RDP 2011-07: Australia's Prosperous 2000s: Housing and the Mining Boom 5. Monetary and Financial Policy

5.1 The Framework

The past decade saw less debate than in previous decades about the appropriate monetary policy framework for Australia. Throughout the 2000s, there was broad community and political support for the key elements of the framework which include: (i) a medium-term inflation target; (ii) the cash rate being the instrument of monetary policy; (iii) the Board of the RBA setting the cash rate independently of government; and (iv) the RBA being accountable for, and communicating, its decisions.

The main framework-related issue over the decade was the role of monetary policy in addressing financial imbalances. While this has recently been topical at the global level following the financial crisis, it was extensively discussed in Australia in the early years of the decade. Here, the particular issue was the extent to which the RBA should take account of the then rapid increases in housing credit and housing prices when setting the cash rate.

In 2001, even as the RBA was cutting interest rates as a result of the global slowdown in the aftermath of the tech boom, it was expressing concerns that lower interest rates risked further boosting housing prices and credit. Then in 2002 and 2003 as interest rates were being increased, the RBA frequently noted the risk of imbalances building up in the housing market. In 2003, in particular, the most common theme in speeches and in the RBA's research agenda was the risks posed by unsustainable growth in both housing credit and prices. In part, the RBA's strategy during this period was to bring to the public's attention the risks involved with making investment decisions on the assumption that the then current trends would continue.^[7] Unlike every other developed country, and most large emerging economies, the RBA did not cut interest rates at any point in 2003.

During 2002 and 2003, the RBA came in for some criticism from those who saw it as exceeding its mandate or who interpreted its actions as targeting housing prices. The RBA went to considerable lengths to explain its actions as consistent with flexible inflation targeting and to explain that it was not targeting credit growth or asset prices. Developments in the housing market were, however, given as one reason for increasing interest rates in response to general macroeconomic conditions sooner rather than later.

Internationally, the debate on how monetary policy should respond to emerging financial imbalances is far from settled. The weight of opinion has, however, shifted somewhat towards the view that in some situations it may be appropriate to respond to a big run-up in assets prices that is accompanied by rapid credit expansion.^[8] While this view can sit uncomfortably with a more rigid inflation-targeting framework where the policy rate is set so that the inflation forecast at a fixed horizon is equal to the target midpoint, it is not inconsistent with the medium-term inflation-targeting framework that the RBA has employed since 1993. In particular, in some situations, responding to financial imbalances may deliver an average inflation rate that is closer to the target and less volatile, even if it results in some short-run deviation from the target. This is particularly so if such a response can help avoid a costly ‘boom and bust’ that damages the financial system. The challenge here is how this can be done in practice. How might adjustments in interest rates be calibrated? What is the trade-off with other policy instruments? And, how are such actions best explained to the public? These questions are likely to be debated frequently over the decade ahead.

Looking back, it is difficult to judge how effective the RBA's approach was in the early 2000s. The Bank's comments at that time did, however, attract widespread media coverage, including in the popular press. Following the increase in interest rates at the end of 2003, housing price growth did decelerate sharply, and Australia was able to avoid the worst of the excesses seen in other housing markets around the world. Furthermore, the adjustment in housing prices was not accompanied by major stress in either the household or financial sectors.

Whatever conclusions one draws from that particular episode, the past decade has seen a shift globally towards a more flexible approach to inflation targeting. With the adoption of inflation targeting by some countries in the 1990s, there was a discussion about the importance of constraining the discretion of the central bank, so that it delivered on its inflation objective.^[9] In a sense, this was understandable given the experience of earlier decades. But as inflation expectations became better anchored, a number of central banks have adopted a more flexible approach with greater consideration given to medium-term outcomes, including for output and employment. Recently it has also become clearer that low inflation does not guarantee financial stability and so there is increasing thought being given to how the setting of monetary policy should take into account financial stability issues.

A second framework-related issue that was at times controversial was the degree of transparency of the RBA's decisions. While in 1990 the RBA was one of the first central banks to commence releasing a statement announcing changes to the policy interest rate, for many years, the RBA was ambivalent about the practice of releasing statements and minutes after every Board meeting. The main concern was that too frequent communications would create additional uncertainty. But by 2007, the evaluation of the benefits and costs of increased communication had changed, partly based on the experience of other central banks. Since then, a statement has been released after each Board meeting and minutes have been released two weeks after the meeting.^[10] In February 2008, the Bank also began publishing numerical forecasts for both inflation and output on a quarterly basis, after having published descriptive forecasts in the Statement on Monetary Policy for over a decade, and the amount of material published by the Bank, and the number of public speeches given by senior staff, has increased significantly. Unlike many other central banks, RBA officials take questions from the media at these speeches, although the RBA does not hold regular press conferences as have become increasingly common elsewhere.

One issue that attracts attention periodically is the structure of the RBA Board, which has a majority of part-time external members drawn primarily from the business community. This longstanding structure is unusual by international standards and has both its critics and defenders. Its critics raise the issues of conflicts of interest and the capability of part-time members to question the views being put by the RBA executives. In contrast, supporters of the current structure point to the importance of bringing timely, real-world experience to the RBA's deliberations and the generally successful outcomes delivered by the current arrangements. Over the decade the only change made to the appointment process was in 2007, when the Treasurer announced that new Board appointments would be made from a register of eminent candidates to be maintained by the Secretary to the Treasury and the Governor of the RBA.

The Statement on the Conduct of Monetary Policy, which records the common understanding of the Governor and the Government on key aspects of Australia's monetary policy framework, was re-signed four times during the decade.^[11] On each occasion, the broad objectives of monetary policy and the key elements of the inflation target were reaffirmed. The largest change to the Statement was in 2010, when a separate section on financial stability was added, recognising the RBA's longstanding responsibilities in this area. The other main changes were made in 2007 and related to the RBA's independence and its increased transparency.

5.2 The Major Policy Considerations

Apart from developments in the housing market, two major issues confronted monetary policy over the decade. The first was the very large shift in the relative price of commodities, which led to Australia's terms of trade rising to their highest level in over 140 years. The second was the North Atlantic financial crisis and the associated severe global recession.

Looking back over the past decade, the most frequently recurring theme in the RBA's communications was the rise in Australia's terms of trade. This rise has not only been very large, but it has taken place almost continuously since 2003, although there was a sharp, but temporary dip, during the financial crisis. It was largely unexpected and, in hindsight, is explained by the boom in China following a period of relatively low global investment in resource extraction and food production. Like many others, the RBA repeatedly revised up its forecasts for the level of commodity prices and the terms of trade over the period (Figure 10).

This rise in the terms of trade, and the frequent upside surprises, meant that for most of the decade monetary policy was being tightened. Indeed, from 2004 to 2008, the RBA's two-year-ahead forecast for inflation, based on the assumption of a constant cash rate, was in the top half of the medium-term target band. Not surprisingly, there was a long upswing in the cash rate running from 2002 to 2008, with monetary policy becoming restrictive in 2006 (Figure 11). The pace of tightening picked up in late 2007 as it became clear that capacity pressures in the economy were leading to a sharp pick-up in inflation. This pick-up was substantially larger than the RBA had been expecting and it saw underlying inflation increase to a little above 4½ per cent.^[12]

This peak in inflation occurred in the September quarter of 2008, just when the financial crisis was intensifying dramatically following the failure of Lehman Brothers. Despite the high inflation rate, the RBA cut the cash rate rapidly over the final months of 2008 as the global economic outlook deteriorated markedly. Including the 25 basis point cut in September, the cumulative reduction from the peak in the cash rate was 425 basis points to 3 per cent in April 2009, a new cyclical low but substantially above policy rates in almost all other developed economies.

Importantly, the RBA also provided significant liquidity support to the domestic money market. Unlike many other central banks it was able to do this through its pre-existing framework for market operations. This framework allowed significant flexibility as the RBA had long dealt with a wide range of counterparties, dealt in the market every day, and conducted repurchase agreements for a range of maturities and with different classes of collateral. Following the failure of Lehman Brothers, the RBA, among other actions, increased the supply of settlement balances to increase the liquidity of the system and widened the pool of securities eligible for repurchase agreements.^[13] These actions helped smooth the operation of the financial system in what were very troubled times globally. Overall, the assistance that was provided was considerably less than in many other countries and was able to be unwound relatively quickly as conditions improved.

Footnotes

See Bloxham et al (2010) for a fuller discussion of the RBA's approach during this period as well as actions taken by APRA and ASIC. [7]

See Cagliarini, Kent and Stevens (2010) and Miskhin (2011) for more details. [8]

There was also a discussion on the need for ‘penalties’ on the central bank if the inflation target was not met. [9]

See Stevens (2007) for a full discussion of the reasons for this change. [10]

These re-signings occurred in 2003 following the reappointment of Ian Macfarlane as Governor, in 2007 when Glenn Stevens was appointed Governor, and in 2007 and 2010 following federal elections. [11]

See Lowe (2011) for a detailed account of this pick-up in inflation. [12]

See RBA (2009) and Debelle (2010) for more details. [13]