Hold your applause: RBA review doesn’t explain central bank’s problem

The conclusions of the review and its recommendations are not based on evidence. They deserve debate and reflection, not uncritical applause and adoption.

The recommendations of the review of the Reserve Bank have been so widely welcomed, including by Treasurer Jim Chalmers, that their rapid adoption seems all but certain. Time, then, to raise a few queries and point out a few problems. After all, the decisions of the RBA affect all us one way or another, and without our say so.

One issue is that the conclusions of the report and its recommendations are not based on evidence. That is not to say the recommendations are wrong, but that they are speculative. They deserve debate and reflection, not uncritical applause and adoption. The review essentially says the way Canada and Britain make monetary policy is state of the art, and Australia should adopt it. We should have a monetary policy board composed of economic experts. It would replace today’s board which is typically composed of senior business people plus an independent economist, the secretary of the Treasury and the governor and deputy governor of the bank.

Yet the review’s only serious criticism of the performance of the RBA is for the period 2016 to 2019, where it recounts a story that rates could have been lower, and if so employment could have been higher. Otherwise, the report gives a big tick to the performance of the RBA under its current structure.

There is no claim in the report that the model used in Britain or Canada has produced better outcomes, because as a matter of fact it has not. The review does not compellingly portray the problem it is addressing.

John Edwards served on the RBA board from 2011 to 2016.

As the comparisons included in the review show, over the past three decades Australia has on average experienced higher growth in real income per head, lower unemployment and about the same inflation rates as Britain, Canada and the US.

In those countries monetary policy decisions are made by committees of economists – the model now proposed for Australia. Even today unemployment is lower in Australia than in Canada or Britain, inflation is lower than in Britain (though higher than Canada), and output growth is markedly higher than in either Britain or Canada.

As the review concedes, Australia has done at least as well as its peers. On the numbers, I would say rather better. It is relevant, too, that the review does not offer an examination of the record of the Bank of England or the Bank of Canada, though theirs is the model proposed.

The review is very critical of the RBA board’s performance from 2016 to 2019. Indeed, its recommendations for big changes hinge on its interpretation of this period.

The criticism here, which originated in a scholarly article by the now Assistant Minister for Competition, Charities and Treasury Andrew Leigh and a colleague, is that the RBA left rates too high over the period.

Inflation was below target, and lower rates would have increased employment. The review documents that the board did not disagree with any of the rate setting recommendations of the governor, and did not ask for studies of the option of lowering rates at a time when inflation was below the 2 to 3 per cent target.

Fair enough. But it is surely relevant to the attitude of the board that the 1.5 per cent cash rate at the time was lower than it had ever been, and that the low rate was producing the expected effect. Unemployment fell from 6 per cent in June 2016 to 5 per cent in October 2018, the Australia dollar declined against the US dollar from late 2017, and GDP growth was around average. When in 2019 it became apparent that growth was slowing and unemployment rising, the RBA recommenced cutting rates. By the time Covid came along, the cash rate was 0.75 per cent. It might have been that case that growth could have been a little faster if rates were a little lower, but bear in mind the cash rate had come down from 4.75 per cent in 2011 to 1.5 per cent in 2016.

Andrew Leigh was critical about the pace of rate movement. Picture: Gary Ramage

Would another half a per cent or so have made a big difference? It seems to me a slender argument on which to dramatically change the set up – but in terms of actual evidence of underperformance it is the only one the review adduces.

Both Leigh’s original piece and the review’s commentary on it rely on the results of running a RBA model, and believing its results. This to me hints at the problems that might arise if the only participants in monetary policy decisions are economists who actually believe their models.

And that is likely to be the outcome. While the review suggests it may be that business people or people with skills other than monetary economics could be appointed to the monetary policy board, in practice the economists would predominate. Their accustomed discourse is of a particular kind, not easily intelligible to the untrained. The review remarks by way of criticism that current RBA board discussions are non-technical, which is true. But a discussion among economists is generally impenetrable to those from other areas of life, as is a professional discussion among IT consultants, doctors, dentists, sailors or building workers. Every trade has its argot. A businessman or a union official will generally not be able to usefully participate in a professional discussion among economists. In practice this will have to be a board of economists, discussing decisions in their own ­language.

Australia is a big place. I wonder if it is possible in the long term to have major decisions affecting all of our lives made in Martin Place by a narrow and of course unelected group of individuals. For example, it cannot long be thought legitimate if there is no one around the table from Queensland or Western Australia or Tasmania or South Australia, or if women are under-represented. These considerations reduce the possible talent pool of economists by requiring a geographical or gender overlay.

And how big is this pool anyway? It is surely not possible to appoint public servants to the panel. There is a big pool of competent economists well versed in financial markets working for financial institutions, but they are far too conflicted to be candidates. The candidates will mostly be academic economists, but academic economists are highly specialised.

There are very good macro­economists working in Australia, but perhaps not enough to regularly rotate different ones through the proposed monetary policy board. We need to know more about the actual availability of suitable people, and not just of male economists from Sydney or Melbourne or Canberra.

Reserve Bank governor Philip Lowe addresses media after the release of the recommendations. Picture: Nikki Short

In the review’s recommendations, the external members of the monetary policy board will be encouraged to speak publicly about their outlook for the economy. Presumably they will be asked about their preferences for what decisions the board should make.

Under the current arrangements, the governor is spokesman for the board. Under the new arrangements there will perhaps be as many views running as there are external economists on the board. At the same time the governor will be required to give a press conference after each board meeting. For the markets, for market economists, predicting and interpreting the RBA will reach a new level of engagement and interest, like an old video game that is suddenly refreshed with new characters and situations. It will be fun, but it will take some getting used to. For the governor it probably won’t be so much fun.

The treasurer as opposed to the Treasury has good reason to be wary of the deeper significance of the recommendations. At present, the treasurer and the governor agree on a “statement on the conduct of monetary policy” which gives the RBA its inflation target. Though never used, there is provision in the legislation for the treasurer to overrule a decision of the RBA. There is language which enjoins the RBA to keep the government informed about the evolution of policy, and this language is one basis for the customary meetings which the governor offers to the treasurer after board meetings. The Treasury secretary sits on the board but it is not specified whether the secretary represents their own views or those of the government. Under the new legislation, all this would go. The objectives of monetary policy would be in legislation, not an agreement with the treasurer and the RBA. The reserve power for the treasurer to direct the RBA would be removed. It would be specified that the treasurer would have no authority to direct the Treasury secretary in respect of their vote on the monetary policy board. The actual and reserve powers of the treasurer on monetary policy would be eliminated.

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Except that the government would appoint its board members (and even there, constrained by tight criteria), the independence of the RBA would be complete. Yet this completeness of separation would be conferred at the very time that monetary and fiscal policy have become more closely intertwined. During the Covid epidemic the RBA bought a large share of the bonds the Australian government issued to fund its vast fiscal programs, including JobKeeper. The RBA is now running down its bond inventory, with consequences for the interest rate the government pays on newly issued bonds. This closer connection between monetary policy and fiscal policy will continue for a while to come.

The power of the RBA arises from its authority to create and destroy money, an authority conferred by the nation.

Why is it necessary to put the exercise of this authority beyond recourse to the government that confers it? Are there not possible circumstances where a government might decide the RBA is acting contrary to the national interest? What if, for example, the RBA had refused to buy bonds in 2020, thus disabling the operation of fiscal policy?

These are possibilities, remote as they may be, that the treasurer needs to mull over before committing to his own disempowerment in monetary policy. The Treasury secretary is well taken care of by the review, but not the treasurer.

I also wonder about the proposed external board that would monitor and advise on the personnel and structure of the RBA.

This board will explicitly have no responsibility for monetary policy, and presumably not see any papers or participate in any briefings relevant monetary policy. Shorn of its monetary policy responsibilities, the RBA is just another public service agency. It has around the same number of employees as a mid-sized local government council. Is it really plausible that talented and busy people will enjoy being on a board whose only responsibility is to monitor the human resources policies, remuneration structures, risk policies and so forth of a relatively small agency? There will still be some prestige, but among the knowing, not much.

There are things to like in the review’s recommendations. Giving explicit and equal weight to full employment and inflation while recognising there will usually be a trade-off between them is a good recommendation. Requiring the RBA to show how deviations of either or both from target will be addressed is also a good idea.

Even so, there are enough questions about the recommendations of review to justify a more considered examination. Central to its recommendations is that the changes are put into legislation. Once legislated, it is very difficult to go back.

John Edwards is a senior fellow at the Lowy Institute and an adjunct professor at the John Curtin Institute of Public Policy at John Curtin University. He served on the RBA board from 2011-2016.