1. What is Monetary Policy?
The Reserve Bank of Australia is responsible for formulating and implementing monetary policy. For countries like Australia with floating exchange rates, monetary policy involves the management of short-term interest rates to achieve domestic policy objectives. Most advanced economies follow this approach, including Australia, Canada and New Zealand.
In some countries, an alternative focus for monetary policy is the exchange rate: a country may choose to have their exchange rate fixed to a major international currency, or in some kind of target band. In this case, monetary policy essentially involves the management of that exchange rate commitment. A number of smaller economies have fixed exchange rates, for example, Hong Kong, whose currency is fixed to the US dollar.
2. What are the Objectives of Monetary Policy?
2.1 The Reserve Bank Act
Central bank charters differ from country to country, but they typically include, in one form or another, a responsibility for price or currency stability, and often some broader economic objectives in terms of stability and growth. In Australia, the objectives of monetary policy are formally established in the Reserve Bank Act 1959.
This sets out three objectives:
- the stability of the currency of Australia;
- maintenance of full employment in Australia; and
- the economic prosperity and welfare of the people of Australia.
The first of these, the stability of the currency, is generally interpreted to mean price stability; that is, a stable value of the Australian dollar in terms of its purchasing power over goods and services.
2.2 The inflation target
These objectives are made more explicit with the adoption of the Bank's inflation target. To quote from the latest Statement on the Conduct of Monetary Policy issued in September 2016:
Both the Reserve Bank and the Government agree that a flexible medium-term inflation target is the appropriate framework for achieving medium-term price stability. They agree that an appropriate goal is to keep consumer price inflation between 2 and 3 per cent, on average, over time. This formulation allows for the natural short-run variation in inflation over the economic cycle and the medium-term focus provides the flexibility for the Reserve Bank to set its policy so as best to achieve its broad objectives, including financial stability. The 2–3 per cent medium-term goal provides a clearly identifiable performance benchmark over time.
How does the RBA use this inflation target to guide monetary policy?
First, Australia's inflation target is an expression of the average to be achieved over a period of years, rather than a ‘hard-edged’ band within which the inflation rate is to be confined in every period. There is sufficient flexibility for policy to take account of short-run developments in employment and economic growth. In other words, there is some scope for policy to play a role in stabilising short-run business cycle fluctuations. In the longer run, as the statement sets out, the main contribution that monetary policy can make to growth and prosperity is to keep inflation low.
The second point concerns the measurement and definition of inflation. The inflation target refers to the headline CPI, though the Bank also looks at measures of underlying inflation. Over time, measures of underlying inflation and the CPI move closely together, though the headline CPI is more volatile (Graph 1) as it is more affected by temporary factors, such as changes in petrol prices. The medium-term focus of the inflation target provides the Bank with the flexibility to ‘look through’ temporary fluctuations in the CPI.
2.3 Why 2–3 per cent?
There is considerable international evidence that high inflation is harmful to economic performance. In particular, countries that have had relatively high rates of inflation in the post-war period have tended to experience lower rates of economic growth than low-inflation countries. This is not a mechanical relationship that explains country differences precisely from year to year, but one that is evident in terms of averages over long periods of time.
There are several ways in which inflation causes harmful economic effects, of which three, in particular, are worth highlighting.
- Interaction with the tax system. Most tax systems measure income in a way that does not allow for inflation. To give just one example, interest received is fully counted as income for tax purposes, even though it partly represents a compensation for inflation rather than real income. Similarly, interest paid by businesses is fully counted as a cost, when in fact it is partly a transfer to compensate the lender for inflation. As a result, when inflation is high, the tax system tends to overstate the real value of both interest receipts and payments; consequently, interest income is taxed more heavily than intended and business interest costs receive a bigger than intended benefit from tax deductibility. This effect seems to have been important in encouraging excessive borrowing by businesses in the 1980s, and would therefore have been a destabilising factor for the economy during that period.
- Uncertainty. Inflation is a source of uncertainty that makes economic decision-making more difficult. Periods of high inflation are usually periods of greater-than-average variability in inflation. They are also periods when individual relative prices and wages become more variable. These facts point to the uncertainty that high and variable inflation can generate, as people become confused about how quickly the general price level is rising and what are the appropriate prices for individual goods and services. That in turn makes the price system less efficient as a mechanism for allocating resources.
- Distributional effects. Because inflation erodes the real value of money, it redistributes wealth from those who own monetary assets to those who owe money. The big winners from inflation in the 1970s and 1980s were those who were able to use borrowed money to finance the holding of assets that rose in value; inflation reduced the real value of their debts but pushed up asset prices. Other winners tend to be those who can tailor their tax and other affairs in a way that takes advantage of inflation – often those who are already among the better off. More generally, the expectation of inflation tends to generate private behaviour designed to minimise its effects or to exploit them. This is at best wasteful of productive resources and may involve significant distortions to private incentives – for example, the incentive to invest in those assets that tend to rise most in value when inflation is high.
These arguments point to a general conclusion that inflation is harmful to economic performance, so policy should aim at keeping inflation low. But how low an inflation rate is low enough? Should we be aiming at zero?
There are several reasons why aiming for zero inflation might not be warranted, and why a low positive target may be the most appropriate. First, the economy is subject to what are called ‘downward nominal rigidities’. That is, prices and wages that do not normally fall even when market equilibrium might require that. But with a small amount of inflation in the system, these prices and wages can fall in relative terms (by not rising with the general price level) even if they cannot fall in absolute terms. This is an argument that small amounts of inflation may help to make price systems more flexible. Secondly, there may be biases in the measurement of inflation such that true inflation is on average overstated by standard measures. This can arise for example when rising quality of a good or service is not properly taken into account when measuring its price. To the extent that this is the case, inflation would be overstated and the target would need to make allowance for this by aiming higher than zero. Finally, it is likely to be costly to reduce inflation, so some judgment needs to be made as to how far inflation reduction should be taken, allowing for both the costs and benefits of doing so.
These arguments help to justify the general approach of aiming for a low positive inflation rate, although they do not easily translate into a precise figure for the appropriate target. The target of 2–3 per cent adopted by the Bank reflects an overall assessment of all these factors, which seems both achievable and broadly in line with international practice. This is close to what has been achieved in recent years in Australia as well as in other countries. It is also in line with other countries' inflation targets (see Table 1).
|Further details||Ten-year average*
|Australia**||2–3||On average over time||2.4|
|Brazil||4.5||Tolerance band of +/− 2 percentage points for 2016 and +/− 1.5 percentage points for 2017||5.9|
|Canada||2||Target range/band of 1 – 3 per cent||1.6|
|Chile||3||Tolerance band of +/− 1 percentage point; over a medium-term horizon of two years||3.5|
|Colombia||3||Tolerance band of +/− 1 percentage point||4.1|
|Czech Republic||2||Tolerance band of +/− 1 percentage point||2.0|
|Euro Area||< 2||Below but close to 2 per cent; over the medium term; for the euro area as a whole||1.6|
|Hungary||3||Over the medium term; tolerance band of +/− 1 percentage point||3.7|
|Iceland||2.5||Tolerance band of +/− 1.5 percentage points||5.6|
|Indonesia||4||For 2015, with a tolerance band of +/− 1 percentage point||5.9|
|India||4||Tolerance band of +/− 2 percentage points for financial year 2015–16 onwards||8.3|
|Japan||2||The Bank will aim to achieve this target ‘at the earliest possible time’.||0.3|
|Mexico||3||Tolerance band of +/− 1 percentage point||4.0|
|New Zealand||1–3||On average over the medium term, with a focus on keeping future average inflation near 2 per cent||2.0|
|Norway||2.5||Close to 2.5 per cent over time||2.0|
|Peru||2||Tolerance band of +/− 1 percentage point||3.2|
|Philippines||3||For 2015-2016, with a tolerance band of +/− 1 percentage point||3.9|
|Poland||2.5||Tolerance band of +/− 1 percentage point||2.2|
|Romania||2.5||Tolerance band of +/− 1 percentage point||4.0|
|South Africa||3–6||For headline inflation in all urban areas||6.2|
|South Korea||2||For 2016 onwards||2.4|
|Switzerland||< 2||On a longer-term basis||0.1|
|Thailand||2.5||Tolerance band of +/− 1.5 percentage points of headline inflation (annual average)||2.2|
|Turkey||5||For 2013–2016 period||8.2|
|United Kingdom||2||Tolerance band of +/− 1 percentage point||2.4|
|United States***||2||Longer-run inflation goal||1.6|
Last updated January 2017
* Data to December 2015
** Data to December 2016
*** Price index for personal consumption expenditures
2.4 Management of trade-offs
As noted above, the monetary policy target in Australia allows some scope for policy to take account of short-run trade-offs between inflation, and activity or employment, subject to the goal of meeting the inflation target on average over the course of an economic cycle. The short-run trade-off faced by policy-makers can be described as follows: other things equal, at a given point in time, an easing of policy (a cut in interest rates) will stimulate the economy and will tend to make both economic growth and inflation higher than they otherwise would have been. Conversely, a rate increase will tend to lower growth and inflation in the period immediately ahead. This means that, over short periods, policy can be thought of as having to balance one policy objective against another – for example, achieving a higher growth outcome but a less satisfactory inflation rate.
It makes sense for policy to take into account the nature of this trade-off. Consider, for example, a situation in which inflation is regarded as likely to be too high. A rise in interest rates will help to reduce inflation but can also be expected to reduce growth. How far and how quickly interest rates should be raised will depend partly on how the economy is performing at the time. If the economy is operating with very little surplus capacity or is overheating, a fairly rapid rise in interest rates might be called for; if, on the other hand, there is significant surplus capacity in the economy, the appropriate increase in rates might be more gradual. Thus, it makes sense for policy to take account of short-run cyclical developments in pursuing the inflation target.
But having made that point, it is important to recognise that this type of trade-off does not exist in the longer run. Ultimately, the growth performance of the economy is determined by the economy's real productive capacity, and it cannot be permanently stimulated by an expansionary monetary policy stance. Any attempt to do so simply results in rising inflation. The Bank's policy target recognises this point. It allows policy to take a role in stabilising the business cycle but, beyond the length of a cycle, the aim is to limit inflation to the target of 2–3 per cent. In this way, policy can provide a favourable climate for growth in productive capacity, but it does not seek to engineer growth in the longer run by artificially stimulating demand.
Debelle G (2009), ‘The Australian Experience with Inflation Targeting’, speech to Banco Central do Brasil XI Annual Seminar on Inflation Targeting, Rio de Janeiro, 15 May
Richards A (2006), ‘Measuring Underlying Inflation’, address to the Australian Business Economists, Sydney, 28 November
Stevens G (2003), ‘Inflation Targeting: A Decade of the Australian Experience’, address to South Australian Centre for Economic Studies April 2003 Economic Briefing, Adelaide, 10 April
3. How are Monetary Policy Decisions Made?
The formulation of monetary policy is the primary responsibility of the Reserve Bank Board. The Board normally meets eleven times each year, on the first Tuesday of the month except in January. Hence the dates of meetings are well known in advance. For each meeting the Bank's staff prepare a detailed account of developments in the Australian and international economies, and in domestic and international financial markets. The papers contain a recommendation for the policy decision. Senior staff attend the meeting and give presentations. Decisions by the Reserve Bank Board to change interest rates are communicated publicly, on the day of the meeting at 2.30 pm.
Stevens G (2009), ‘The Conduct of Monetary Policy in Crisis and Recovery’, address to The John Curtin Institute of Public Policy and the Financial Services Institute of Australasia Public Policy Breakfast Forum, Perth, 15 October.
Stevens G (2006), ‘The Conduct of Monetary Policy’, address to luncheon co-hosted by The Anika Foundation and Australian Business Economists, Sydney, 13 July.
4. What is the Relationship Between the Reserve Bank and Government?
The Reserve Bank Board makes decisions about interest rates independently of the political process – that is, it does not accept instruction from the Government of the day on interest rates. This principle of central bank independence in the operation of monetary policy, in pursuit of accepted goals, is the international norm. It prevents manipulation of interest rates for political ends, and keeps monetary policy focused on its long-term goals.
With this independence naturally comes a need for consultation and accountability. The relationship of the RBA with the Government is one of independence with consultation, as outlined in Consultation with Government and Accountability to Parliament.
The Reserve Bank's conduct of monetary policy is explained publicly through several channels. The Bank makes a public announcement of any policy decision, giving detailed reasoning for it. Minutes of the monetary policy meetings of the Reserve Bank Board are published two weeks after each meeting. It publishes four Statements on Monetary Policy each year, which contain a detailed analysis of the economy and financial markets, and an account of the considerations for the policy stance adopted by the Bank. The Governor appears twice each year before the House of Representatives Standing Committee on Economics, to answer questions on the Bank's conduct of policy.
Stevens G (2007), ‘Central Bank Communication’, address to The Sydney Institute, Sydney, 11 December.
5. How is Monetary Policy Implemented?
In countries like Australia, the instrument of monetary policy is a short-term interest rate that can be closely controlled by the central bank. The relevant interest rate for Australia is the ‘cash rate’, which is the market interest rate on overnight funds. The Reserve Bank exercises quite close control over the cash rate through its financial-market operations and it functions as the policy instrument. It is periodically adjusted by decisions of the Reserve Bank Board, which are explained in the public statement announcing the decision.
It might be asked how policy can be effective in the management of the economy as a whole when it operates through such a short-term instrument. In practice, the cash rate has a very strong influence on other interest rates, and therefore helps to set the level of short-term interest rates in the wider economy. This is true both for money-market rates and for key rates of banks and financial intermediaries; for example, mortgage and business loan rates tend to move broadly in line with movements in the cash rate. As explained in more detail below, this gives monetary policy quite a powerful influence over the aggregate economy.
This description of policy as operating through a single main instrument contrasts sharply with the picture existing before financial deregulation, which took place mainly over the decade to the mid 1980s. In the pre-deregulation period, monetary policy operated through a mixture of financial-market operations and direct controls on markets and financial institutions. These included controls on bank interest rates, reserve requirements and various other balance-sheet restrictions. A change in policy under this system could be achieved through a range of different mechanisms or through some combination of them. This system of policy management was gradually rendered ineffective as markets developed ways of avoiding regulations through growth of the unregulated parts of the financial sector. In the current deregulated financial market, monetary policy is much more transparent and easier to explain, since it works directly through the short-term interest rate. In having made this evolution from a regulated to a deregulated environment for monetary policy, Australia's situation is quite similar to that of many other countries.
From day to day, the Bank's Domestic Markets Department has the task of maintaining conditions in the money market so as to keep the cash rate at or near an operating target decided by the Board. The cash rate is the rate charged on overnight loans between financial intermediaries. It has a powerful influence on other interest rates and forms the base on which the structure of interest rates in the economy is built. The close relationship between the cash rate and other money market interest rates can be seen in Graph 2. Changes in monetary policy mean a change in the operating target for the cash rate, and hence a shift in the interest rate structure prevailing in the financial system.
The Reserve Bank Board's explanations of its monetary policy decisions are announced in a media release, which is distributed through electronic news services and published on the Reserve Bank's website at 2.30 pm on the day of each Board meeting. Any change to the cash rate target will take effect from the following day.
The Reserve Bank uses its domestic market operations (sometimes called "open market operations") to keep the cash rate as close as possible to the target set by the Board, by managing the supply of funds available to banks in the money market.
The cash rate is determined in the money market as a result of the interaction of demand for and supply of overnight funds. The Reserve Bank's ability to pursue successfully a target for the cash rate stems from its control over the supply of funds which banks use to settle transactions among themselves. These are called exchange settlement funds, after the accounts at the Reserve Bank in which banks hold these funds.
If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds; in the process, they will bid up the cash rate. The actual level of the cash rate, which results from the Reserve Bank's market operations, as well as the target rate are shown in Graph 3.
Debelle G (2008), ‘Market Operations in the Past Year’, address to 2008 FTA Congress, Melbourne, 31 October.
Debelle G (2008), ‘Open Market Operations’, address to Australian Debt Markets Conference 2008, Sydney, 27 June.
6. How does Monetary Policy Affect the Economy?
Having discussed the instrument and objectives of monetary policy, it remains to describe how policy influences the economy. This topic can usefully be divided up between the effects on economic activity, covered in this section, and the effects on inflation, covered in the final section.
In describing the processes by which monetary policy affects the economy, it should be kept in mind that they are far from being purely mechanical in their operation. Predictions about the effects of a policy action are, like economic forecasts generally, always subject to uncertainty. The task of policy is to make decisions on the basis of the best available information, recognising that these uncertainties exist.
The general principle that short-term interest rates affect aggregate demand and activity is illustrated in Graph 4. The pattern illustrated in the graph is that important changes in trend for a broad measure of demand have generally been preceded by significant changes in the level of short-term interest rates. Substantial rises in interest rates, designed to restrain inflationary booms, have been followed by contractions in demand. Conversely, substantial interest rate reductions have been followed by periods of significantly faster growth. In responding to cyclical developments and inflationary pressures, monetary policy has had a powerful influence on aggregate demand and economic activity.
We can identify several mechanisms through which these effects can occur, broadly grouped under five headings.
6.1 Saving and investment
Higher interest rates increase the cost of borrowing to finance expenditure. They increase the incentive to save, or to delay spending, and they reduce the net (after-interest) returns to investment. For households, the biggest single investment decision is likely to be the decision to buy a house. Although interest rates are not the only factor in this decision, a rise in mortgage rates will tend to have the effect of encouraging some households to delay the purchase of a home, or to reduce the amount that they can spend on a home. This sort of calculation is probably very familiar to most people: aspiring home-buyers have a limited capacity to meet interest payments and, when interest rates fall, the size of the loan they can afford increases.
This tendency is evident at an aggregate level from Graph 5, which shows that higher mortgage rates tend to be associated with reduced numbers of housing starts. Conversely, lower mortgage rates stimulate house purchases. These effects will generally flow on widely to other parts of the economy. Changes in the number of houses being built will affect demand for other household goods as well as demand for building materials. Employment in the housing industry will also be affected, with further effects on the wider economy flowing from the resultant changes in income and spending.
For the business sector, it seems plausible to think that interest rates will have a direct effect on the incentive to invest. The mechanism for this is through their effect on the ‘hurdle rate’, or required rate of return on investment. When the cost of finance is high, fewer investment projects might be expected to generate sufficiently high rates of return to justify going ahead; whereas when interest rates are lower, more such projects will be undertaken. On this basis, we would expect aggregate business investment to be responsive to changes in the general level of interest rates. The operation of this kind of mechanism in practice, however, is quite hard to detect, because there are so many other important factors driving investment at the same time. In particular, investment is strongly influenced by the economic cycle, which affects both the demand for a firm's products and the cash available for investment from profits. These factors are also influenced by monetary policy, and it is probably through these indirect channels that monetary policy has its most important effects on business investment.
6.2 Cash flow
A second way in which monetary policy affects the economy is through the cash flow channel. This is closely related to the previous one but it refers to the effect of interest rates not on the incentive to spend, but on the amount of cash available for spending. Again, it is useful to distinguish between households and businesses.
Most households, at some point, take advantage of financial arrangements that allow them to borrow. Overall, the household sector in Australia is a net borrower, and as a result, a net payer of interest (Graph 6). Those households who have debt will notice that their interest payments are a much higher proportion of their own incomes than indicated by the net payments data. This is because the net figure hides much larger gross figures for interest receipts and payments of different population groups. The average pattern is to borrow a lot when younger – mainly to finance home ownership – and to pay it back later and gradually become a net financial asset holder in later life. This means that, although interest payments are quite small for the household sector in aggregate, interest rate changes can have significant effects on the cash flows of different population groups.
The effects of changes in interest rates are different for debtor and creditor households: a rise in interest rates reduces the cash flow for debtors while raising it for creditor households. However, as households are net payers of interest, the effect on household spending through this channel would not be expected to be fully offsetting. Furthermore, the usual assumption is that debtor households are more sensitive to changes in cash flows arising from changes in interest rates than creditors. This is because debtor households are less likely to have significant financial assets to help them maintain their spending patterns in the face of a change in income. Combined, these factors suggest that the net effect of a rise in interest rates is likely to be to reduce total household spending and, by the same reasoning, a fall in rates will increase household spending.
Changes in interest rates can also have a significant effect on the cash flows of businesses. In the late 1980s, for example, when both the amount of debt outstanding and the level of interest rates were relatively high, net company interest payments reached over one-third of profits. This squeeze on cash flows was probably one of the factors that contributed to the subsequent decline in business investment over the next couple of years, although more general cyclical factors were also important.
6.3 Money and credit
A third possible channel for the effects of monetary policy works through money and credit. The standard description of this mechanism is that a tightening of monetary policy makes it more difficult for borrowers to obtain loans, and thereby directly constrains their spending. We have to be careful to distinguish this idea from the two channels already discussed, which work through the cost of finance rather than its availability. To the extent that there is a separate money and credit channel, it is thought of as working through the quantity of finance available.
When the financial system was heavily regulated, this kind of quantity mechanism was very important in the operation of monetary policy. Interest rates charged by banks were regulated, and an important part of the mechanism by which monetary policy affected the economy was through the rationing of loans. A tightening of policy would reduce the supply of funds to the banks and force them to reduce their lending. Although the price of a bank loan might not have changed much, a potential borrower was much less likely to be able to get a bank loan when financial conditions were tight. (And incidentally, such a borrower would often have gone to an alternative non-bank lender to obtain the loan at a higher interest rate.)
In the system as it operates today, this kind of regulation-induced credit rationing does not occur, since intermediaries' interest rates are not regulated. However it is possible that some market-induced changes in credit supply still play a role in transmitting the effects of monetary policy changes to the economy. This is argued to result from the fact that lenders continually adjust their credit standards, making it harder or easier to obtain loans depending on their assessments of the risk that borrowers will default on loan payments. For example, we might expect credit standards to tighten somewhat in times when interest rates are rising, if higher interest rates are perceived as increasing the average risk of default.
These effects are very hard to detect in practice. We can observe that credit growth is correlated with growth in the economy as a whole (Graph 7). But this does not mean that changes in the supply of credit are causing the economic cycle. To a large extent the explanation probably works in the other direction, through the effect of the business cycle on the demand for credit – when aggregate economic growth slows, borrowers have less need for finance, and so credit growth will also slow.
There may however be particular episodes when the supply of credit does become an important driving force. The best example of this was in the 1980s. In the period following financial deregulation, banks and other intermediaries expanded their lending to an extent that contributed to booming economic conditions and rising asset prices. This behaviour later went into reverse when the business cycle turned down and it became clear that asset prices were over-inflated and debt levels too high. This period seems to have been somewhat exceptional, however, and in the normal course of events credit availability does not seem to be a major part of the mechanism by which monetary policy actions are transmitted to the general economy.
This discussion raises the further question of what is the role of money and credit in the policy decision-making process. There have been periods in the past in some countries where the money aggregates were accorded a highly significant policy role – for example in Australia in the late 1970s and early 1980s. Monetary policy aimed at keeping the money supply, to the extent possible, to a pre-announced growth rate set each year. This policy framework reflected a view that the money supply had a reasonably stable relationship to the variables that policy was ultimately interested in, particularly inflation and output. By controlling money supply growth, therefore, it was expected that policy would contribute to stable outcomes for these variables. Economists refer to the money supply in this type of system as an ‘intermediate target’. It is not the instrument of policy because it cannot be precisely controlled, and it is not a policy objective in its own right, but is something that is targeted because of a presumed close link to the ultimate objectives.
Monetary targeting was abandoned in Australia, and in most other countries, because it was found that the monetary aggregates were becoming increasingly unstable and unrelated to the variables of ultimate concern. With no suitable intermediate target available, countries have now generally moved to policy systems that focus directly on the ultimate objectives of policy, such as inflation and output growth.
None of this means that money and credit are irrelevant to monetary policy. While they do not constitute an important part of the transmission process, and they are not policy targets or objectives in their own right, they nonetheless have a potential role as information variables. Monetary policy decisions always have to be made on the basis of imperfect information about economic prospects, and the money and credit aggregates represent part of the information (along with an array of other economic indicators) that can potentially help in making these assessments.
6.4 Asset prices
Interest rate changes can affect asset values, which in turn affect people's (and firms') wealth and therefore their spending decisions. There are several classes of assets through which this type of mechanism might be thought to work, including property (both owner-occupied and investment), shares or other financial investments. In theory, higher interest rates can be expected to reduce many asset values relative to what they would otherwise be, because they increase the opportunity cost of holding those assets. A fall in asset prices, in turn, could be expected to dampen spending by reducing wealth, and also by reducing borrowing capacity to the extent that the assets concerned could have been used as collateral for loans.
How important these effects are in practice is quite uncertain. It is certainly not true that asset prices respond mechanically to changes in interest rates. They are influenced by too many other factors, such as changes in expectations and general business cycle conditions, for that to be the case. The influence of asset prices on spending decisions also seems to be quite variable. There have been episodes where swings in asset prices seemed to have a big impact on spending, particularly in the 1980s period discussed above. In the initial phase of that asset price cycle, rising asset prices helped to expand collateral and fuelled growth in credit and spending; this was followed by a period of falling asset prices when these effects went into reverse. In this sense, these effects are closely related to the credit supply channel already discussed. Furthermore, strong growth in asset prices from the mid 1990s through to the mid 2000s contributed to robust consumption growth over the period.
6.5 The exchange rate
Fluctuations in the exchange rate affect the economy by changing the relative prices of domestically-produced and foreign-produced goods and services. From the point of view of monetary policy management, exchange rate fluctuations are important in two ways. First, they directly affect the price level. For example, a depreciation of the exchange rate makes imported goods more expensive, and, since imported goods make up a significant proportion of domestic spending, this will have an effect on the average price of goods purchased. This is illustrated in Graph 8, which shows that import prices at the wholesale level respond very directly to changes in the exchange rate. However, the response at the retail level is somewhat more protracted, and the pass-through of exchange rate changes to retail prices appears to have become more muted since the early 1990s. A notable exception to this is the price of petrol, which rapidly reflects exchange rate movements. Secondly, exchange rate changes affect economic activity. By making imports more expensive and exports cheaper, an exchange rate depreciation will tend to increase demand both for domestic import-competing goods and for exports. This would represent an expansionary impact on the economy at an aggregate level.
So an exchange rate depreciation will tend to add to both inflation and economic activity and, conversely, an appreciation will tend to reduce prices and activity. Movements in the exchange rate therefore form an important part of the economic environment in which monetary policy decisions must be made.
The exchange rate is also an important channel through which monetary policy's effects are transmitted to the economy. Other things equal, a rise in domestic interest rates is generally considered to put upward pressure on the exchange rate by increasing the return on domestic interest-bearing assets relative to foreign investments. As with the other channels already discussed, we should be wary of attributing too much precision to this mechanism. Exchange rates are influenced by many factors and the markets can at times be quite volatile, so the response to a change in one particular factor – such as monetary policy – is always hard to predict. For example, with equity flows becoming increasingly important, investors may instead focus on the implications of a change in policy for future growth in output and profits. The point being made here is one of tendency: higher interest rates will tend to strengthen the exchange rate, and this is one of the mechanisms by which a tighter monetary policy works to restrain inflationary pressures.
6.6 Monetary policy and inflation
So far the discussion has mainly focussed on the effects of monetary policy on aggregate demand. To complete the picture, we need to consider how monetary policy affects inflation. Leaving aside the direct effect operating through the exchange rate on import prices, monetary policy can be thought of as affecting inflation through two main channels.
First, monetary policy affects inflation indirectly, via its effect on aggregate demand and economic activity. When demand runs ahead of the economy's productive capacity, it tends to put upward pressure on inflation – for example, buoyant demand enables producers to widen their margins, while strong demand for labour tends to strengthen the ability of employees to bargain for higher wages. These effects on wages and prices are interdependent. Price increases encourage demands for higher wages, while wage increases add to costs which in turn are often passed on in higher prices. This interdependency gives considerable inertia to the inflation process. Once wages and prices start to accelerate they are hard to slow down, underlining the need for early policy action when inflationary pressures start to develop.
None of these effects operate instantaneously. When a situation of general excess demand starts to develop, it may take some time before this becomes evident in higher prices and wages. It also takes some time for the effects of monetary policy to work through the economy. So in seeking to control inflation, monetary policy has to be anticipatory. This means that policy decisions need to be based on forward-looking assessments of inflation trends and prospects, based on the best currently-available information.
Some of these points are illustrated in Graph 9, which summarises aspects of the policy experience in the past few years. Of particular interest is the episode in the mid-1990s when inflation briefly rose above the 2–3 per cent range, before falling back to a rate of around 2 per cent. Inflationary pressures were generated by a surge in growth as the pace of recovery from recession picked up in 1993 and 1994, but inflation itself did not increase until a year or two later. The important point here is that policy was conducted in a forward-looking fashion. Interest rates were raised early in this episode to forestall the inflationary pressures and, likewise, they were lowered in 1996 and 1997 as the inflationary pressures eased.
Second, monetary policy can affect the inflation process more directly by influencing expectations. Cyclical demand pressures can be thought of as moving the inflation rate relative to where it is currently expected to be. But those expectations in turn depend on the overall policy climate and the historical inflation experience. Part of the role of policy is to set a climate that is conducive to maintaining expectations of low inflation. To the extent that policy is successful in achieving this, it will make it easier to keep inflation low, and will help reduce the cost of bringing inflation down when necessary to do so.
Policy-makers and economists around the world have focused intensely on the question of how this kind of favourable influence on expectations can be achieved. Part of the answer that is usually given relates to the design of the policy system. A system that clearly states the inflation objective, and contains a clear commitment to achieving it, can help to focus the public's inflation expectations. This is an important part of the thinking behind the move to inflation targets in many countries. But equally important is that these commitments have to be demonstrated in the actual conduct of policy. While public commitments can help to shape expectations, in the end they will only be believed if policy is conducted in a way that is consistent with them.
Stevens G (2009), ‘The Conduct of Monetary Policy in Crisis and Recovery’, address to The John Curtin Institute of Public Policy and the Financial Services Institute of Australasia Public Policy Breakfast Forum, Perth, 15 October.
Stevens G (2008), ‘Monetary Policy and Inflation: How Does it Work?’, remarks to the Australian Treasury Seminar Series, Canberra, 11 March.
7. What is the Reserve Bank's Role in the Exchange Rate?
The nature of Australia's exchange rate regime and the Reserve Bank's role is covered in the following paper: