations from the inflation target, in pursuit of other objectives. And the only other objective that was explicitly mentioned was financial stability. So now the agreement was effectively giving the RBA a license to lose the inflation target if it had financial stability concerns, which under Governor Lowe, it has.

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Kirchner: There was an assumption that inflation would take off because the unemployment rate was low. This didn't happen, so inflation and inflation expectations both declined. But the RBA was very reluctant to ease monetary policy because it was concerned that this would lead to an acceleration in household leverage and strengthening in the housing market. And so the Reserve Bank very explicitly let the inflation target go, in pursuit of the financial stability concerns.

Beckworth:  So the new governor erred on the side of the financial stability mandate, over the inflation target part of the mandate? He put more weight on the financial stability. Is that fair?

Kirchner: Yeah, I think that's right.

Beckworth:  Okay.

Kirchner: There are various statements which I quote in my paper in Economic Analysis and Policy where the RBA, in explaining its policy decisions says, "Yes, we could have higher inflation and stronger economic growth if we were to ease policy, but we're worried about what's happening in terms of…

Beckworth:  So they were explicit about it? They were like, "Look. We are going to err on the side of reining in our concerns about financial instabilities that are emerging in the economy, at the expense of inflation"? So in my mind, that puts the cart in front of the horse. I think you alluded this in your paper, but if you want to... One of the conditions to maintaining financial stability is to maintain stable nominal income growth. Right? You've got to pay the bills on all these existing financial contracts, the mortgages, the loans. And if inflation continues to drop, it implies a drop in nominal income growth as well. In fact, I've looked at, as you know, measures of nominal income in Australia, and it fared relatively well through the great recession.

Beckworth:  It took a little bit of a downturn, but overall, it was relatively stable up until about the same period you see nominal income or nominal GDP beginning to fall below its trend path. So my concern is, you focus so much on financial stability, you lose sight of the fact you want to maintain stable income growth as well. But the other observation I have from this is it seems, and correct me if I'm wrong here, that Governor Lowe is showing us what a central bank that implements the BIS vision of the world would look like. Right? So the BIS, for years, has been preaching financial stability, financial stability, financial stability. And we finally have a central bank that has implemented that, who's worried more about financial stability than the other part of their mandate. And this is one potential outcome we get from it.

Kirchner: Yes, Governor Lowe certainly spent time at the BIS. I mean, that's not unusual for a career. RBA, do a stint at the BIS. But I think he certainly drank too much of whatever it is they put in the water at the BIS.

Kirchner: Such that he became very preoccupied with financial stability issues. And that interest of his really pre-dates the financial crisis, so he was writing about this back in the early 1990s. So it's a concern that he has, that pre-dates the financial crisis. I think he would see the financial crisis as essentially validating that concern. But I think in many ways, Governor Lowe is a breaker or discontinuity in the approach that previous governors have taken to monetary policy, I think.

Kirchner: His predecessors, Ian Macfarlane and Glenn Stevens, were very pragmatic in their approach. They weren't particularly model-driven, I think their approach was to take the price and full employment mandates and look out the window, see what's happening with the economy and respond to that. And that was a very effective approach. Philip Lowe, I think, errs on the side of worrying too much about apprehended financial stability risks. So if you read the RBA's financial stability reports, for example, they would say, "Well, the financial system's in good shape, risks are low, and we want to keep them that way."

Kirchner: Well, if that's the case, if financial stability risks are in fact well-contained and well-managed, why do you want to sacrifice your inflation target and full employment objectives responding to what is essentially an apprehended concern? In many ways, it involves the central bank second-guessing capital stacks between consenting adults. I mean, implicitly you're saying, there must be some sort of market failure in the decisions of households, in relation to their balance sheets. And I think there's a lot of evidence to that. The Reserve Bank in its financial stability reports doesn't present any evidence for that point of view. I think the best you can say for it is, well, if Philip Lowe wants to run monetary policy in such a way that these risks do not emerge, but involves incurring a real cost for a questionable benefit.

If financial stability risks are in fact well-contained and well-managed, why do you want to sacrifice your inflation target and full employment objectives responding to what is essentially an apprehended concern?

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Beckworth:  Right. Yeah, to be clear, financial stability is an issue, you want to keep an eye on it, but you don't want to emphasize it so much that you jeopardize growth in the real economy. And we have examples of this. Right? We have many historical examples. I mean, one you've covered in your work is the case of Sweden. Right? Where they were really concerned about home prices, to the extent they tightened policies. Was this 2011 they did this? Was this the period where they...?

Kirchner: Yeah.

Beckworth:  Yeah. So Lars Svensson was there. He was one of the members of the central bank. So they sacrificed real economy, I'd say they sacrificed nominal income growth at the altar of financial stability. So there's a balance you need to draw there, but if you're going to come out and explicitly say, "We're willing to let inflation deviate from its target to hit a financial objective," I think you are putting the cart before the horse there. I mean, you want to maintain financial obligations that have been agreed to, and obligations of businesses and households that can only be met by income growth. So where does that stand now? I mean, any soul-searching going on at the RBA about this? Any look backs, "Hey, maybe we erred too much on the financial stability mandate?"

Reflecting on the Financial Stability Tradeoff

Kirchner: I think Lars Svensson has a very good framework for thinking about these issues, which partly reflects his experience as deputy governor of the Swedish Central Bank. And he was a dissenter from the approach that the Swedish Central Bank took at the time. And subsequent to that experience, has developed formal models for thinking about the relationship between financial stability and other parts of the central bank's mandate. And I think Lars presents a very straightforward cost benefit framework for analyzing this issue, which is to say, "What do you gain in terms of financial stability from a policy approach of leaning against [inaudible]?”

Kirchner: So in other words, trading off your inflation target and full employment mandates against financial stability concerns. And his argument is that under any reasonable parametrization of the problem, the gain in terms of financial stability is just not worth the cost, in terms of forgone output and inflation below target. And in particular, I think he would argue in a way that's consistent with your own research, David, is that if you're running monetary policy that's too tight, well, yes, it might limit growth in debt, but it also limits growth in incomes. So you're hitting both the numerator and the denominator of the debt to income ratio. So his arguing would be that there's very little gain in terms of widely used financial stability metrics like debt to income ratios for the cost incurred.

Kirchner: That work is being replicated within the reserve banks, and there was a research discussion paper by Peter Tulip and Trent Saunders, looked at Australian monetary policy in terms of Lars Svensson's framework. That paper was very interesting in that the Reserve Bank sat on that paper for about 12 months, if not longer, I think because it was concerned that it would paint current policy settings in an unfavorable-

Beckworth:  Really? That's fascinating.

Kirchner: And when they released the paper, they released it alongside another paper on household debt, which was clearly designed to divert attention from it. So they're a little bit touchy on this issue. I think certainly, within the bank, a lot of people question the approach of the current governor. I think a lot of people are uncomfortable with his approach precisely because they see it as a departure from previous practice. But the fact is, the government has effectively given the RBA a license to do it, in terms of the changes that were made to the statement on the conduct of monetary policy in 2016.

Kirchner: Interestingly, after the last federal election, typically there's... When there's a change of governor or a change in governor, you will revisit the statement and either reaffirm it or change it. There was a lot of back and forth between the government and the RBA this time on the statement. We don't know exactly what the nature of that back and forth was, this was all behind closed doors. But it took a very long time for the government to agree to reaffirm the 2016 statement. And I think that reflected the government's concern that the RBA was not fulfilling the inflation part of its mandate. And there was speculation that they were thinking of toughening the accountability measures around the inflation target. For example, requiring the governor to write a letter to the treasurer, for example, to explain why they had undershot the inflation target would be one such that was supposedly considered.

Kirchner: In the end, the governor just reaffirmed the 2016 statement. So whatever the nature of that discussion was, I think the Reserve Bank won that discussion. But I think it does reflect a little bit of disquiet in government circles, the RBA underperforming its mandate. And I think the RBA will need to be very careful, going forward, that it doesn't actually de-legitimize not only the inflation target but monetary policy itself. Because the RBA has been undershooting its inflation target for so long, people are now questioning whether the RBA can hit it. People have been calling for the abandonment of inflation targeting, or lowering the inflation target because there are some people who interpret the undershoot as an inability of the bank to hit the target, as opposed to a deliberate policy choice.

I think the RBA will need to be very careful, going forward, that it doesn't actually de-legitimize not only the inflation target but monetary policy itself. Because the RBA has been undershooting its inflation target for so long, people are now questioning whether the RBA can hit it.

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Beckworth:  Yes, it reminds me of the Fed being bewildered by its inability to hit its inflation target, while ignoring the fact that it raised interest rates nine times between 2015 and 2019. There are policy choices that could have been done very differently. But let me ask this though, about the RBA. I was reading your description of it, that the actual governance has a nine-member board where you have the governor, you've got a deputy governor, you've got the secretary of the treasury which is a little surprising, but you also have six part-time external members including a number drawn from the Labor Movement.

Beckworth:  So you actually have Labor Movement representatives on the board of a central bank, which is really interesting. And I would think that that would minimize group think, or bring in some additional insights from outsiders who don't necessarily view financial stability as the final goal. Has that been manifested? Do we see the labor representatives...? Do more diverse views at the board play a role in the decision-making?

The Effects of Diverse Views on the RBA Board

Kirchner: Well, of the six part-time external members of the board, one is typically an economist, which is exactly what you want on a board that is there to set monetary policy. The others have typically been either business people and often, in the past, a representative of the Labor Movement. That practice has fallen by the wayside a little bit.

Beckworth:  Oh, okay. So there aren't that many Labor on the board?

Kirchner: No. No. So historically, Labor party governments have often appointed someone from a trade union movement to the board. And the motivation for that was partly to ensure that labor as well as business were represented in monetary policy. I mean, I think the RBA would defend the current board structure along similar lines to the ones you suggest, which is they argue that having business people on the board who aren't necessarily monetary policy experts, it gives them greater insight into what's happening in the real economy.

Kirchner: But the fact is, the Reserve Bank has a very extensive business liaison program through which they get feedback from the business community that's much broader and deeper than they'd get from members of the... They can get as much feedback from business community as they want without having to have business people sitting on the board.

Beckworth: But the board itself isn't that diverse, I guess is my question? You want to avoid group think. So one of the critiques of ECB, maybe the Fed is you get a bunch of economists together, and they all live in their ivory towers and aren't really exposed to different trains of thought. I guess, is that a problem with the RBA, do you think? Or do they get past it with this...? At least, on paper, a more diverse board?

Kirchner: I think we have the opposite problem that apart from the economist part-time external board member, the other members of the board are not sufficiently trained or equipped to interrogate the recommendation of the board.

I think we have the opposite problem that apart from the economist part-time external board member, the other members of the board are not sufficiently trained or equipped to interrogate the recommendation of the board.

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Beckworth:  Oh, I see.

Kirchner: And so this is a problem, I think, that-

Beckworth:  So they just rubber stamp the decision because they don't know any better?

Kirchner: Yeah.

Beckworth:  Okay. Well, let me-

Kirchner: I think-

Beckworth:  Go ahead.

Kirchner: In fact, the board has tended to be a rubber stamp for the recommendation put to it by the bank. So you don't really get around the group think problem, if indeed you have a group think situation within the bank itself.

Beckworth:  Okay. What has the RBA done during the crisis? Has this overly weighted focus on financial stability given way to more radical interest rate cuts and concerns about full employment?

The RBA's Crisis Policies and Actions

Kirchner: I think the pandemic has prepared to the stability concerns, at least in terms of house prices and household leverage. So I think that's less of a concern for policy. The Reserve Bank has lowered its official cash rate to 0.25% which the RBA views as the effective low bound because the RBA runs a corridor system. And so normally they'd have a symmetric quarter point corridor around that target cash rate. So if you've got a 0.25% cash rate then the bottom of the corridor would be at zero. At the moment, they're running a slightly asymmetric corridor with a 0.1% floor which we can come back to in a bit, if you like. So they follow the official cash rate. They have never been a fan of negative interest rates. The governor has ruled out taking interest rates negative. To reinforce that 0.25% cash rate, they've offered some forward guidance, which is to say they expect that the cash rate will be held at that level for the next three years.

Kirchner: So they're effectively trying to lower expectations for the future cash rate. Although I'd say their guidance doesn't differ substantially in practice from the guidance that we got from the bank before the pandemic hit. The other thing it's done is to introduce a peg for the three-year bond yield of 0.25%. So it's really tying down the short end of the curve, out to three years, at 0.25%. So it's actually a form of yield curve control.

Beckworth:  Right, yeah.

Kirchner: And so the reason they targeting the short end is because most retail and wholesale borrowing in Australia would effectively be priced off the short end of the curve.

Kirchner: So from the point of view of monetary policy transmission, I think the RBA views that as the part of the curve that they really need to nail down. It's a loose peg, it's not a hard peg like the official cash rate. But they've been able to hold the three-year bond yield more or less at 0.25% since they announced that policy. So the other element of what they have done is, they've intervened in the secondary market for government bonds. Basically, buying bonds, partly with a view to hitting that three-year bond yield target. But also with a view to smoothing out some of the liquidity issues that arose in the bond market back in March.

Kirchner: Your previous guest, Darrell Duffie, I think very nicely described the [inaudible] in the Treasury market that happened in March during the peak of the concerns about the pandemic. Just as people were selling US treasuries to raise cash, that happened in the Australian market as well. So there was a big spike in Australian bond yields right up in March. So the RBA was, even before it announced the three-year bond yield peg, it was intervening in the secondary market to supply liquidity. So it's not really doing QE. I mean, it is intervening in the bond market for the liquidity purposes, and to hit that three-year bond yield target. But of course, if this commitment were fully credible, then it wouldn't have to intervene at all. And in fact, that's more or less the position the RBA finds itself in today.

Kirchner: They haven't intervened in the bond market for the last few weeks. And no-one really wants to take on the RBA in that market, so I think now they will be able to maintain that three-year bond yield target without further intervention. And this is, of course, what the RBA wants. They never really wanted to expand their balance sheets significantly, in the way that the Fed did during the last or the current crisis. They've never been comfortable with the idea, I think, of the big balance sheet expansion. So yield curve control gets in the way of reinforcing the commitment on the cash rate without having to do QE.

I think now they will be able to maintain that three-year bond yield target without further intervention. And this is, of course, what the RBA wants. They never really wanted to expand their balance sheets significantly, in the way that the Fed did during the last or the current crisis. They've never been comfortable with the idea, I think, of the big balance sheet expansion.

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Beckworth:  Okay. Well, in the time we have left, I want to go back to a point you raised earlier, and that is there's been some discussion about the RBA changing its framework, its target. Now the ones you suggested weren't very encouraging; lower the inflation target or abandon it. But there's been some other talk as well, and I'm going to bring up, of course, my hobby horse, nominal GDP targeting. So there was a paper in 2018 by Warwick McKibbin and Augustus Panton, it was a Brookings paper. But the paper's title was, *Twenty-five Years of Inflation Targeting in Australia: Are There Better Alternatives for the Next 25 Years?*

Beckworth:  And they go through and review some of this history we've talked about. And they come out in favor of a nominal income target. Now this would have been just a few years after governor Lowe has arrived, and I suspect he's probably not particularly interested in it. But is there a broader discussion in Australia for an alternative framework that includes some kind of make-up policy, maybe even nominal GDP level targeting?

Is There a Change in the Monetary Framework Looming in Australia? 

Kirchner: There's certainly a lot of support for nominal income targeting within the academic community. There was a op-ed that was written by Warwick McKibbin, Richard Holden and John Quiggin that was published in the Australian Financial Review earlier this year, which advocated moving to nominal income targeting, which was interesting in that I think those three authors would come all come at it from slightly different perspectives, but nonetheless land on the same conclusion. My concern here is, I think Warwick McKibbin and his co-authors would probably argue for nominal income targeting on the basis that inflation targeting is broken. And I don't think it's broken, I just think the central bank's not doing it. Or at least, not doing it properly.

Kirchner: So I mean, I think you can still make inflation targeting work. One of the things you could do is, use nominal GDP as an intermediate target or indicator variable that tells you how to go about doing inflation targeting. And I think this is a good illustration of the way in which the RBA's policy choice to undershoot the inflation target has, in some ways, discredited the existing inflation targeting regime and discredited monetary policy. So it's natural that people would then speak into other alternatives.

I think you can still make inflation targeting work. One of the things you could do is, use nominal GDP as an intermediate target or indicator variable that tells you how to go about doing inflation targeting. And I think this is a good illustration of the way in which the RBA's policy choice to undershoot the inflation target has, in some ways, discredited the existing inflation targeting regime and discredited monetary policy.

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Kirchner: I mean, the other aspect of this is, Warwick McKibbin and I think John Quiggin as well have both been quite critical of what they would see as an over-reliance on monetary policy. So Warwick, at the end of last year, for example, was arguing against reductions in the individual cash rate, arguing against QE. He was saying that if you ease monetary policy, all this would do would increase household leverage and increase house prices, which is exactly what Governor Lowe would say. So given their reluctance to use monetary policy instruments, it begs the question, if you give the RBA a nominal income target but you don't have much conviction in monetary policy, well, how is the RBA is going to get that target?

Beckworth:  So they're arguing for a more fiscal policy-heavy approach to a nominal income target?

Kirchner: Warwick McKibbin and John Quiggin, I think, would both be or have been very strongly in favor of relying more heavily on fiscal policy.

Beckworth:  Okay.

Kirchner: Which I think is unnecessary and ineffective for a smaller... An economy like Australia. I think monetary policy can do the job. I think there are attractions to nominal income targeting. Not least, I think it helps avoid some of the mistakes that have been made through the inflation targeting regime.

I think monetary policy can do the job. I think there are attractions to nominal income targeting. Not least, I think it helps avoid some of the mistakes that have been made through the inflation targeting regime.

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Beckworth:  Yes. I think one thing Australia does have going for it, as well Canada is... All the countries that did relatively well during the great recession is their small open economies. So I think monetary policy is much more agile, it can make sharper turns, it can use the exchange channel more effectively.

Beckworth:  So I agree with you. I think monetary policy itself is still very effective, if it's consciously chosen to be utilized. So you're right. You can pick any number of different targets, and if you're not using the tools at hand, it's a moot point. So let's hope that the RBA will change course and embrace the other part of its mandate more readily; the price stability and full employment part of the mandate, after the crisis, after things do calm down. Well, with that, our time is up. Our guest today has been Stephen Kirchner. Stephen, thank you so much for coming on the show.

Kirchner: It's been an honor, David.

Photo by Brendon Thorne via Getty Images

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