By guest contributor Ken Atchison
In April, the Treasurer Dr Jim Chalmers released the review of the Reserve Bank of Australia (RBA) by three economic academics. Commissioned by the Federal Government in 2022, it had a challenging brief; how to make the RBA the world’s best and most effective central bank in the future.
An extensive report has been delivered. In the report financial stability was discussed. APRA is the regulator responsible for the banking sector. Oversight of the financial system is provided by the Council of Financial Regulators (CFR). The CFR includes the RBA, APRA, ASIC and Treasury but not Austrac. This structure was not challenged. Appointment of the Governor of the RBA as Chair of CFR was not challenged.
The primary focus of the review was the conduct of monetary policy which reflects the great capabilities of the three academics. Monetary policy is the primary function of the RBA. Separation of monetary policy management from the other functions of the RBA was proposed, including the introduction of two boards. However, conflict and confusion between two boards is a probable outcome.
Failures in the conduct of monetary policy in the recent past were considered. Greater complexity of financial markets was outlined as a reason for mistakes. Additional external resources and greater acknowledgement of internal resources was advocated. With the current resources available to the RBA, complexity should not have been an issue as changes in financial markets are constantly occurring and have always occurred.
A policy of near-zero interest rates was applied by the RBA in 2020, 2021 and the first half of 2022; this was the RBA’s major failure. The policy led to materially low real interest rates. (Real rates are nominal rates less the inflation rate.) It did not acknowledge the large fiscal stimulus introduced by the Federal Government and encouraged material credit growth, asset price increases and subsequent increases in inflation.
Acknowledgement of mistakes and any lessons from them were not highlighted. Four primary lessons have emerged from the review and subsequent analysis by commentators.
Interest rates were reduced to extremely low nominal levels and negative real rates in 2020/21 without acknowledgement that fiscal policy was extremely stimulatory.
Attempting to control the AUD exchange rate effectively “imported” US and European monetary policy of very low or negative nominal interest rates to Australia which had severe consequences generating excess demand for goods and services and significantly higher asset prices in Australia.
A flawed belief that central banks, through monetary policy, can control all activity in a country was applied which meant no acknowledgement of private sector activity or fiscal policy.
Capital adequacy tests imposed by APRA for bank lending favours residential property which has a consequence of concentrating bank lending to this sector resulting in higher prices for established residential property. This was exacerbated by very low interest rates.
In a significant financial history book, Edward Chancellor stated clearly that interest rates must be positive in real terms. In the book “The Price of Time: The Real Story of Interest” the point that inflation resulting from low interest rates destroys value of money is clearly explained. Very low interest rates have stimulated speculative excess in asset prices in the past and has resulted in significant increases in credit creation resulting in high inflation of goods and services.
Mistakes are made by central banks. Lack of accountability for making mistakes and then rectifying them subsequently is the greater error. Changes in the RBA’s structure does not address this. Changes in the personnel are required if accountability is not accepted. Current policy being applied by the RBA indicates that accountability for the mistakes has been accepted.
However, as a result of the mistakes made in the recent past interest rates in Australia will be higher for longer. Having followed offshore easy monetary policies in the previous decade and a near-zero rate for just over two years to May 2022, the RBA must now follow the monetary tightening being imposed primarily by the US. Otherwise the AUD will fall, adding to inflation in Australia. This may result in the AUD being stronger for longer. Implementation of the recommendations in the review will not alter this outcome.
A current official interest rate of 3.85%, compared with inflation of 6.6%, provides guidance for the future on interest rates. A positive real interest rate is required. Even if inflation falls to 4%, further interest rate increases to 5% – 6% by the RBA will be required.