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A future-focused review must question Reserve Bank’s inflation target

Updated: Nov 22, 2021

The RBA should welcome a review

Warwick McKibbin

20 September 2021

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The Organisation for Economic Cooperation and Development statement in the latest assessment of the Australian economy that there should be a review of the Reserve Bank of Australia is welcome news, Warwick McKibbin writes. The Organisation for Economic Cooperation and Development (OECD) rarely publishes documents that haven’t already been through a review process with the Australian Treasury, and the Australian Labor Party has been calling for a review for some time, suggesting that one is inevitable.

There have been several reviews of central banks in different countries in the last few years, including the Bank of Canada, the United States Federal Reserve, and the European Central Bank (ECB). These reviews have helped refocus these institutions’ roles and adjust the monetary framework better to suit these economies’ current and future economic conditions. I was recently involved in an expert panel that evaluated the ECB review.

What should be the focus of a review of the Reserve Bank of Australia (RBA)? Most of the review should be forward-looking rather than criticising past decisions. To the extent that a historical assessment will be helpful, it is to learn lessons for future institutional and policy design.

The review should ask several questions: Is the central bank mandate of inflation targeting still relevant given the recent experience of consistently missing this target? Is inflation targeting the best framework for future years when the Australian economy undergoes a significant structural adjustment to climate change and technological innovation?

What are the policy levers available for implementing the monetary policy mandate? Is the current structure of the RBA Board relevant today? Should resources be made available to members of the RBA Board to support independent analysis? What mechanisms should be in place to maintain regular scrutiny and accountability for the RBA actions but ensure the RBA is independent of the government of the day? The RBA’s goals are enshrined in the Reserve Bank Act of 1959, which states that the RBA is responsible for the stability of the currency, full employment, and the welfare of the people.

This Act is implemented through the Statement on the Conduct of Monetary Policy, which is an agreement between the federal treasurer and governor of the RBA. The RBA policy mandate set out in the Statement can be described as targeting inflation over the cycle.

The concern with inflation came from a time when demand shocks dominated the Australian economy, but supply shocks are more likely to dominate demand shocks in the upcoming structural transition. In a world dominated by supply shocks, it is well known that inflation targeting regimes are not the most suitable policy framework.

Augustus Panton, an economist at the International Monetary Fund, and I have argued in a Reserve Bank conference volume that this is not the appropriate monetary framework for a central bank today. Since that paper was published, the COVID-19 pandemic and the significant increase in government and private debt give even greater weight to the argument that some form of nominal income target will be a better target than inflation.

The structure and role of the RBA board and its operating procedures also need review. Membership of the RBA is a part-time position. Historically the composition of the nine-member board reflected the sectoral composition of the economy with representatives from agriculture, mining, manufacturing, retail, a member of the union movement, an academic, the treasury secretary, and governor and deputy governor. This structure was intended to bring the expertise of the broader community to the monetary policy process. This structure has evolved over the years, with the Howard government removing the union representation. Before I was appointed to the board in 2001, my opinion was that the RBA Board should be an expert panel similar to the Monetary Policy Committee of the Bank of England. In this structure, RBA officials would have to argue with experts in monetary economics in Australia’s monetary policy setting. Since being on the board and seeing firsthand many of the business community members making substantial contributions to the board discussion my view has changed, and I now believe the board should include a mix of economists with diverse perspectives and representatives of the business community.

However, the secretary of the treasury should only attend the meeting to provide information on the current and future stance of fiscal policy but have no voting role to avoid conflicts of interest. Each board member should be allocated the services of junior staff within the RBA to provide research support and analysis to develop independent views that may better inform the RBA policy deliberations.

During the financial crisis of 2009, having access to my global economic models and PhD students proved invaluable in informing my position on how to respond to the crisis. The RBA staff are intelligent, well-trained economists, and many have spent their entire careers inside the Bank. I believe the RBA has done an excellent job since learning the lessons of the policy mistakes that caused the 1991 recession that we didn’t “have to have.”

The response to the Global Financial Crisis and the COVID-19 pandemic in 2020 has been world-leading.

The RBA should welcome a review. Now is the right time as the Australian economy prepares for a period of significant structural change driven by climate shocks and climate policies globally and a period of rapid technological change.

This piece was first published by the Australian Financial Review.

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