How policy makers should respond to Australia’s slowing economy
Published by The Guardian, Saturday 21 September
With the unemployment rate rising from 5.0% at the start of the year to 5.3% in August, and the latest GDP figures showing slow growth and the economy going backwards when accounting for population increase, talk is very quickly turning to what can be (or should) be done.
There are two policy arms of the economy – fiscal and monetary. The government controls the fiscal side through spending and taxes; the Reserve Bank controls the monetary side.
The RBA has already cut the cash rate twice this year, to a record low of 1%. But with inflation growth still below the 2%-3% target the question is whether the bank is doing enough, or whether the government needs to do more.
We asked three experts on the economy – Stephen Kirchner from the United States Studies Centre, Brendan Coates from the Grattan Institute, and Emma Dawson from Per Capita – to discuss these questions.
Greg: Is the RBA right to call for greater fiscal intervention by the government, and are we at a point where monetary policy is less powerful than it was in the past?
Dr Stephen Kirchner is director of the trade and investment program at the United States Studies Centre, University of Sydney.
Stephen: Governor [Philip] Lowe would be on stronger ground asking for help from other arms of policy if the RBA was pulling its own weight, but it is not. The persistent undershooting of the inflation target is a deliberate policy choice the RBA has made that has left the unemployment rate around 0.7 percentage points higher than it should be, even on its own estimates.
The case Lowe has made for spending on infrastructure and other policies to enhance productivity is independent of the economic cycle and would be no less important in a boom than in an emerging downturn. He is conflating long-term structural policy measures with short-term demand management. Lowe is trying to shirk responsibility and deflect blame for underperforming his mandate. Chris Kent recently showed monetary policy transmission is as powerful as ever.
The point of having a floating exchange rate and an inflation-targeting central bank is that fiscal policy does not have to worry about short-term demand management.
Emma Dawson is the executive director of Per Capita.
Emma: Yes, and yes. Monetary policy is far less effective at stimulating the economy than it was pre-GFC. The two decades before the GFC saw sustained economic growth, increased living standards and relative economic stability, producing an environment in which households increased consumption and took on more debt.
Since the GFC, high levels of household debt, particularly for housing, combined with stagnant wage growth and a disproportionate increase in the cost of non-discretionary spending – far in excess of either CPI or wage growth – has crushed consumer confidence, meaning that even with interest rates at record lows, people are less willing to take on debt or reduce saving; they are focused on paying down existing debt and meeting the increased costs of living. Therefore, repeated interest rate cuts by the RBA are being met with a very muted response from consumers.
Monetary policy is meant to stabilise immediate economic settings; what we are seeing now is long-term, structural weakness in the economy, which has been exacerbated by the contractionary force of fiscal policies over more than five years. Stagnant wage growth is due to a deliberate reduction in bargaining power for workers, the government’s policies to restrict wage growth in the public sector, a lack of investment in infrastructure and moribund industry policy settings. That the government is pursuing a surplus in this environment is counter-productive.
Brendan Coates is program director for household finances at the Grattan Institute.
Brendan: I agree with Stephen that the RBA should continue to be held responsible for hitting its inflation target, and it has been failing to do so for an extended period. After all, the US unemployment rate has a three in front of it. Ours has a five in front of it, and is rising. The difference between 3% and 5% unemployment is hundreds of thousands of people who are not in work, slowing economic growth and hurting the budget balance. The RBA’s monetary policy choices account for a significant share of that difference. Our unemployment rate is higher than it could or should be because monetary policy has been too tight.
But there are reasons to think that as the Reserve Bank’s policy rate inches closer and closer to zero, the benefit from further cuts gets smaller and the cost gets larger (although the evidence is not as clear as we’d like it to be). Now is not a time for fiscal and monetary policy to be pulling in different directions.
Greg: What are the consequences of the Reserve Bank missing its inflation target? Has the RBA lost credibility? Should the target be lowered?
Brendan: The big problem here is expectations: if the Reserve Bank repeatedly misses the target, and also publicly claims (as Lowe has) that monetary policy isn’t going to work, then you entrench expectations for low inflation (and even deflation). And while there are not that many rate cuts left in the arsenal, there are other tools the Reserve Bank can use. In particular, there’s certainly plenty of scope to use so-called unconventional monetary policy to stoke inflation and ensure the RBA hits its inflation target, ultimately boosting economic growth and lowering unemployment below 5%.
Lowering the target would be a big mistake: a lower inflation target, such as 1-2% (rather than the 2-3% band we have currently) would suggest we should soon be raising interest rates, slowing the economy down even further from where we are today. After all, the RBA’s preferred measure of inflation is currently running at 1.6%. The central question in the monetary policy debate abroad is whether the inflation target should be lifted, rather than lowered. Instead there is a clear need to strengthen the focus on the RBA hitting its current inflation target.
If the bank wants to achieve two objectives, it needs two policy instruments. Fortunately, it has them: monetary policy for inflation, and macro-prudential policy in concert with Australian Prudential and Regulatory Authority (Apra) for financial stability.
Recent comments from the treasurer signalling that the mandate to the RBA will be revised to “strengthen that target to ensure that we continue to see inflation where the Reserve Bank and the government want it to be” are a promising sign.
Stephen: By choosing to undershoot the inflation target, the RBA has damaged the credibility not just of the target, but monetary policy itself. Some commentators have suggested the target needs to be revised lower. But moving the goal posts would fail to hold the RBA accountable for delivering on its mandate.
The actual target range is less important than having the RBA deliver the inflation outcomes people expect. As Brendan notes, the debate in the US has been almost exclusively about raising the target, even though the Fed has also undershot its 2% goal.
Inflation expectations implied by the Australian bond market have collapsed. Financial markets no longer believe the RBA is committed to the inflation target.
1. Reinstate the Labor party’s 2010 agreement that subordinated the financial stability objective to the inflation target;
2. Have Lowe front a press conference after each CPI release to explain the outcome and underscore the RBA’s ownership of inflation;
3. Make Lowe’s reappointment conditional on inflation averaging between 2-3% over the remainder of his term.
Emma: I agree that monetary policy has been too tight and that this is partly responsible for our relatively high unemployment rate; when the RBA itself has clearly stated that the non-accelerating inflation rate of unemployment (NAIRU) is really closer to 4%, the RBA’s tardiness in cutting interest rates is difficult to understand. Unemployment rates in comparable OECD nations have been well below Australia’s for well over two years, without causing break-outs in wages or inflation.
Both Brendan and Stephen are right to point out that the tightness in monetary policy over the last three years is, in part, due to the emphasis on financial stability in the mandate agreed with the treasurer after the 2016 election. I agree that recent comments from the treasurer that the mandate will be revised to reinstate the primacy of the inflation target are encouraging; it’s critical that the new agreement be settled ASAP.
While the RBA has flirted with the use of unconventional monetary policy to stimulate growth, it remains reluctant to do so, in line with its historical reliance on interest rates alone. The RBA could certainly be less conservative in its approach to monetary policy.
I don’t agree that the RBA’s failure to hit its inflation target has damaged its credibility; most observers recognise the challenges presented by a global downturn in wage growth and historically low inflation. The critical issue is for monetary and fiscal policy to pull in the same direction.
What responsibility should the government take for the reduced growth in demand and the undershooting of the inflation target? Is this a sign that fiscal policy should become more expansionary?
Stephen: Fiscal policy is a powerful tool for creating incentives (or disincentives!) to work, save and invest. It can also be deployed in ways that enhance the productive potential of the economy. But this contribution is independent of demand management.
With a floating exchange rate and an independent inflation-targeting central bank, fiscal policy is irrelevant to demand management. A fiscal expansion would only lead to capital inflows, an appreciation of the exchange rate and crowding-out of net exports. Moreover, if the RBA were doing its job and inflation were target-consistent, it would have to offset anything the government might do with fiscal policy that moved inflation away from target.
The treasurer should not try to do Lowe’s job for him.
Brendan: As Stephen notes, there’s good evidence that monetary policy is still effective, even if it’s perhaps a little less effective than otherwise as we approach the zero lower bound. It’s not a lack of ammunition that’s holding the RBA back, but an unwillingness to use that ammunition to achieve that part of the bank’s mandate.
But I disagree with Stephen that fiscal policy should never be used for demand management, or that it can’t be effective, especially if the economic outlook becomes particularly dire. David Gruen, then deputy secretary at the Treasury (and formerly with the RBA) made the case for short-term fiscal stimulus as demand management in the aftermath of the global financial crisis.
It’s clear that the government is making the Reserve Bank’s job harder. If we have to choose between going down the route of unconventional monetary policy, or shifting fiscal policy a little, it’s not clear to me why we’d just want to rely solely on the former and not at all on the latter.
But the big pitfall with fiscal policy is timing. Whereas the case to act quickly was unambiguous during the global financial crisis, it’s quite a bit harder today. Most indicators are pointing to a slowing economy, and some are looking pretty bleak, but none clearly signal we’re at crisis levels yet. So it’s more a case of the government standing ready to act with fiscal stimulus, if it needs to.
Lowe’s calls for infrastructure spending are problematic: good quality infrastructure projects take time to plan and deliver, which means any infrastructure stimulus typically arrives too late to help, as it did after the early 1990s recession. The best fiscal stimulus policies are temporary, fast to roll out and involve “no regrets” – in other words, spending with a solid policy rationale, as I’ve argued here. If the government needs to act, it would be better to focus on building social housing, which would provide effective and targeted support to the construction sector when the pipeline is at risk of drying up, while addressing an important social problem, and boost Newstart, which is clearly too low today.
Emma: There is a clear case for more expansionary fiscal policy now, if not yesterday. Like Brendan, I disagree that fiscal policy shouldn’t be used to stimulate demand; there are strong precedents, both here and internationally, for short-term fiscal stimulus to stoke demand during economic downturns, and we are certainly seeing a downturn in Australia today.
While Brendan is correct to say that the conventional indicators of a recession are not present in the Australian economy, there is merit to the argument that those indicators are no longer fit for purpose given the structural changes to the labour market, including the rate of underutilisation, the consistent reduction in the share of profits going to labour and the lack of business investment since the GFC. While I agree that we need urgently to boost our stocks of social housing, a government program to do so would take even longer than bringing forward already agreed infrastructure projects, as it would necessarily involve Coag agreement and the procurement of land.
Rather, the government should legislate four quick measures to inject funds into low- and middle-income households:
1. Immediately increase the rate of Newstart by at least $75 per week;
2. Bring forward stage two of the tax cuts legislated in July;
3. Legislate to reverse the cuts to penalty rates across all awards;
4. Abolish the cap on APS salaries and provide pay rises of at least 3% to federal employees.
Greg: The talk, on the back of NAB’s advice this week, has quickly shifted to a cash rate falling to around 0.25% and even the use of quantitative easing – something the RBA has said in responses to questions “is unlikely”. Do you share the bank’s confidence that further cuts to the cash rate alone will do the job? What are your thoughts on the more unorthodox monetary policy measures such as QE?
Stephen: Lowering the cash rate is the most effective way to respond to the emerging global downturn. Monetary policy begins to work straightaway, not least via a lower exchange rate, which is the Australian economy’s most important shock absorber.
The RBA should transition to QE as soon as the level of the cash rate becomes a constraint on its ability to meet its mandate. We are not there yet, but very close. Since inflation is below target, the RBA has little to lose by acting quickly and decisively. Unlike fiscal policy, changes in monetary policy can also be unwound very quickly.
The RBA should purchase debt securities to lower interest rates across the yield curve, as well as credit spreads and the exchange rate. More targeted measures could also be used to address points of friction in the transmission to retail lending rates.
Some have suggested so-called “people’s QE,” where the central bank directly finances fiscal transfers to households. This would work, but perhaps too well. It would break down the institutional separation between monetary and fiscal policy. Once that divide is breached, it will be very hard to put back together.
Emma: For reasons outlined in my response to question one, I don’t believe further cuts to interest rates will be sufficient to stoke demand. Having said that, if the RBA did elect to engage in QE, then I am in that camp that prefers a “people’s QE”. I’m not sure what Stephen means by it “working too well”, or why that would be a problem. A stimulus provided directly to households rather than through financial markets is what’s needed now. Effectively, a people’s QE would be faster and more effective, as it could target low and middle-income earners, put cash directly into the pockets of people likely to spend it immediately, thereby lifting the retail sector, and overcome the obvious reluctance of households to take on more debt.
But the obvious riposte to that is that this kind of stimulus is best delivered by government as a package of fiscal measures.
Brendan: The RBA’s responses to the House economics committee suggesting QE and other unconventional monetary is “unlikely” to be needed jar with an increasingly weak Australian economy, of which the NAB survey is simply the latest sign. There’s a good probability that more stimulus will be needed than the remaining interest rate cuts available and the RBA should stand ready to use unconventional monetary policy if required.
Various estimates suggest QE in the United States lowered long-term interest rates by about 150 basis points. Given that evidence, with the RBA following the approach of the US Fed and others in buying up government and other bonds (adjusted to Australian markets, as Stephen outlined), there’s little reason to go with something more dramatic such as a “people’s QE” option.
Greg: How do you think the RBA measures up to other central banks when it comes to transparency and accountability?
Stephen: The RBA dramatically improved its transparency under Glenn Stevens. A more important issue is how effectively it uses its transparency mechanisms. The effective stance of monetary policy is determined more by interest rate expectations than the actual cash rate. The RBA is often reluctant to signal an explicit policy bias, which means it is underutilising the expectations channel.
Accountability is a bigger issue. The RBA is internationally anomalous in not separating the governance of the bank and the setting of monetary policy, placing the board in the position of overseeing itself on monetary policy. In the US, monetary policy is set by the Federal Open Market Committee, which is separate from the Fed board, although has overlapping membership.
As I argue in this article, the RBA has all but conceded that the external board members are conflicted in their role as setters of monetary policy. This is why the contributions of individual board members are suppressed in the minutes.
The board should not set monetary policy. This function should be given to a monetary policy committee made up of RBA executives and external academic appointees with expertise in monetary policy. The governor’s performance-based remuneration should also be tied to inflation outcomes by the board.
Emma: As Stephen notes, the RBA has significantly improved its transparency and accountability since the changes announced in December 2007, and it is now on par with the central banks of comparable OECD nations such as Canada and the US, and the European Union. Notably, the decision of then-governor Glenn Stevens to immediately release the minutes of the RBA’s monthly board meetings brought it into line with best practice by the US Federal Reserve and the Bank of England.
It’s unclear to me what a press conference after the monthly release of the board minutes would add to the information already available to the media and the public through current arrangements.
I am sceptical of accountability measures that would tie the governor’s reappointment or remuneration to the achievement of specific outcomes, whether enforced by the board or the treasurer.
We should be wary of introducing more prescriptive measures that may undermine the perceived or actual independence of the RBA, which remains one of our most trusted public bodies at a time of declining confidence in the institutions of democracy both here and internationally.
Brendan: While there’s been some progress, there is still much more the Reserve Bank could do to improve transparency and accountability. It lags well behind the approaches adopted by central banks abroad in several important dimensions. For example, the governor of the US Federal Reserve holds a press conference after each monetary policy committee meeting. The treasurer could even consider an arrangement like the British government has with the Bank of England: when inflation figures are released that are outside the target range, the governor must write a public letter to the parliament that acknowledges this and explains the reasons for this deviation.
I agree with Stephen that the lack of external expertise on the RBA board is a problem: you only have to look at the grilling that Lowe received from federal Labor MP (and Harvard-trained PhD economist) Andrew Leigh at the House economics committee hearing recently for systemically missing the inflation target to see what a robust and informed discussion could bring to the table. It’s hard to imagine RBA board members without that degree of expertise being able to push back on the RBA staff view. But like Emma, I don’t agree with Stephen that remuneration should be tied to inflation outcomes set by the board.