Equal weighting on employment inflation risks undermining RBA’s accountability

The Reserve Bank of Australia building in Martin Place, Sydney. Picture: AAP

The need to review the operation of the Reserve Bank of Australia has been apparent for some time.

The commissioning of such a review by Jim Chalmers was therefore an expected development.

The release of the report, “An RBA fit for the future”, has attracted considerable attention.

The review panel was well qualified to undertake the task. One overseas and two local appointments, all with deep experience in economic policy, provided a mix of skills for the review. There were a large number of submissions, as well as a series of consultations with interested parties.

It’s worth outlining here how the RBA has operated in recent times. The act that underpins its operation outlines the objectives of the bank as threefold – the stability of the currency, the maintenance of full employment, and the economic prosperity and welfare of the people of Australia.

The review panel makes the obvious point that this last objective is an overarching purpose and should not be included as a specific objective.

Since the 1990s, the operations of the RBA have been mainly governed by a letter of understanding signed by the treasurer and RBA governor. There is reference to the centrality of the inflation target of 2-3 per cent a year achieved on average over the business cycle.

The RBA’s independence has been upheld, although the secretary to the Treasury has been ex-officio a member.

One of the less defensible – indeed highly problematic – recommendations of the review panel is that inflation and full employment be given equal weighting in the objectives of the bank. This fails to acknowledge the inevitable trade-off between the two variables (or is the Phillips curve completely dead?). Additionally, the weighting should vary according to where inflation and unemployment actually are. If inflation is running at 20 per cent a year, for instance, it is not sensible to give these two variables equal weighting.

The broader point is that this suggestion involves a watering down of inflation-targeting that has been the core feature of the bank’s operation for many years. It also undermines the bank’s accountability. If inflation overshoots, it can claim to be doing a good job on unemployment. This is just bad policy.

Members of the public no doubt mainly view the performance of the RBA based on its very recent decisions, in particular, the 10 quickfire rises in the cash rate. The review panel takes a longer timeframe when making its assessment, concluding that “the RBA has contributed to good economic outcomes through flexible inflation targeting”.

Even so, a number of improvements are still recommended. The key change being proposed is the creation of a monetary policy board “with responsibility for monetary policy decisions and oversight of the RBA’s contribution to financial system stability … but not broader corporate governance”. This arrangement is not uncommon overseas, although some hesitation arises by dint of putting “experts” in charge. (We have seen what having “experts” in charge has done in other contexts and how this can go awry.) Skills listed include open-economy macroeconomics, the financial system and labour markets.

Is this recommendation a criticism of the current board? Currently, the board is made up of people with mainly commercial/business skills. In the past, these individuals could bring valuable market intelligence to board discussions. But in this digital age, the value of this input, narrow as it tends to be, is much reduced. There has also often been a perception of a conflict of interest for some board members because of their commercial interests.

A further perception has been that the governor holds sway – too much perhaps – with his deep knowledge of central banking matters and the full backing of the staff and its research/modelling. In other words, the other board members have simply filled up the board room while the governor’s decisions are rubber-stamped.

The are two key, related questions now. Will the changes recommended by the review, particularly the creation of the monetary policy board, lead to better decision-making? And had these changes been in place over the past decade or so, would there have been different outcomes?

We should not forget the major errors the bank has made under the leadership of Philip Lowe. There were the years of undershooting the inflation target and now the overshooting of the target.

There was also the controversial use of quantitative easing during the pandemic, which assisted the federal government to overstimulate the economy and set in train the current inflationary bout. And there was the governor’s faulty forward guidance when he told us repeatedly that interest rates would not rise until 2024.

Would these mistakes have been made had there been a monetary policy board? Judged by overseas experience, it’s not clear that the outcomes would have been much different.