Zac Gross on the Past, Present, and Future of Australian Monetary Policy

Zac Gross is a senior lecturer at Monash University and was formerly an economist at the Reserve Bank of Australia. Zac joins Macro Musings to talk about the Australian central bank and the recent review of its framework. Specifically, David and Zac also break down Australian monetary policy over the past few decades, the RBA’s yield curve control experiment, the future of its operating system, and a lot more.

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 [email protected].

David Beckworth:  Zac, welcome to the show.

Zac Gross: Thanks for having me, David.

Beckworth: Well, it's great to have you on and you are another acquaintance of mine that I got through Twitter. I guess we would call it X now, but I prefer Twitter, so I'll say Twitter. But we've interacted on Twitter. You've been active in the monetary policy space there and have exchanged ideas with me on what's happening in Australia. And it's always exciting to get someone from Australia on the show because, Zac, Australia is a very fascinating place, at least from my perspective when it comes to the economy, the macroeconomy. And let me list three things in particular I find fascinating about Australia. And the first one is that between 1991 and 2019, there was no recession, almost a 28-year-run.

Beckworth: Recession free, that's just remarkable. That's probably the longest expansion recorded, I think, in modern history for advanced economies, so phenomenal. Second and related to that is that Australia survived a great recession or great financial crisis relatively unscathed. So that 2007-2009 period, Australia really didn't experience the pain that the rest of the world did. And that's despite Australia having similarly high-priced homes, leveraged household balance sheets. I mean, households had a lot of debt. So many of the things we point to in the US during this time, Australia had, but somehow they didn't have the same crisis. So it really helps flesh out the story. What caused the great financial crisis? Was it just housing? Was it a run on markets? So I want to come back to that later.

Beckworth: Third point, and this one is also fascinating because it has parallels to the US economy and that is Australia, on average, ran a current account deficit from the 1960s up until a year or two ago. Now, it's running surpluses. But that's a long run of current account deficits. And as a result, Australia, like the US, is a net debtor to the world. Its net asset position is that it has a lot of liabilities it owes to the rest of the world. So we're very similar in that regard because we've run these current account deficits, so very fascinating. In fact, the Reserve Bank of Australia had a great chart showing all of the liabilities that are owed. A lot of foreigners have invested in long-term bonds from Australia, which suggests to me that they view Australia as another provider of safe assets. But in any event, we'll get to some of that later. It’s just a very fascinating place to be and to think about, and you have worked there in policy. You've worked at the Reserve Bank of Australia. So maybe tell us about your time there. What did you do at the Reserve Bank of Australia?

Breaking Down the Australian Macroeconomy and the RBA’s Monetary Policy

Gross: So I joined the Reserve Bank of Australia straight out of my undergraduate degree. So I worked there for three years in a mix of their research division, working on the modeling team and then on their economic analysis department. So I worked there for a couple years before I ultimately went off and did my PhD overseas in both modeling and some of the more data orientated work.

Beckworth: Now, if you read the stated role of the RBA on its website, so what is it supposed to do? I guess this is commissioned to it by parliament, but it says the following: “determine and implement monetary policy in pursuit of price stability in full employment. Second, foster the stability of the financial system, secure a stable and efficient payment system, deliver efficient and effective banking services to the Australian government, and finally provide secure and reliable Australian bank notes.” Well, that doesn't sound any different than the Fed or the ECB right? Yet, I know it is different in a very fundamental way, and that is, when it comes to the nature of the economy. So the US is large. Relatively speaking, it's closed or at least less susceptible to outside external shocks. Australia is a smaller, very open economy, very susceptible to swings in commodity prices, exchange rates. And so that has to have a bearing on the conduct of monetary policy. Did you find that to be the case?

Gross: Yeah. I think that's absolutely correct. I think when you're operating in the small open economy, while the goals of a central bank might be quite similar to what you might see in the US or indeed Europe, what you pay attention to might be quite different. So for example, the exchange rate is just quantitatively much more important in a small economy such as Australia or perhaps the UK. We import all of our cars, all of our petrol, certainly all of our iPhones. So when we see swings in the Australian dollar, that pass through to consumer prices is going to be much more material to our forecast for inflation and what that matters for the goal of price stability.

Gross: So that's one sort of obvious and perhaps the most obvious difference between Australia and a big country like the US. But there are perhaps other more subtle differences. So comparative advantage means that some sectors will naturally just be much more important macroeconomically in a small open economy. Now, in Australia's case, that's the mining sector, and the RBA estimates that the mining sector and its related inputs make up about 15 to 20% of the total economy, which is a really big deal if you're thinking about it from a macroeconomist point of view. So it almost forces you to be more of a microeconomist. If there is a flood in a Brazilian mine halfway across the world, that'll have a really big impact on Australia's terms of trade and consequently for how you run the economy as a central bank. So it certainly forces you to dive into the nitty-gritty of specific sectors much more regularly as a macroeconomist in a small open economy.

Beckworth: So you have to be more precise, pay more attention to detail. You can't just look at aggregates like maybe you could at a place like the Fed or the ECB. And to be clear, they also paid attention to the details, but it'd be easier, at least at the Fed. And as you say, the pass through of exchange rate to inflation is much stronger in a place like Australia. Now, the Reserve Bank of Australia is also known for being one of the first inflation targeters, I believe in the early nineties. So right after New Zealand, Canada, the UK, I believe Australia was the fourth inflation targeter. And that was a big change, right, in the early '90s for the Reserve Bank of Australia. Walk us through that story.

Gross: Yeah. So the move to an inflation target, there was no big bang moment in Australia. It was something that came about as we were exiting the early '90s recession. And then through a series of speeches, the RBA slowly adopted this approach of targeting inflation following, as you mentioned, our colleagues across the Tasman Sea in New Zealand. So it was sort of a slow evolution towards an inflation target. I think much like other countries, that we have a target range of somewhere between 2 and 3%. I think it's fair to say that the choice of that 2 to 3% was at least somewhat arbitrary or due to the historical accident. There was no, I think, great science behind it. But it was something we adopted in the early '90s and was solidified through a series of speeches made by the RBA at the time and then formally in an agreement with the government.

Beckworth: So it picked the inflation target of close to 2% which many other countries have done. Some of them have ranges as you mentioned. And so you could make the argument as you did that this is largely an accident of history or it's just path dependency. 2% seems to be good enough. Other places will do it. It's standard. Central bankers all speak the same language, so we go that path. What about this argument for the 2% inflation target? There's been some research in the past, the Boskin Commission, that argued that we tend to overstate inflation, the official CPI measures, at least in the US, in the past. So there's substitution bias, things like that that tend to overstate it. And once you do that, you're actually getting pretty close to actual price stability. Maybe zero to 1% once you correct for this measurement problem. Do you think that's something that was important in Australia as well?

Gross: So I think the original choice in Australia, we’re slightly above 2%, 2.5% is the midpoint of our target range. I think that was based on the RBA's judgment at the time of what was sustainable and what was achievable. So obviously there are these issues with bias in the official measures of CPI and you can debate whether we should be targeting CPI or PCE deflator and I'm sure some of your guests will have strong opinions of that. But ultimately I think the precise level was chosen mostly as a matter of judgment. And I think there's an ongoing debate at the moment as to whether we should be lifting that inflation target or not. But I think that the issue of bias in CPI measures is a real one. But there are good reasons to prefer a positive inflation target, even if bias might mean that that 2.5% is really closer to two in actual terms.

Beckworth: So in Australia do you have the same issue that we have in the US where have a CPI and a PCE? Do we look at headline or do we look at core? Are these same conversations happening over there?

Gross: We do, we focus almost exclusively on the CPI. Though our measure of underlying inflation is different, I think, to actually most of the rest of the world, while core inflation, stripping out fuel and food, is perhaps the most common measure of underlying inflation in other countries. In Australia for some reason, I think, again, another historical accident, we focus mostly on trimmed mean inflation as our primary measure of underlying inflation. I'm not sure if there's a good reason to be focusing on trimmed mean or the core, or any of the other various measures, but for whatever reason, Australia mostly focuses on that trimmed mean measure, which I think has gotten a bit more popularity or attention in the US, but certainly not compared to what we see in Australia.

Beckworth: Oh, that's interesting. I didn't realize it's such a big deal there. So going back to the comment you made about discussions of a higher inflation target, we're going to talk about the RBA's review later in the show. But just for now, are you suggesting that there are conversations over there as well about raising that inflation target, nudging it up a little bit, given the difficulty maybe of inflation going all the way back down to 2, 2.5% or the zero lower bound concerns? What's the motivation behind the conversations there?

Gross: So I think from the economists' point of view, the main motivation was the long period had spent at the zero lower bound. And the thinking was that if we're going to be going forward in a world where interest rates are going to be close to zero, then maybe a higher inflation target will allow central banks more room to move when it comes to a future downturn. Now, that conversation I think has been put on ice or that aspect of the conversation has been put on ice since the recent run-up in inflation around the world. But I think in the long term, assuming that this burst of inflation is at some point transitory and returns to our target band, that's a conversation I think that will perhaps start up again.

Gross: Perhaps on a more political angle, I think there are some people who are saying, "Well, we had 7% inflation and that was unpleasant and we're back down to 3% now or 4% now. Maybe that's good enough." I think from the point of view of a central bank's credibility, the idea of being close enough to the target is perhaps a bit unwise. I think if we constantly took that approach to deviations from inflation from its target, we would not have a target at all. We'd always have a roving band of inflation. So I'm not sure that particular argument, while it's potentially popular with people who don't want to see higher interest rates last for any longer than they need to, I think that, economically, it's a bit of a risky argument when it comes to central bank's credibility.

Beckworth: Yeah, absolutely. I agree with that. If you are going to change the inflation target, you need to do it well after you've been at your inflation target and you've had a long discussion. You don't use it as an excuse to deal with the current challenges. So that's been a part of the conversation nonetheless. Zac, let's talk about some of the recent developments and not so recent developments at the RBA. I want to go back to that 1991 period I mentioned before. You guys had a 28-year run, no recessions, an amazing accomplishment. You and your co-author have a paper that addresses this phenomenon and it's titled, *Assessing Australian Monetary Policy in the 21st Century* in the Journal of Economic Record. And you address this key question: why such a great run from 1991 to 2019? I want to start with the 2001 recession because I believe you looked there as well. So Australia also avoided the 2001 recession which was mild in the US, but nonetheless it avoided it. What happened at that time?

Assessing Australian Monetary Policy: 1991-2019

Gross: So in 2001, as you said, the US had a mild-ish recession, although perhaps we didn't know it was mild at the time. And Australia managed to avoid at least a fall in the growth rate of GDP. And when we look back on the historical episodes of both 2001 and the global financial crisis, we find that a reason why Australia managed to perform so well was the proactive response of the Reserve Bank of Australia. In both 2001 and 2008, they cut interest rates aggressively and that was a big reason why the Reserve Bank of Australia managed to avoid a fall in GDP in both those episodes. Now, ultimately that was not the whole story, especially when it came to the global financial crisis. That came at the same time as a very large boom in commodity prices driven by Chinese growth. So at least for the global financial crisis, we also had a bit of luck working on our side. At the same time, we had a mining boom coinciding with a global financial crisis, which more or less helped cancel each other out. But I think the ultimate takeaway is that Australia, through a bit of good luck, but also good policy, managed to achieve those high growth rates, and it's attributable to both good luck and good policy.

Beckworth: Yes, I became aware of the RBA success during the great financial crisis or the Great Recession because it was the one central bank and [one of the] advanced economies that seemed to be doing a relatively great job, wasn't constrained by the zero lower bound. I think that's huge. Let's stay on that point for a while. One of the reasons it didn't hit the zero lower bound and resort to QE like some of these other banks is because inflation rates were already pretty high coming into this, correct? They already had some higher inflation. Now, was that luck or is that just the Reserve Bank of Australia being proactive and thinking ahead?

Gross: I would say that was almost a policy mistake. So in 2007, early 2008, before the global financial crisis really hit, the inflation rate was well above the target band at over 4% and interest rates were climbing quite aggressively to try and get control of the situation. They were at over 7% in early 2008. So you could almost argue that the RBA had made a policy error in letting the economy and inflation take off as quickly as it did. And in some ways they were rescued by the big fall in global demand that the global financial crisis caused. So look, it's definitely a combination of the two. Ultimately, when the crisis did hit in late 2008, the RBA cut rates aggressively, even though inflation was still above the target band because they could see the fall in demand coming and that was absolutely the right call, but there was more than a bit of luck there. And one could argue the reverse situation happened during the COVID-19 crisis when inflation was below target. We had a very sluggish economy and then all of a sudden we had the biggest fiscal stimulus I think we've ever seen, and that managed to revive our economy right when the RBA was running the economy too slow. So there's absolutely been a bit of luck when it's come to Australia's economic performance, but you can't fault policymakers in their response, at least to the global financial crisis, when it comes to helping stave off recession in Australia.

Beckworth: As they say, sometimes it pays to be lucky rather than smart, but sometimes your luck runs out as it did during the pandemic. As you said, they came in with low inflation, but going into 2008 they had high inflation. So that mistake actually was a blessing in disguise, it allowed them to cut rates without hitting a zero lower bound. And I think that's an important point, and that may be an argument for those who want to raise the inflation target. There's a good case study of having that extra cushion, but I think it also speaks to this point you raised about being proactive. They proactively cut rates ahead of the collapse in demand and inflation.

Beckworth: So one taking a very static view could have said, "No, we can't do this. Inflation's still high, we need to keep rates up until it falls." But the Reserve Bank of Australia took a very proactive... So kudos to them for doing that. Now let me go to the commodity price point you raised. So commodity prices were going up during 2008, I believe, and that definitely buoyed the economy in Australia, but didn’t they also collapse the next year or two? I mean, so you can say yes, Australia was lucky because of the commodity boom, but it also was able to work its way through the commodity bust without going through a recession, is that right?

Gross: That's right. They did fall in 2008 and '09 when the recession hit, but they'd already started rising actually a bit earlier than that. So they really started to pick up in 2005. So there was a big level shift in the price of iron ore and coal driven by China's rise. And that level shift really meant that Australia… there was a big demand for investment in the mining sector in Australia, we're one of the lowest cost miners in the world and that increase in demand was always going to mean a permanent increase in demand from Australian commodity producers. And so they saw a big influx of investment during that time, which lasted long through the global financial crisis. Indeed, we sort of break the mining boom down to phase one and phase two with this short interregnum period in between, which was the global financial crisis. So commodity prices actually ended up peaking in 2011, 2012, at least when it comes to the commodities we export, and that was really phase two of the mining cycle where the boom continued to grow.

Beckworth: Okay, so that actually propped up Australia's economy for many years. Okay, fair enough. Well, let's move on from the great performance during the 2007, 2009 period and move to the period where the Reserve Bank of Australia struggled with inflation undershooting this target, 2016 to 2019. I know you also looked at that in your paper, and I'm assuming you worked on it as well at the RBA. So walk us through that episode, what happened?

Gross: So starting around 2016, the inflation rate fell below the Reserve Bank's target band of 2 to 3%. And while a central bank's main playbook would suggest that if inflation is low, you cut interest rates to try and stimulate the economy and increase inflation, the RBA didn't do that, and in fact they kept interest rates on hold for the next three years up until the middle of 2019. And we were not at the zero lower bound at that time, the cash rate or the RBAs policy rate was at 1.5%. So there was plenty of room to cut. We were far above the zero lower bound, or at least had some room to cut. But for a variety of reasons, the Reserve Bank of Australia, despite inflation being persistently below 2%, didn't cut interest rates, in fact, it kept them unchanged.

Gross: And that inflation undershooting actually continued for five years or so until the pandemic hit, in which case it initially got worse. And then we saw in 2021 and 2022 a big upswing in inflation as the rest of the world did. So that inflation undershooting was, I think, a pretty big policy mistake. The RBA had room to cut, inflation was telling them they should cut. The unemployment rate was also quite high at this time, well above estimates of the NAIRU. And so in our paper we conclude that this was a really significant policy error by the RBA in which they kept interest rates too high for too long and we saw sluggish growth as a result.

Beckworth: So what was the hesitation during that time to cutting rates?

Gross: The RBA's provided a few reasons why they didn't cut interest rates at the time, but I think the main explanation is that they were concerned, perhaps overly concerned, with house prices and household debt. As you mentioned at the beginning of this chat, Australia has historically very high house prices and at the time they were growing quite robustly. And I think the RBA governor, Philip Lowe, was worried that even lower interest rates would mean even higher house prices, households being forced to take on even more debt to buy those expensive houses. And that might lead to potentially vulnerabilities in the Australian financial system. So it was essentially a policy of leaning against the wind, keeping interest rates higher than they ought to be in order to try and discourage asset price growth.

Beckworth: Which is interesting because in the review, which we'll get to in a few minutes, that was one of the recommendations that the RBA not do, correct? Not to lean against these asset bubbles and debts?

Gross: That's right. So there's plenty of research on the topic of leaning against the wind, some of it by Lars Svensson, some of it done in Australia by Peter Tulip. And the consensus of that research is that leaning against the wind is a bad policy idea. Yes, you might be able to restrict asset price growth and perhaps on the margin reduce the risk of a financial crisis that high levels of debt might generate. But ultimately the cost in terms of higher unemployment and slower inflation, slower wage growth is far higher and it makes much more sense for a central bank to focus on inflation, focus on the unemployment rate, and then if a crisis doesn't eventuate, respond with either macro prudential regulation to try and prevent the crisis from happening in the first place, or respond with lower interest rates, should house prices fall, and you find yourself in a situation where you need additional demand. So I'd say this was a policy approach that flew against the recommendations of the research, but it's one the RBA pursued nonetheless.

Beckworth: It's interesting that you mentioned Lars Svensson because he was at the Riksbank, the central bank in Sweden, and they actually had to deal with the same issue. They also were leaning against the wind and that actually hurt their economy. So he can speak from experience as well as from theory as can you, you've lived through that too. So there's two case studies right there that suggest it may not be the best option in addition to the research that's been done on it. Okay, so that was the low inflation period. Many central banks and advanced economies dealt with this issue. The Fed did, the ECB did, and this is one of the motivations for the review. And again, we'll get to the review in just a minute. But before we do that, one last development I want to talk to you about that occurred during the pandemic period beyond the rise in inflation, and that was the RBA's yield curve control experiment or period. So talk us through that, what happened and how did it end?

The RBA’s Yield Curve Control Experiment

Gross: So the Reserve Bank in March of 2020, like other central banks around the world, cut interest rates straight to zero and then implemented unconventional policy measures. And while most other central banks implemented some form of quantitative easing, the RBA instead adopted a policy of yield curve control where they said they targeted a specific yield, which was effectively 0%, on the three-year government bond. And so that meant that the interest rates on all government bonds up to that three year term were also effectively pegged at 0%. It was effectively a form of very strong forward guidance. They were saying that they thought the cash rate would be kept at zero for the next three years, and they were backing up that forward guidance with an explicit peg for the three-year bond at that 0% rate.

Gross: And for a long time that yield curve control worked fairly well. Very few interventions in the market were required to keep interest rates at 0%. They would intervene occasionally, but fairly rarely. And that program was maintained right up until the end of 2021. And that's when we first started to see signs of inflation bouncing back. We got a moderately strong inflation print in October, 2021. And that's when financial markets started to realize that maybe we're inflating quicker than we thought, certainly quicker than the global financial crisis. And if that was the case, then this promise to hold interest rates at 0% for three years was not going to be viable.

Gross: And so financial markets started to sell these bonds and that led the yield to rise. And the RBA was faced with a tricky situation. They could either agree to buy all the bonds in the market to keep the peg and keep their credibility, or they could abandon it overnight in a bit of a messy situation where they just said, "Look, the peg's been broken, we're not going to try and enforce it." And ultimately they decided to do the latter. And so over the course of about a week after that very strong CPI print was released, the RBA decided not to try and enforce a peg and it rapidly collapsed. So it was a policy that worked for a while, but all of a sudden when it was realized that the forward guidance of 0% for three years was not viable, not credible, it collapsed very quickly.

Beckworth: Yeah, and that is the Achilles heel of yield curve control, it's exiting it when you know it can't be maintained or sustained. And that's something that we are seeing now with the Bank of Japan, it has a yield curve control in the 10-year government bond and it has slowly widened the bands. And if you look at the 10-year yield versus a 10-year swap rate, they have diverged quite significantly. And so what you see, I think, is the same story unfolding. They haven't completely abandoned their yield curve control. They've widened the range for the 10-year yield, but the markets know this can't be sustained, it's not credible given the inflation and other developments going on. So that's always the tricky thing. Any kind of pegged price, exchange rate control, yield curve control, even exiting the zero lower bound, all those moments when you've got to get away from it, how do you do it minimizing disruption, minimizing losses? So another great case study from the RBA as well as from the Bank of Japan on that issue.

Beckworth: Okay, so we've been talking about some of the recent history of the Australian economy, the role that the RBA played in it, an important role as you note in your paper and as you've articulated on the show. Let's talk about the review. So the Reserve Bank of Australia underwent a review, I believe it came out in March this year, 2023. And you had some external folks come in and provide it. The panel members were Carolyn Wilkins, Renée Fry-McKibbin, and Gordon de Brouwer. And I know Carolyn Wilkins because she was the deputy governor for a long time at the Bank of Canada, she's also now an external member of the Bank of England's Financial Policy Committee. So we've got some great folks there. You also had some experts papers done, some research papers done as well, Eric Leeper, Andy Levin, some others wrote some work done. But tell us what was the goal of this review? How wide ranging? Was it just the framework? Did it also apply to the operating system to its role in banking and financial stability? How broad was the review?

Breaking Down the RBA’s Recent Monetary Policy Review

Gross: So the motivating factor for the review was that inflation undershooting period from 2016 through till the pandemic. And I must confess my co-author on that paper that discussed that inflation undershooting is Andrew Leigh, and Andrew Leigh is actually a member of Parliament now and is actually a minister in the government that launched the review. So the government was well aware of the economic issues involved in the undershooting, and I think that was the main motivation for launching the review into the RBA. They wanted to unpack why this policy mistake was made, whether it meant that the RBA's framework needed to be updated and in particular this idea of leaning against the wind, whether it should be changed, and also whether the RBA needed structural change, just in the way that, as you said, the operating system works, whether the composition of the RBA board was really best practice.

Gross: So it was a fairly broad review. It covered a whole range of different factors, and it came up with over 50 recommendations that covered all of those areas. And so I think while some of the conclusions of the review, I guess, wouldn't be a surprise to an economist, the idea of leaning against the wind not being best practice according to the research, and perhaps we can talk about the composition of the board as well. I think what's perhaps most unique about the review is it's an example of a central bank being, in some sense, interfered with by the government, but having a positive outcome. We saw the government launching a review into the RBA and I think it's come up with a lot of really positive recommendations that will improve monetary policy in Australia going forward.

Beckworth: Well, that's an interesting observation that it's an example of politics or the body politic itself weighing in on monetary policy, particularly after a run of below target inflation, which can be translated into maybe potentially below real growth as well. That reflects weak aggregate demand that could have been done differently under a different monetary policy framework. It's also interesting that the motivation was this low inflation period, just like that was the motivation for the Fed's review from 2019 to 2020, and I believe to some extent the ECB's review as well. So both the Fed and the ECB, the Fed more explicitly, have adopted inflation targeting with makeup elements, so I think it's well known to our listeners, FAIT, Flexible Average Inflation Targeting. The ECB is not as strong, but it also talked about having a symmetric inflation target and they would be willing to run inflation temporarily high if it was persistently below target. So that has a little bit of a flavor of it, not as strong, but a little bit of flavor of makeup policy. Now, I did not see that in the RBA review, is that right? They did not want to do any kind of makeup policy.

Gross: That's right. So I think it's an interesting comparison you make to the Federal Reserve and the ECB review because I think it's fair to say that the RBA, while they participated actively in the review, they were not enthusiastic about having one in the first place, which is why I think it was very an initiative led by the government. And I think the comparison is also interesting in that the RBA review came after the takeoff in inflation. And so FAIT had the unfortunate luck of being implemented just before we saw a really unexpected increase in inflation. And I think some people would unfairly attribute that to FAIT, or it certainly hasn't given that flexible average inflation target much room to demonstrate its potential appeal. But the RBA review actually came later. It came well after the inflation shocks had been realized.

Gross: And so partly for that reason, I think, they steered away from any form of makeup policy and they re-endorsed the flexible inflation target of between 2% and 3%. And while there was some discussion I think early in the days of the review about, should that inflation rate be lifted to try and escape from the zero lower bound, the fact that they were able to see the inflation shock play out in real time meant that a lot of those recommendations about a higher inflation target or potentially having a makeup policy became less relevant and accordingly weren't major parts of, or they didn't make it into the final recommendation. So I think it's an interesting hypothetical, what would have happened to the Federal Reserve's review if they held it two years later instead of just before inflation took off. Maybe they wouldn't have recommended that makeup policy, but I guess it's a hypothetical we'll never know the answer to.

Beckworth: Well, timing is everything, and the RBA just got the timing right to not bring on board makeup policy. It will be interesting to see, though, 2024, 2025 when the Fed does its next round of reviews, whether they consider any tweaks to the framework. I think a lot of it will depend upon where inflation has gotten to by that point. If inflation's back to 2%, I think there are many options on the table. If it hasn't gotten to 2%, they're probably going to be very conservative in what they do moving forward. Now, as I mentioned, the Fed does it every five years, which is a new thing for the Fed. The Bank of Canada has been doing five-year reviews for a long time. This was their first review for the Reserve Bank of Australia, I understand, since the early '90s when the inflation targeting framework was introduced. And I'm wondering, are they going to do a regular review as well every five years or so?

Gross: Look, that was one of the recommendations of the review. As you said, it's been 30 years since the RBA sat down either internally or with external experts to reassess its framework and how it operates. So hopefully we will get another review in five years' time and we'll have a regular process much like other central banks around the world. I think that would have greatly assisted the RBA when it comes to changes in its framework. When it adopted leaning against the wind, in 2016, it did so largely without much discussion. It was included in its new framework, but there wasn't much debate about it. There wasn't much, either with… well, there may have been debate within the RBA, but there was no debate externally with external economists and external experts. And so I think that's one reason why these policy areas can get made if there's not that external robust discussion.

Gross: At the very least with the makeup policy that the Fed has, they had that discussion and I think it probably reflected the consensus wisdom at the time. Now, maybe that consensus wisdom will change, and obviously with that regular review you've got that opportunity for any change in consensus wisdom to be reflected in the new framework going forward. But I think ultimately that's why these sorts of reviews are really important, because you can have that discussion, make sure you are operating according to best practice, and then if best practice changes, you can change your framework to match the new consensus. Because ultimately monetary policy, it's unfortunately or perhaps fortunately for us, not a static science, there is no one global answer that will solve all of our problems until the end of time. We're going to need to change how we do things as the economy changes.

Beckworth: So, Zac, one of the recommended changes from this RBA review was to change the structure of the board itself, or the monetary-policy decision-making body. So walk us through those suggested changes.

The Suggested Changes for the RBA

Gross: So the RBA board, as it's currently made up, has the governor, their deputy governor, and then six external representatives, along with the Secretary of the Treasury as well. Now, these six external representatives, traditionally, have been mostly captains of industry, people who you might expect to see on the board of Walmart, for example. Basically, people who have very little, if any, expertise in monetary policy and macroeconomics. So they usually, out of that six, appoint one token external economist, although not necessarily a macroeconomist. And so you have a board which is mostly external members and mostly non-economists. Now, I think this is pretty obviously a very strange setup to run a central bank. Most other central banks have economists making the decisions, and while there are obviously economists in the room, and the governor's an economist, having a majority of non-economists on the board is certainly, I think, a very strange way to run a central bank and mostly an accident of history. It was just a norm that developed over time and one that governments saw no need to depart from.

Gross: And so one of the big recommendations of the review was that, look, this board of non-experts means that you have poorer policy decisions made, the board minutes are dumbed down from what they could be, and some of the mistakes aren't being questioned by a range of experts. So perhaps unsurprisingly, when you have non-experts run your policy process, you get poor policy outcomes. And so one of their recommendations has been to shift away from that approach and to something that more closely resembles the Bank of England's approach to running monetary policy. So you have a monetary-policy committee staffed with experts, both from within the bank and some external to the bank, and they're much more involved in the process.

Gross: So in terms of lessons for other central banks, one obvious lesson is don't appoint the chairman of Walmart to your central bank. That might lead you down a dire path. But I think this is a good example of how an accident of history might perpetuate itself and not really change until a really serious policy error gets made, and then people start to wake up and say, "Well, why did this policy error get made? What can we do about it? Does it really make sense to have all these non-economists running monetary policy for Australia?" And I think the answer to that is pretty obviously no, and that's exactly what the review found.

Beckworth: It seems like a reasonable recommendation. How well received has it been?

Gross: Look, amongst economists themselves, I think [there’s been] pretty universal acclaim. Perhaps self-interestedly, we all like the idea of more economists being appointed to the board. I think there's been a reasonable amount of pushback in the popular press. A lot of people said, "Oh, what do these academic experts know about the real economy? They don't have their finger on the pulse." Or some have even gone so far as say, "Well, they'll feel a need to override the central bank and we'll have a whole bunch of academic economists trying to run roughshod over the governor and make all sorts of other policy errors."

Gross: Look, I think there's been a lot of hyperventilating about it. Certainly, the experience from overseas shows that external experts will provide an additional check on the policy process, but I think actually overruling the central recommendation from the central bank staff and the central bank governor is actually fairly rare. So I think there'll be a lot of panic about the change. There's probably a lot of panic about any form of change, and potentially some captains of industry in Australia that might be a bit disappointed that they won't also get a turn helping to set monetary policy. But ultimately, I think this is a pretty clear improvement on the status quo, and hopefully, the external experts who are appointed to the RBA's board will do a good job of improving policy without completely running roughshod over the RBA staff themselves, who are of course also pretty expert at managing the Australian economy.

Beckworth: Absolutely. Now let's talk about inflation in Australia. We've touched on it already, but how high did inflation get, number one? And number two, did inflation become a big public concern? Was this something in the polls that people worried about and therefore politicians will worry about and therefore the RBA will be forced to think about?

Australia’s Inflationary Experience

Gross: Yeah, so inflation had peaked in Australia a little bit later than in the rest of the world, around just shy of 8%. So perhaps a little bit lower than what we saw in the US and a little bit later. And I think that's in part due to the fact that our COVID imposed lockdowns lasted longer in Australia. We were quite aggressive on COVID zero, and so large parts of the country were locked down right up until the end of 2021. And so that sort of revenge spending boom only really got started in the middle of 2022. So we had a later peak in inflation, but it is slowly coming down here, as it is in the rest of the world. One big difference between how Australia has experienced that rise in inflation and I think how the US in particular has dealt with it is how interest rates are reflected in the mortgage market.

Gross: So in the US there is a norm for 30-year fixed rate mortgages. And so if you've bought a house, you've got your mortgage, even though interest rates might rise quite a bit to deal with an inflation burst, that probably won't affect you directly. By contrast, in Australia, the vast majority of households have either an adjustable rate mortgage or a fixed rate with a very short term, maybe one or two years at most. And so while inflation has certainly been unpopular, I think what's been far less popular is the increase in everybody's adjustable rate mortgage. So if you were previously paying maybe a little bit above 2% on your mortgage and you are now suddenly paying over 6% on your mortgage debt of maybe $1 million Australian, which would be still hundreds of thousands of US dollars, you'll have seen a very large fall in your disposable income.

Gross: And that increase in interest rates is very unpopular in Australia from the perspective of Australian households. And I think what makes it perhaps even more unpopular is that the RBA during the crisis gave this very strong forward guidance that interest rates would remain at zero, which in fact turned out not to be the case. And so when you tell Australian households, "Don't worry, interest rates will be at zero according to our best forecasts," and then you instead raise interest rates in perhaps the most aggressive tightening cycle they've ever experienced, I think you'll get a lot of popular discontent with the central bank. And that's part of what's fed into, I think, the review and some of the popular anger at the RBA in the past couple of years.

Beckworth: So are the rate hikes having a real bearing on the economy? We look at the Eurozone, for example, they look like they're in a recession, two quarters of negative real growth. Do you see a similar thing happening in Australia?

Gross: So I think if you look at the hard data, we've yet to really see it hit the economy as we might expect. The unemployment rate is still at 3.5%. We're seeing some falls in some of the more interest rate exposed sectors. So there's been a bit of a cutback in retail spending over the past few months and a slightly bigger contraction in the construction sector. We're seeing a number of insolvencies there, but I think it's fair to say that given the very sharp increase in interest rates, I don't think we've seen a similar decrease in activity perhaps than we might have expected going into the rate hiking cycle.

Beckworth: That's interesting. So that's another similarity with the US economy. Lots of talk over here about how the economy's become less interest rate sensitive, and maybe that's part of the story. But I think housing's a big part of this conversation as well. So in Europe they also have shorter term mortgages, adjustable rate mortgages, and it has a bearing. Now, it's beginning to have a bearing here as well. So mortgage rates in the US are now above 7%, so new mortgages are being affected, real estate jobs are being affected, but it hasn't quite had the bite as it did in Europe and it sounds like in Australia. So it'll be interesting to see, if we keep these rates up where they are, which it looks like we're going to do, how long will this continue to have a bearing on the economy and what will be the ultimate outcome. Alright, let’s talk about the balance sheet of the RBA and the operating system. So you mentioned during the pandemic the RBA actually went out and engaged in a form of QE. So I assume that means that the RBA then operates in a floor system or abundant reserve system, at least during this period. What historically has been the RBA's operating system?

The RBA’s Operating System

Gross: Well, I guess I'd first step back and say part of the motivation for the yield curve control program was a desire not to have a very large balance sheet. So going into the crisis, the Australian government had a relatively low level of government debt. And because there was a relatively small pool of government bonds out there to buy, I think part of the motivation for the yield curve control program was that, look, under quantitative easing we would have to buy probably a fairly large stock of bonds and potentially drain the market of government bonds to a unhealthily low level. And instead, if we can implement a yield curve control target and it's credible, which it was for at least the first 18 months of its life, then we won't have to make too many purchases. And that logic was sound. I think it's more or less what played out, but I guess what the RBA didn't appreciate was that the fiscal response to the COVID-19 crisis would mean that even if we went into the crisis with a low level of government debt, we would rapidly resolve that problem.

Gross: And accordingly, in November or later on in 2020, the RBA did end up implementing its own quantitative easing program when the economy was still performing fairly sluggishly. So in theory we probably could have gotten away with a relatively small expansion of our balance sheet if we'd stuck to yield curve control and not engaged in quantitative easing. But ultimately we did end up going into a quantitative easing program, and that did lead to a large expansion of our balance sheet. So prior to the crisis, in part because I guess we've been lucky enough not to hit the zero lower bound at any point and not to have to engage in quantitative easing, the RBA did have a very small and narrow balance sheet, and so it was able to implement monetary policy according to, I guess, the traditional corridor system with relatively sparse reserves. Since 2020, however, that balance sheet has ballooned out and we have defaulted back to a floor system. And similar to the Federal Reserve, even though interest rates are now well above that zero lower bound, we still remain in that floor system today.

Beckworth: Are they planning to go back to a corridor system, shrink the balance sheet down and return to what they had before the pandemic?

Gross: Yeah, I think that's the plan. They've spoken about this mostly in terms of quantitative tightening and how they're going to shrink down the balance sheet. I think the actual, I guess, public discussion about a floor versus corridor system, it's obviously a relatively niche technical topic, perhaps excluding listeners of this podcast. But they haven't explicitly talked about their desire about which system to keep, but they have talked about shrinking the balance sheet. I think part of that motivation will be returning to the corridor system that they're much more used to in terms of how they set the overnight cash rate.

Beckworth: Well, This sounds like it could unfold a lot like what happened in Canada during the 2007-2009 period. They also came in with a corridor system, scarce reserve operating system. They blew up their balance sheet during their recession and then they shrunk it back down relatively quickly. So they went from a corridor to a floor to a corridor, and one could say maybe the floor is a special case of the corridor when you're just at the very lower part of the corridor and you're stuck there for a while. So it'll be interesting to see. I guess one last question on this, is this a particularly poignant or important issue over there? Is it only people like you and me who talk about it in Australia?

Gross: Look, it definitely doesn't get the amount of attention that, well, perhaps it ought to. I think most people have cared about the level of the interest rate and they aren't too fussed about how it's set. The RBA does publish a lot of research on this. So while the balance sheets are still large, activity on the cash rate market or the federal funds rate market equivalent has started to pick back up. And that's in part due to the fact that the reserves aren't completely evenly distributed amongst participants in the cash market. And we, in fact, have a few taxes on banks that disincentivize the major banks from participating in the market. So we are seeing the cash rate market perk back to life, even though the balance sheet hasn't completely gone back to its original level. I think there is that desire to see that cash market return. It was a fairly successful system for the RBA at the time, and I think that's probably what they'll try and achieve. I think from the point of view as a lecturer teaching macroeconomics, I think the corridor system has a slightly easier intuition to teach students. So perhaps from a purely selfish point of view I hope they do return, but I think it's something that we'll have to wait and see as to whether they can fully achieve that return to the corridor system.

Beckworth: Well, I hope they do as well. I'm a big advocate of the corridor system, as listeners of the show will know. I'm also a realist and I don't expect the Fed any time soon to return to it. But I do think maybe a midway goal would be moving to a tiered reserve system, which is somewhere between a corridor and a floor, where some of the reserves are remunerated and the rest of them are not. Okay, well, let's move from that and go back to the review a little bit, and I want to talk about their discussions on alternative approaches. So you outlined already that the timing was really poor for any kind of makeup policy to be a part of this conversation, or if it was a part of the conversation, it was shot down pretty quickly because, hey, look, we've got plenty of inflation, no worries about hitting our target. If anything, we're going to overshoot our target.

Beckworth: But nonetheless they had some discussions apparently, because in the appendix to the report, and they discussed it in the report some too, but the appendix provided some detailed discussions of these alternative approaches. So they have a section on average inflation targeting. They've got a section on price level targeting. They have a section on nominal income growth targeting, and then my favorite, nominal income level targeting. And I just want to read a few excerpts from this. This is appendix two in the back of the report, and we'll provide a link to the report, listeners, in our show notes. So check it out. We'll also provide a link to Zac's paper we've been drawing on in this discussion.

Beckworth: But it goes through average inflation targeting and it lists the advantages and it lists the disadvantages, some of the challenges. And I want to read the one last concern it has with average inflation targeting. It says, “average inflation targeting would make it more difficult for monetary policy to ‘look through’ temporary fluctuations in inflation. For instance, due to short-lived supply shocks or one-off shifts in administered prices, a need to respond in subsequent years to offset those one-offs might come at a substantial cost to central bank's employment or real activity goals,” which is very true, and I think that's also a concern of price level targeting. If prices go up because of a real shock or changes in tax laws, those things themselves will be a drag on the economy. You don't want to add salt to the wound, make it worse by further constricting the economy with tight policy.

Beckworth: And that's why I believe one of the key motivations for doing FAIT, flexible average inflation targeting... So the way the Fed set it up is they would only respond to inflation undershoots. So they're very clear about this. If they go under... And [this is] tied to zero lower bound, so largely demand shocks pulling inflation down. But once you're above the target, it's back to the old regular flexible inflation targeting. And I think that was a concern. They didn't want to have to engineer a recession to respond to prices being higher simply from supply shocks. But I also think this speaks to some of the challenges the Fed did have in '21, '22. Clearly, some of the inflation was supply-driven. Some of it also became demand-driven. Knowing in real time how to break that up is very tough. How much was supply-driven? How much was demand-driven? How long will transitory last? And I think at that point, it becomes a bit of an art, and there's going to be confusion, which is why I then of course resort to nominal GDP targeting or nominal income level targeting.

Beckworth: And so they have some nice things to say about it, and I would note I would not advocate nominal income growth targeting. I think that comes with a lot of challenges. But they say some nice things here, and Zac, I just got to echo these nice things they say, then I'll echo their concern with it too, and you can maybe respond to this. So I'm not going to read everything, because they do say a lot, but a few quotes here from their assessment of nominal income level targeting. They say in particular an important potential benefit of a nominal income level target is that it may better promote economic recovery from downturns, particularly where monetary policy faces the effective lower-bound constraint when there is a downturn in real activity. So that's just the forward guidance appeal of any level target. It could be price level, it could be a nominal GDP level target as well. I think the difference is, of course, is it has a better way of dealing with real shocks versus demand shocks. They also note there may also be benefits to financial stability from increases in inflation expectations at times of surprisingly low economic growth. So there's a financial stability argument for nominal income targeting.

Beckworth: But then they go into some of the concerns, and they note, “one particular concern for nominal income level targeting is that nominal income measures are frequently revised such that the goalposts for monetary policy will change in unpredictable ways.” That's fair. “A historical revision could leave central banks with an unexpected gap to make up. Consumer price index data are not revised, while employment data are. Nominal income measures are also released with a greater lag length than the inflation and employment data and are only available on a quarterly basis.” Well, that's a pretty damning indictment, right? But they leave something for me. They say this, “though both of these features could presumably be improved if they were a priority.” In other words, if you were to go to a nominal income level targeting regime and there's dedication to it, you could dedicate resources to get better real-time measurements of this data. So it's not impossible, but it clearly is a challenge in present form to do it. So any thoughts on that discussion?

Alternative Approaches to Monetary Policy

Gross: I used to be quite sympathetic to nominal GDP targeting, but I think in the case of Australia in particular, it is a very poor policy fit, and that goes back to our original discussion about what it's like to be a small open economy, particularly one with a large mining sector attached. Whenever the price of iron ore or coal jumps up or down, which it does with alarming frequency, you see really large fluctuations in nominal exports in Australia, and accordingly, nominal GDP. And importantly, these fluctuations in nominal GDP have relatively little correlation with the underlying state of the Australian economy, such as the unemployment rate or the rate of consumer price inflation, and that's because if the iron ore price increases when a mine in Brazil floods, for example, we'll sell a lot of that iron ore at a lot higher prices, but it won't fundamentally change even how much employment is in the mining sector. It'll be this large windfall bonus to the mining companies that will have relatively little spillovers into the broader economy.

Gross: So when it comes to targeting nominal GDP in Australia, I think that would lead to a very poor implementation of monetary policy. You'd have monetary policy responding to the supply shocks from overseas in a way that isn't really optimal for the Australian domestic economy, which is where, at the end of the day, most of the Australian economy is in terms of unemployment and the inflation rate. So while I can see the case for it in a very large economy, in a smaller open economy I think the case is a lot weaker. And while Australia is an extreme example of that, with our very volatile terms of trade due to our mining sector, I think it probably applies to a lot of other small economies that will, through the natural process of comparative advantage, they'll always have some sector that is more volatile and perhaps more exposed to international prices. So I think that's the big problem with nominal GDP targeting in the Australian context.

Gross: Now, a natural response to that is to say, well, no inflation targeting central bank targets headline CPI. That's too volatile, too responsive to one-off shocks. They all target some sort of underlying measure of inflation, more or less. They target core PCE or trimmed mean CPI. And so accordingly, a nominal GDP targeting central bank could take a similar approach and say, "Look, we're targeting nominal GDP, but what we really care about is some measure of core nominal GDP." And what that could be could vary. It could be some measure of domestic final demands, excluding that nominal export sector, or it could be nominal consumption, nominal wage growth. The possibilities are endless.

Gross: Unfortunately, because we haven't had a country that's tried to pursue this policy approach, I don't think that work's been done about what that underlying measure of nominal GDP might be. So similar to what you were saying about the fact that we only have it quarterly and we only have it with long lags, I think at the end of the day, if nominal GDP was to be successful, we'd probably end up needing some form of core nominal GDP or some measure of underlying nominal GDP. But what that is and how we would measure it, what the best choice is, I think really hasn't yet been determined. Perhaps that's a future project for you, David, at the Mercatus Center, but I think that would be a key input into any future nominal GDP targeting central bank.

Beckworth: Well, Zac, I appreciate you leaving the opening there at least for some glimmer of hope for some form of nominal GDP targeting in Australia, but I agree. I think it would make more sense there to do something like a nominal income target that's based on wage data or a consumption target. So Evan Koenig, who used to be the Dallas Fed, he actually promoted a PCE target, the personal consumption expenditure, the nominal form of that. So there are other alternatives out there and based on what model you use. Evan Koenig's model, he actually preferred PCE over the total nominal GDP measure because he thought it was better tied to some of the structural parts of the economy. But nonetheless, interesting discussion, always room to grow and learn more and to look at work where we can apply maybe ideas that work in bigger economies to smaller open ones. So, [this is] a fertile area for research for all the listeners out there. With that, our time is up. Our guest today has been Zac Gross. Zac, thank you so much for coming on the show.

Gross: Thanks for having me, David.

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