Michele Bullock confronts a new set of economic problems as she takes charge of the Reserve Bank

The easy money of the Covid era exacerbated today’s high inflation and budget bloat.

Michele Bullock takes charge of the Reserve Bank with headline inflation at 6 per cent and a jobless rate of 3.7 per cent. Picture: NCA NewsWire / Martin Ollman

On Monday, Michele Bullock will become the ninth governor of the Reserve Bank of Australia. Welcome to the economists’ prime-time “hot seat”: the relentless public glare, immense pressure to perform with the clock ticking, but a million bucks a year guaranteed.

Bullock becomes the face, voice and prime mover of the central bank’s merciless interest-rate squeeze to quell high inflation. Her top priority, keeping inflation in the 2 to 3 per cent band, will become more difficult according to her predecessor, Philip Lowe. He warns more frequent supply shocks, deglobalisation, climate change, the energy transition and shifts in demographics will lead to volatility in prices growth, above and below the target zone.

Still, there are reasons it could be a fortuitous time to launch a new monetary era. Inflation is subsiding from its peak last December but isn’t expected to return to within the central bank’s mandate for another two years. The dawdle back to target may seem odd, given inflation is the scourge that wrecks economies.

The aim of the RBA’s dozen cash rate hikes since May last year is to achieve a better balance between demand and supply, thus reducing price pressures. But, while doing so, it hopes to preserve as many jobs as possible during the slowdown. Bullock comes to the top job with the lowest jobless rate of any governor since Sir Jock Phillips succeeded “Nugget” Coombs in July 1968. Last month the jobless rate was steady at 3.7 per cent; there are 1.1 million more people in work than before the pandemic.

In a speech in Newcastle in June, Bullock said unemployment would have to rise to 4.5 per cent to satisfy the inflation goal. Union officials were outraged, as the central banker led with the textbook rather than the politicians’ talking points. Even with a forecast rise in the jobless rate, employment is expected to keep rising (it’s just that the number of people entering the workforce, enhanced by migration, will be greater). Many young people and the long-term unemployed have been able to find work. As Bullock pointed out, the new jobs have not been limited to cities or boom regions. Unemployment was at 4 per cent or below in three-quarters of the country’s 87 regions.

Low unemployment is the legacy of the overblown fiscal and monetary stimulus. Lowe often used the analogy of providing insurance against awful outcomes to justify slashing the cash rate to near zero, then using unconventional tools such as bond purchases and so-called yield curve control.

Outgoing RBA Governor Philip Lowe. Picture: NCA NewsWire / Nikki Short

“The (Morrison) government and the RBA responded forcefully to the pandemic,” Lowe said in his public farewell speech a week ago of the Team Australia mindset. “This approach worked. The Australian economy avoided falling into the abyss and then bounced back well.” But with the benefit of hindsight, Lowe conceded, “we did do too much”.

The Albanese government will soon launch a broad inquiry into Covid policy responses. As Bullock steps up, it’s a good time to reflect on how we can achieve better economic outcomes, and perhaps not just in extremis.

In his valedictory speech, Lowe said once inflation came back down again in the next few years we could find ourselves at the “zero lower bound” of interest rates (the cash rate was cut to 0.1 per cent in November 2020 and was kept there until May last year). If we get there again, it is better for Canberra to use the budget rather than relying on monetary tools in emergencies or during sharp downturns. Treasury concurs.

Lowe said the country got better outcomes when policy tools were “well aligned”.

“My view has long been that if we were designing optimal policy arrangements from scratch, monetary and fiscal policy would both have a role in managing the economic cycle and inflation, and that there would be close co-ordination,” he said.

Lowe said monetary policy was a powerful instrument, but it had its limitations and its effects were felt unevenly across the community. He called for a revamp of the “existing policy architecture” by giving an independent body (rather than elected representatives and officials) limited control over taxing and spending.

“During my term, there have been times where monetary and fiscal policy worked very closely together and, at other times, it would be an exaggeration to say this was the case,” Lowe said, adding he was “disappointed that the recent RBA review did not explore them in more depth”.

The expert panel’s take, published in April, was middle-of-the-road. No radical changes to the institutional settings were proposed, but it also called for better policy co-ordination between Treasury and the RBA: sharing research and developing enhanced modelling that incorporated fiscal variables in monetary scenarios, and vice versa.

As former RBA deputy governor Stephen Grenville argued in our pages, Treasury’s “policymaking performance was let off the hook in the review”. “The long-time received wisdom that fiscal activism has no role in the cycle (with fiscal policy confined to the automatic stabilisers) needs reassessment,” Grenville wrote in April. “The deeper lesson, not articulated in the review, is that monetary policy is not all-powerful in controlling inflation or economic activity.”

Treasury has lately been reviewing its responses to the pandemic, with former senior official Nigel Ray conducting an independent evaluation of JobKeeper, which cost taxpayers $90bn.

In a submission, economic modeller Chris Murphy looked beyond the economic and health crisis measures deployed by Canberra (worth $337bn) and plugged in another $92bn announced in the same timeframe, for a total cost of $429bn. “All of the measures can have a macroeconomic impact,” he argued.

Murphy’s bottom line: “The very large broader fiscal response to Covid meant that there was fiscal overcompensation: for every $1 of income the private sector lost under Covid, fiscal policy provided $2 of compensation.” This meant unemployment was around two percentage points lower for the first three years than otherwise, helping to offset the effect of social distancing on unemployment.

The Australian National University visiting fellow’s modelling showed the after-effects of “excessively expansionary” macro policy, including over-prolonged loose monetary policy, generated excess demand that temporarily added up to three percentage points to the annual inflation rate at the end of last year (four-fifths of it due to fiscal policy). His simulation shows this inflation effect does not completely dissipate until mid-2025.

“In future pandemics, a higher level of stability in unemployment and inflation can be achieved if fiscal policy is designed to compensate, rather than overcompensate, for the income losses from social distancing,” Murphy argues. “JobKeeper would be replaced by a program better targeted at income compensation, although the budget cost may be similar.”

Naturally, there’s a lot of “in hindsight” in today’s critiques. But as Treasury secretary Steven Kennedy said in a lecture at the ANU in July last year, Australia avoided potential calamity, especially the long-term “scarring” when workers lose their jobs, during the global financial crisis and pandemic due to the scale and speed of the policy responses. The Treasury chief said post-game analysis, or alternative scenarios, miss the uncertainty or the peril forgone. “There is a balance to be struck between preventing excessive labour market scarring and ensuring the response is proportionate so that long-term fiscal sustainability is preserved,” he said.

The bigger questions remain: what tools to use and how. “Outside of a crisis, fiscal policy often has long lags as it takes time for measures to be approved through parliamentary processes,” Kennedy said. “Monetary policy is likely to remain better placed for demand management, as has been the case for many years. However, should fiscal policy be required, recent experiences suggest it should be designed around the four Ts – timely, targeted, temporary and tailored to the situation.”

Murphy says a secondary lesson is that monetary policy needs to take more account of the stimulus already provided by the fiscal response, so that interest rates do not remain very low for too long. The RBA review found the board, like other central banks, “was too slow to wind back the overall level of monetary support in the face of rising inflationary pressures”.

The expert panel said the RBA response “also reflected persistent errors in forecasting inflation and unemploy­ment”, particularly after many years of low inflation, and did not pay enough attention to risks such as persistent supply snarls and inflation expectations, and “relied too much on wage pressures as an advanced signal of persistent inflation pressures”.

This view of inflation dynamics must change at the RBA; in part, it already is with fresh thinking on the board. Bullock has a challenge in winning back a public that feels scorched by recent events, while educating it during a period that is likely to be more financially volatile, with the energy transition a huge part of that.

The new governor is in negotiations with Jim Chalmers and Treasury on a revised set of ground rules for the conduct of monetary policy, which have not been updated since 2016. By the end of the year there’ll be a new deal between Martin Place and Canberra.

“For its part, the government aims to introduce legislation before the end of the year to reinforce the bank’s independence, strengthen its mandate and establish separate monetary policy and governance boards,” the Treasurer said on Friday. But it’s unlikely this refresh will lead to a step-change in modern macro policy or steal any of Treasury’s power over taxing and spending.