Surely Canberra can do more on economy

RBA governor Philip Lowe. Picture: Bloomberg

Financial markets are increasingly speculating that the Reserve Bank of Australia will be forced to launch unconventional monetary policies, most likely quantitative easing involving the purchase of government bonds.

This prospect has attracted widespread criticism, including from former members of the RBA, some economists and academics.

The report last week by a working group of the Bank of International Settlements, chaired by RBA Governor Philip Lowe, considered four types of unconventional monetary policies.

It acknowledged that there were costs associated with employing these policies, but in commenting on the option of forward guidance on the direction of future policy paths, said, “central banks noted few adverse side effects that would not also be associated with conventional expansionary interventions (of monetary policies)”.

In fact in his recent rate cut announcements Dr Lowe employed a limited form of forward guidance. He reinforced the decisions to lower rates with the comment that, “it is reasonable to expect that an extended period of low interest rates will be required in Australia to reach full employment and achieve the inflation target”.

I would argue that there is more scope to exploit this forward guidance before considering alternative unconventional policy interventions such as QE.

In particular, former Federal Reserve chair Ben Bernanke and economists at the Fed tested a variation on “lower for longer” forward guidance, where the Fed committed in advance to not raising rates until any shortfalls of inflation from the target had been fully offset from during the period where interest rates were anchored to around their effective lower bound.

This would mean that with a 2 per cent inflation target the Fed would commit not to begin raising rates from zero or close to zero until average inflation since the beginning of the period of employing forward guidance was at least 2 per cent.

A consequence of this commitment by the central bank is that there would be a period of above-target inflation before interest rates were raised.

Bernanke tested the risk that this eventual overshooting of inflation could unhinge inflationary expectations.

However, he found that even where the central bank’s announcements don’t have full credibility, this type of lower for longer forward guidance gives better outcomes for inflation and unemployment than conventional policies.

Nevertheless, even forward guidance along these lines has its limits. It potentially works well when the source of below-target inflation and extremely low interest rates is a shock or series of shocks that temporarily lower demand in the economy.

In these circumstances forward guidance can help ensure that at the effective lower bound of interest rates monetary policy can still stimulate demand and return the economy to above trend growth to reduce unemployment.

But interest rates have been on a secular downward trend, suggesting that longer term structural factors have contributed to the twin problems of sustained below-target inflation and interest rates pinned to near zero.

Monetary policies, conventional or unconventional, cannot solve the consequences of these structural factors, which include ageing population, wide-ranging regulatory changes and the slowdown in productivity growth.

These supply side developments have fundamentally altered the balance between saving and investment globally and hence the level of interest rates.

As the BIS report states, “The implications of at least some of these supply side developments can be better addressed directly through structural and fiscal policies, which would reduce the risk of overburdening monetary policy.”

Because these are global developments the Australian government can’t relieve the RBA of all the burden of having to ease monetary policy more than it might like.

But, equally, surely the government can do more than it is currently doing, and indeed it may find ultimately it too doesn’t have as much choice as it thinks it has.

Paul Brennan is an independent economist based in Sydney and has worked at Citigroup Global Markets as well as the RBA, federal Treasury and the OECD.