Everyone outside the Reserve Bank seems to agree it was a monumental mistake of the Governor to say in early-2021 that he expected the cash rate to remain at 0.1 per cent until at least 2024. But the decision-making processes that enabled this catastrophic public statement to be made is even more concerning.
That is why the report of the review of the Reserve Bank released last week is so welcome.
First, to the Reserve Bank board. The minutes of the February 2021 meeting state the entire board shared the Governor’s view about the cash rate’s future trajectory.
How much debate occurred at that meeting and at subsequent board meetings? That question begs another: does the Governor’s view prevail at board meetings or is it changed following robust discussion and stress testing among board members?
Governor Lowe claimed following the release of the review that there is lots of debate at board meetings and sometimes he doesn’t speak until the end. Let’s accept that. But it doesn’t sit well with the revelation that the board has not voted against the Governor’s recommendation once in the last decade.
It is said that if you put two economists in a room, you’ll get three opinions. Yet all nine Reserve Bank board members have come to the one view at every meeting in the last decade and that view just happens to have been the Governor’s.
The review recommends the establishment of a nine-person Monetary Policy Board comprising trained economists and chaired by the Governor. While welcome, there is a risk of continuing the sort of groupthink that seems to pervade the upper echelons of the Reserve Bank itself.
Economics is not a physical science but a social science. Its basic laws are sound, such as that if the price of a good goes up the demand for it tends to go down. But many economic theories are based on observed behaviour during a particular time in history.
One of these theories relates to the dreaded wage-price spiral. In the early-1980s, following the oil price shock of 1979, when general prices rose, wages followed them upwards, which caused prices to rise further, and so the spiral continued.
This behaviour has led many economists to argue for sharp interest rate increases to prevent wages following prices upwards.
In fact, the minutes of recent Reserve Bank board meetings include references to this phenomenon, which the board has renamed a price-wage spiral. Ever vigilant in its search for signs of it, the Reserve Bank increased interest rates on 10 successive occasions.
Yet no such signs of this nasty spiral have emerged.
That should not be surprising, since the wage-price spiral of the early 1980s occurred when we had a centralised wage-fixing system and almost half the workforce was unionised. Now the wage-fixing system is largely decentralised, and union membership is less than 15 per cent of the workforce.
But this doesn’t argue against any interest rate rises in the last year. The cash rate realistically could never have been kept at record-low levels until 2024 and beyond.
Rather, it illustrates that using theories developed in a bygone era is fraught.
Yet if the new Monetary Policy Board were to comprise mostly economists from the same philosophical branch of economic thought – whether Monetarists, who tend to be politically conservative, or Keynesians, who are on the progressive side – then groupthink would continue to dominate.
Monetarists have become obsessed with the NAIRU. No, it’s not a Pacific Island country, but the non-accelerating inflation rate of unemployment. It’s the unemployment rate that does not fuel excessive wages growth that would set off a wage-price spiral.
But what is that rate? A 2017 Reserve Bank Bulletin report estimated it at about 5 per cent. A subsequent Reserve Bank paper suggested it was around 4.5 per cent.
The Reserve Bank’s explanation of the NAIRU states that if the unemployment rate is lower than the NAIRU, the economy is operating above its full capacity, and there is upward pressure on inflation.
Who, other than the Reserve Bank and some Monetarists, believes 4.5 per cent unemployment is full employment?
Taken literally, the Reserve Bank would tolerate further tightening of monetary policy to increase the unemployment rate to 4.5 per cent – from the present 3.5 per cent – in its quest to prevent the dreaded wage-price spiral.
Yet the Reserve Bank’s Charter of 1959 imposes a duty upon it, within the limit of its powers, to maintain full employment.
In truth, the NAIRU is an observable reality, not a number derived from an economic model.
A slavish commitment by a Monetary Policy Board to continue hiking interest rates until the unemployment rate rose to 4.5 per cent would put an additional 140,000 Australians out of work and inflict even greater economic pain on renters and mortgagees.
Craig Emerson is managing director of Emerson Economics. He is director of the APEC Study Centre at RMIT University, visiting fellow at the ANU and adjunct professor at Victoria University.