In this article I propose to trace the recent (and accelerating) decline in the respect in which one of our most important national institutions, the Reserve Bank of Australia, is now held.
After having written here recently (“How Treasury Lost its Intellectual Standing”, October 2019) about the decline in intellectual respect paid to another great national institution, the Editor asked me to consider whether a similar process was under way in the RBA; and if so, why?
I have often said publicly, and occasionally written, that Glenn Stevens, who was RBA Governor from September 2006 to September 2016, was the best Governor since the late Sir Harold Knight (although Ian Macfarlane’s ten-year tenure was also exemplary). So as in Treasury’s case, whose intellectual decline can be dated from the 2001 retirement of one of its best secretaries (Ted Evans), any decline in RBA performance may be dated from September 2016 when current Governor Dr Philip Lowe took office. That also would present a parallel to Treasury experience: just as my only criticism of Evans was his failure to engineer a worthy successor (Dr Ken Henry), so my only criticism of Glenn Stevens would seem to be his similar failure.
I shall shortly track the course of RBA policy decisions under the leadership of Mr Stevens and Dr Lowe, and seek to assess their wisdom. Before doing so, however, let me dispose of two preliminaries.
The first is a possible technical objection to my reference, hereafter, to policy decisions of various Governors. Those decisions are issued in the name of the Reserve Bank Board, and some might therefore suggest that any criticisms of them should be directed at the Board, not the Governor. In truth, this is a distinction without a difference. Having sat on the RBA Board for almost six years, ex officio, in my then capacity as Secretary to the Treasury, I know how decisions are taken within that body. If the Governor has made up his mind, the Board will invariably rubber-stamp his opinion.
The second is that, in what follows, I have some criticisms of both the current Governor and Deputy Governor, so it is only right I should mention my personal relationship with them, such as it is. So far as I recall, I have met Dr Lowe only on a few social occasions, exchanging no more than greetings. As for Dr Debelle, I did once encounter him when, about fifteen years ago, I was invited to form part of a panel at the Reserve Bank to interview a distinguished visiting American economist. My impression then was of a committed Keynesian, and one not disposed to suffer fools (like me!) gladly—for which, however, I bore (and bear) him no ill will. I should also emphasise that, unlike myself, both men are highly credentialled economists, each holding a PhD (Econ) from the Massachusetts Institute of Technology, a very prestigious university.
The overnight cash rate, 2008 to 2019
In September 2008, directly prior to the onset of the Global Financial Crisis (GFC), the RBA overnight cash rate stood at 7.25 per cent. By February 2009, under Governor Stevens’s decisive direction, this had been cut dramatically to 3.25 per cent, and in April 2009 to 3.0 per cent.
Remarkably however, in October 2009, while the Rudd government was still blowing the federal budget into what became a decade of major deficits, Governor Stevens began reversing course, lifting the cash rate by November 2010 back up to 4.75 per cent. This remarkably brave decision reflected his judgment that the damage to the Australian economy from the crisis was likely to be much less than had been feared.
There the cash rate remained until November 2011, when the now long-prolonged easing cycle commenced. By May 2013 the rate had come down to 2.75 per cent, and by mid-2015 to 2.0 per cent. These reductions must be seen in the context of an exchange rate that had risen sky-high, hovering above parity with the US dollar for almost the whole of 2012 and the first part of 2013, and still remaining above ninety US cents for most of the next eighteen months. Sustained such levels posed an existential threat to many Australian companies competing against foreign firms.
Finally, for Governor Stevens, two further adjustments in May and August 2016 reduced the cash rate to 1.5 per cent.
Before those two latter adjustments, what might be called the “reluctant” moves downward in the cash rate over the previous five years seem to have chiefly resulted from pressures on the Bank from the continuing actions of major world central banks (the US Federal Reserve, the European Central Bank, the Bank of Japan, the Bank of England and so on). Not only did these central banks swiftly cut their own cash rates to zero or near-zero levels in response to the GFC, but they also embarked on a sustained process of so-called “quantitative easing”, buying large amounts of government securities (in some cases even bank mortgages)—in effect, “printing money” by hugely expanding their own balance sheets.
In truth, what was going on (despite being supposedly forbidden under the international monetary system “rules of the game”) was a process of “beggar my neighbour” competitive devaluation. Each country was seeking to lower its exchange rate vis-à-vis the rest of the world, hoping to advantage its exporters and thus provide some support for its domestic economy. By so doing, they were pressuring our own exchange rate upwards, rendering our exports less competitive and assisting imports to compete with our domestic producers.
Just as, in the late 1970s and early 1980s, the Treasury had sought to insulate (while recognising it could never hope to isolate) our economy from the worst effects of the then international monetary casino, so now the RBA under Governor Stevens did its best to protect our economy from the worst effects of these irresponsible actions by the world’s major central banks (while wary of exacerbating the housing price boom then under way). Again, however, like that earlier Treasury experience, it could not hope to do so completely. So, bit by bit, the overnight cash rate was forced down from its 4.75 per cent level in late 2011 to 2.0 per cent by mid-2015 (by which time the Australian dollar was finally back at a much more normal level, well below eighty US cents).
The two further reductions under Governor Stevens, to 1.75 per cent in May 2016 and 1.5 per cent in August 2016, are more difficult to justify, and with the benefit of hindsight appear at best questionable and at worst plain wrong. Mr Stevens himself has apparently since said that he now regrets them. But perhaps we may now leave this background recitation and turn to the course of events under Dr Lowe’s governorship.
Monetary policy since September 2016
By the time Dr Lowe became Governor, the exchange rate was no longer an urgent constraint on RBA action. In US cents, the Australian dollar has been in the seventies for essentially all of his tenure, and for much of it in the sixties.
However, housing market developments were creating cause for alarm. Contrary to the Bank’s expectations, its two mid-2016 rate cuts had triggered a renewed burst of house price inflation, on top of the huge boom (especially in Sydney and Melbourne) seen since mid-2012. Over the second half of 2016, annualised house price growth spiked back to 17 and 15 per cent in Australia’s two largest cities, and investor housing credit growth jumped. These developments were apparent by late 2016.
Despite this, however, Dr Lowe did nothing to take back even one of the two recent rate cuts—allowing a further six to nine months of price rises before the housing market finally did roll over under its own weight in the second half of 2017. As a result, and unprecedentedly, the RBA found itself facing a housing market downturn that had commenced even though the Bank was still in the midst of a six-year rate-cutting cycle, and with the cash rate at a post-war record low!
With housing prices falling, the Bank then found itself paralysed for two years—unable to raise rates even as employment growth surged, for fear this might turn an orderly housing correction into a rout.
Then finally, in mid-2019, having at least resisted strong pressure to cut rates further to prop up house prices, the Bank suddenly chose to change tack following the 2019 election, and swiftly slash the cash rate from 1.5 to 0.75 per cent—thereby using up almost all of its remaining room for manoeuvre on rates in the event of an economic shock. Worse still, the upshot has not thus far been a burst of additional demand, but rather a sudden burst of consumer and business anxiety, with consumer confidence sharply down.
What conclusions then have I formed as to the wisdom of RBA cash-rate decision-making over recent years? Were there other considerations which justified the Bank’s behaviour? And what alternative course might have been preferable? Let us consider each of these questions in turn.
Where has RBA cash rate decision-making over recent years led us?
Because of its post-2016 decision-making, the RBA now resembles a beached whale, unable to slide back into the water, and blowing hard to alert us to its plight and come to its aid. Some months ago we even heard some very silly talk indeed from the Bank suggesting that, although its cash rate had been cut close to zero, that did not necessarily mean it was out of options. Several major overseas central banks, it said, were now operating with negative cash rates (depositors paying them for being allowed to lodge deposits with them!), and one or two had also resumed their earlier practice of quantitative easing (a fancy term for printing money). Both options, the Bank said, remained open to it. Faced with the criticism this nonsense generated, the Bank pulled back, but that it should even have contemplated it (let alone raised uncertainties by publicly canvassing it) beggars belief. It shows how distressed our beached whale has become.
The basic reason for that distress is that the Bank has now run out of options. After having cut its cash rate from 2.0 per cent in April 2016 to only 0.75 per cent today, it passed the point some time ago where such cuts were having positive effects on consumer and business confidence. Although GDP growth had slowed, people generally did not seem unduly concerned by that. Employment was growing fast, and the unemployment rate was still in the low fives. But the Bank, obsessed with what it discerned as “spare capacity” in the economy, still decided to cut its cash rate further. By this stage, however, such cuts were generating negative responses. People began asking, “What’s worrying the Bank? What does it know about the economic outlook that we don’t? We had better pull our heads in until we find out.”
The RBA’s actions during these years have been all the more questionable in significantly relying on achieving its desired GDP growth stimulus by encouraging people to bid up the housing market—raising prices further in markets that, at least in Sydney and Melbourne, had earlier seen huge price increases, to the point of locking out new home-seekers, young people in particular. Why did the Bank think that would be a good outcome? And why, especially, when it should have been concerned about household indebtedness, where Australia (at around 190 per cent of household disposable income) already stands above almost every other developed nation? The over-borrowed state of our households also renders us vulnerable to any future shock from abroad—a vulnerability made all the greater by the Bank’s having already expended almost all the “powder and shot” that might otherwise have been deployable to counter such a shock. Yet in all those nine papers by the Governor and Deputy Governor mentioned below, there is no mention (one passing reference apart) of household indebtedness as a consideration to which the Bank pays attention in setting its cash rate. This seems to me extraordinary.
What I can only call this fecklessness on the Bank’s part seems all the more wrong-headed given some other considerations. Domestically, the lockout of many would-be home-owners has almost certainly been a major factor in our falling national fertility rate, as young people either put off having more children, or any at all, while they struggle to raise the seemingly ever-increasing deposit required. It was bad enough that this should generate intra-generational envy, with these young people seeing others, more fortunate than they, still able to access housing loans (many drawing on the Mum-and-Dad bank) and proceed to raise their families. Worse, consider the inter-generational hostility created as these young people see their home-owning elders laughing all the way to the bank as their properties rise in price, while they personally struggle. I am not suggesting the Bank has set out to create this situation, but it has inadvertently contributed to it, and the cohesiveness of our society has suffered accordingly. All in all, not a record to be proud of.
Were there other considerations which justified the Bank’s behaviour?
In researching material for this article, I have read all nine speeches delivered by the Governor and Deputy Governor between the start of 2019 and the end of August. (All quotations below are drawn from them.) It may or may not be significant that the first three papers were delivered in the run-up to the May 18 federal election (and the fourth, only three days later, must have been arranged beforehand), which almost everyone expected would result in a Labor victory and change of government.
By no means, however, do such addresses measure the full extent of the loquacity of these gentlemen. On the first Tuesday each month, for example, the Governor holds a press conference after the RBA Board meeting to publish, and invite questions on, the ritual statement then issued in the Board’s name. Twice a year he makes a presentation to, and answers questions from, the House of Representatives Standing Committee on Economics. Then there is his participation in such “panels” as that convened by the Financial Stability Institute in Basel, or the ANU Crawford Australian Leadership Forum; and so on. Dr Debelle also seems very talkative beyond his formally delivered papers, with keynote addresses to, and participation in “panels” organised by, assorted bodies. Last but not least, four times a year the RBA publishes its Statement on Monetary Policy, and twice a year its Financial Stability Review, as well as, of course, its Annual Report. In short, the one thing we are not lacking is Reserve Bank views.
From all this talk, then, and the Bank’s formally published opinions, do other motivations emerge which might justify the Bank’s policy actions under Dr Lowe?
So far as I can discern them, seven considerations stand out as potential factors that might have weighed in the Bank’s thinking, and so might potentially mitigate my critique of its actions. Two of these—concerns about the state of the housing market (both current and prospective), and related concerns about household indebtedness—I have already dealt with above. The remaining five are:
- The need to maintain the credibility of the Bank’s medium-term annual inflation target of 2 to 3 per cent (in both “headline” and so-called “trimmed mean” forms);
- The desire to support “full employment” by reducing any “spare capacity” the Bank discerns in the Australian economy;
- A desire to improve “the welfare of the society”—to which inflation targeting and the pursuit of “full employment” contribute, but of which they are only components;
- The need to prevent the exchange rate from getting “too high”, to protect our exporters and import-competing domestic producers; and
- A desire to ensure the adequacy of credit growth in meeting “reasonable” demands by individual would-be borrowers (for housing loans, for example) and by businesses, particularly small businesses.
Let us consider each of these in turn.
The medium-term inflation target. The Reserve Bank’s medium-term inflation target of 2 to 3 per cent per annum, on average over time, first emerged unofficially in the early 1990s under Governor Fraser, after two decades of rapid inflation averaging 10 per cent per annum in the 1970s and 8 per cent in the 1980s. After the 1996 election of the Howard government, Treasurer Costello formalised it as part of an exchange of letters with new Governor Macfarlane which established the Bank’s independence of the government. This procedure has since been repeated between successive Treasurers and Governors after each federal election. The target refers both to the “headline” growth rate of the Consumer Price Index and the so-called “trimmed mean”, produced by adjusting the CPI to exclude adventitious factors that can sometimes alter it without basically affecting the underlying rate of change in the general price level.
The most obvious thing about this target is that, during the past twenty-five years or so, much has changed on the consumer inflation front—not only in Australia but also in all major developed economies. “Currently, three-quarters of advanced economies have an inflation rate below 2 per cent, and one-third have an inflation rate below 1 per cent.” In Australia, “over the past four years, headline inflation has mostly been below 2 per cent … In underlying terms, inflation has been below the band for three years”. Moreover, “on current projections, it will be some time before inflation is comfortably back within the target range”. But “the Board is strongly committed to making sure we get there” (my italics). So that’s that!
All in all, these statements reinforce that, “from an operational perspective, the flexible inflation target is the centrepiece of our [the Bank’s] monetary policy framework”—and sturdy defence of this target is to be found in almost all of the nine speeches mentioned above. What does not emerge from the Bank’s communications, however, is much awareness of the significance of the fact that times have changed on the inflation front.
In the 1990s, when the RBA had no track record on keeping inflation low and stable, and only a few years earlier inflation had been prone to soar or collapse in the space of months, a continuing focus on taming both the average level and volatility of inflation made sense. With twenty-five years of low and stable inflation now behind us, however, and major structural changes to the economy (in relation to wage-setting, union power and global price competition), it is entirely unclear why anyone should care if inflation spends a few years running a few tenths of a percentage point outside the Bank’s target band—and certainly not when housing prices have been going through gyrations 100 times larger.
The “full employment” objective. “The RBA is seeking to achieve the lowest rate of unemployment that can be achieved without inflation becoming an issue.” It therefore seeks to assess the degree of “spare capacity” in the labour market. “The conventional measure of spare capacity … is the gap between the actual unemployment rate and the unemployment rate associated with full employment.”
As the Bank acknowledges, however, growth of the part-time (including casual) workforce over past decades means that the official unemployment rate is now only part of the picture. The under-employment rate (of people wanting more hours, or wanting to work but unable to find jobs they consider appropriate) means that total “under-utilisation” of labour is higher. The RBA has therefore “constructed a measure of under-utilisation that takes account of part-time workers who want to work more hours”; when combined with the official unemployment rate, this produces a total under-utilisation rate of just over 8 per cent.
Since that measure too is only the Bank’s best estimate, however, in reality this means it is seeking to measure a “gap” between two quantities, while not having an exact basis of assessment for either. But not discouraged, the Bank concludes that “despite the strong employment growth over recent times, there is still considerable spare capacity in the labour market”, and that, “consistent with all this, wages growth remains moderate and is below the rate” (harking back to its inflation target) “that would ensure that inflation is comfortably within the 2 to 3 per cent range”.
Surely, however, when the unemployment rate is still in the low fives, and employment growth has been running well above average, an (uncertain) assessment of labour market “spare capacity” would, at best, justify a moderately stimulatory cash rate setting—not one far below any level previously contemplated by the Bank in its entire history (and that leaves it with virtually no room to respond should a serious shock now strike the economy).
The “welfare of the society” objective. Unlike with the two preceding objectives, the Bank’s invocation of this as a justification for its actions is thin to the point of vagueness. Its listing seems to stem from “the broad mandate for the RBA set out in the Reserve Bank Act 1959”. Section 10 of that Act states:
It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of Australia and that the powers of the Bank … are exercised in such a manner as … will best contribute to: (a) the stability of the currency of Australia; (b) the maintenance of full employment in Australia; and (c) the economic prosperity and welfare of the people of Australia.
The strange thing about (c) is that, surely, there was no need for it in the Act in the first place. Does anyone suggest that one of the nation’s most significant institutions would be seeking anything other than to maximise the economic prosperity and welfare of the people of Australia? That would be unthinkable. All in all, then, while the Bank has dutifully listed “welfare of the society” as an objective, the extent to which it has actually figured in its monetary decision-making seems negligible.
The exchange rate. As noted earlier, for a time the Australian dollar was being driven dangerously high by the irresponsible competitive devaluation policies of major world central banks. However, the Bank concedes that: “The exchange rate has depreciated over the past couple of years” (as the RBA has cut its cash rate) “and, on a trade-weighted basis, is at the bottom end of its range of recent times”—which, it notes, “is helping support important parts of the economy”. With the Australian dollar now below seventy US cents, despite high terms of trade, it is hard to argue that the exchange rate has provided a compelling rationale for the Bank’s decisions to push the cash rate ever lower.
Credit growth adequacy. Finally, on this score, in one speech Governor Lowe says: “Recently, much attention has been paid to the availability of credit … It is clear there has been a progressive tightening in lending standards over recent years … On average, the maximum loan size offered to new borrowers [seems to have] fallen by around 20 per cent since 2015”. However, he adds: “Even so, only around 10 per cent of people borrow the maximum amount they are offered”. Here too, then, the Bank’s regard to this consideration, when setting its cash rate, seems almost perfunctory.
What otherwise might the Bank have done?
Dr Lowe became Governor shortly after the Bank, under his predecessor, had cut the cash rate in June and July 2016 to 1.5 per cent. What if he had then asked himself, “What kind of Governor do I wish to be? Shall I meekly accept the maintenance of this downward shift in our rate (given its likely, albeit unforeseen, impact on housing prices) and, in due course, further it? Or should I more clearly envisage the likely adverse consequences of doing so?”
Such a suggestion on my part might be criticised as benefiting over-much from hindsight; but I honestly don’t believe so. Think about the main considerations that the Bank should have had in mind, namely: (1) The vulnerability to an external shock to which the Bank was already exposed, and the desirability therefore of adding to, rather than subtracting further from, its store of “powder and shot”; and (2) The already high level of household indebtedness, posing a risk to future consumer behaviour and magnifying that aforesaid vulnerability should an external shock emerge. Instead, the Bank went on its heedless way, with obsessive emphasis on (3) Maintaining its cherished medium-term inflation target; and (4) Hunting for “spare capacity” in the economy. In the background also loomed (5) The fragile state of the housing market and the undesirability of the Bank’s sporadic interventions in it.
What if, alternatively, the Bank had conceded what had been clear for some time, that consideration (3) was plainly out of date? A low inflation rate was already firmly anchored; and, in the real world, nobody (apart from the usual speculators) was losing sleep because it was not a fraction higher. Consideration (4), too, could be put to one side, with jobs growth rising faster than the working-age population; while as to (5), the adverse consequences of that, canvassed extensively above, should surely have been in mind. If the Bank, then, had set out to edge its cash rate back upwards (accepting some modest increase in the Australian dollar as a consequence) we might have today a cash rate of (say) 2 or 2.25 per cent rather than 0.75 per cent, and our now beached whale would be disporting itself offshore.
I know that nothing can ever be proven by deploying such a counterfactual. Doing so can, nevertheless, shed a revealing light on what the Bank might otherwise have done.
In my considered opinion, instead of striking out boldly, the Bank under Dr Lowe has pursued a timid and wrong-headed course ending ultimately in failure. Readers must judge, but I rest my case.
John Stone is a former Secretary to the Treasury and Senator for Queensland.