A tangle of interest rate fish hooks

AWU chief Paul Howe's call to change the Reserve Bank charter raises the question: should rates policy be used to target inflation if it conflicts with strong economic growth and low unemployment?

The head of the Australian Workers Union chief Paul Howes has called on the federal government to urgently review the charter of the Reserve Bank of Australia, suggesting its current policy setting is inappropriate while the manufacturing industry struggles under the weight of a high Australian dollar.

It’s useful here to note here what the so-called Charter of the RBA says: in part, that its powers should be "exercised in such a manner as, in the opinion of the Reserve Bank board, will best contribute to: the stability of the currency of Australia; the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of Australia”.

What this means in terms of the conduct of monetary policy is that the Reserve Bank pursues what is called 'inflation targeting' and has done so since the early 1990s. As it argues, this strategy is seen as a precondition of achieving the aims set out in its charter.

In essence the issue Howes is raising is whether inflation should be the top priority in the RBA’s decisions about interest rates while manufacturing, and steel in particular, has been bearing the brunt of a high Australian dollar.

Interestingly, one government response so far – not surprising, but somewhat annoying – is that such a discussion is "unproductive” because of the independence of the reserve bank which, the feeling seems to be, should be sacrosanct.

This kind of response is rather unhelpful and potentially a red herring. The issues raised by Howes are not necessarily the same as the question of the independence of the Reserve Bank.

More importantly, the issues raised by Howes are also a bit more profound than simply a question about the current stance of monetary policy – that is, about the current settings on interest rates – and should serve as a basis for an on-going discussion about macroeconomic policy.

Howes’ argument opens the door to a deeper frustration with the dominant form of monetary policy wisdom which assigns monetary policy primarily to controlling inflation, to the neglect, as some see it, of other policy goals.

For some, the problem is whether one policy – interest rate policy – can be used simultaneously to achieve more than one goal. Should it be used to target inflation if there is a conflict between that and the interest rate levels required by other goals, such as strong economic growth and low unemployment?

It is probably fair to say that this is much less of a dilemma for the conventional economist. He or she might respond with the point, raised by the current Reserve Bank governor Glenn Stevens himself in the past, that there is a long-term growth path which monetary policy (and for that matter fiscal policy) can do little about.

What it can do about this, according to conventional wisdom, is to get inflation under control and minimise the extent the economy is deviating from that long-term path.

In this view, monetary policy can do something more persistent about the rate of inflation. Herein lies, albeit crudely put, the conventional rationale for the assignment of monetary policy to the task of keeping inflation under control.

And just for good measure, to keep those pesky politicians’ hands away from interest rates, let’s make the central bank independent. The Reserve Bank will know better than politicians, so the argument goes, the risk of increasing inflation with little gain, of being tempted to use interest rates in the short-term to target unemployment or a sluggish growth.

In a nutshell this would be a conventional economic response to the kind of argument Paul Howes has put.

Of course, there will be other arguments, one being that trials of the manufacturing sector reflect structural changes and to the extent policy can help, it is microeconomic reform that is called for. I suspect this is code for greater "labour market flexibility” and some of the worrying claims this term sometimes brings with it.

Needless to say, as with most economics, there is dissent within the ranks about the assignment of monetary policy. And dissent is something the economics profession is always coy about admitting.

That dissent would argue that macroeconomic policy, including monetary policy, can have persistent long-term effects on the growth rate of the economy. Interest rates can affect in a persistent way not only the level of economic activity, but relative prices and also the distribution of income.

This dissent starts from the view that long-run growth is dependent on the growth of aggregate demand and not growth in the effective quantity of resources. Policy at the macro as well as at the micro level can impact on that long-run growth of demand.

In other words, the dissenting voice would note that interest rate policy does not just have persistent effects on the rate of inflation.

But if you accept this proposition, things become a lot less black and white. The justification for using interest rates as the preferred tool to target inflation is much weaker. One then has to weigh up the different objectives – low inflation, low unemployment, strong growth.

And the argument that the latter two will be cleaned up as long as we get inflation right has much less force.

Of course, one then has to think of alternative policies which may be brought to bear on inflation; either in the form of incomes policies or through imaginative use of the tax system.

As to the former, the Australian experience is not a glorious one, and turned out to be not much more than a device for cutting real wages.

As to the latter, this is something that requires an imaginative debate we have not had in this country. But the groundwork is there to the extent that we have been thinking about radical surgery to the tax system in this country for some time.

The independence of the central bank is a somewhat thorny issue. Dispensing with the conventional economic wisdom does not in and of itself means dispensing with a degree of independence.

It does however mean that such independence can’t be justified on the grounds that monetary policy needs to focus primarily on inflation.

It may well be that arguments for independence are consistent with the dissenting view of macroeconomic policy which recognises its influence on the long-run growth path of the economy. Though such arguments will have to contend with the question of why it should monetary policy should be more independent of the government of the day than other policy arms.

On the other hand, it is interesting to reflect on the point made by other economists over the years – some orthodox, some non-orthodox – that monetary policy is far too important to be left in the hands of an independent central bank and should "fall within the orbit of general economic policy with the government of the day bearing full responsibility for it”.

Graham White is a senior lecturer at the University of Sydney's School of Economics. This story first appeared on The Conversation. Reproduced with permission.

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