The Reserve Bank of Australia has lost control of monetary policy. This is a simple fact borne out by the RBA’s decision earlier this week to cut rates in response to similar moves by central banks elsewhere.
Policymakers still think that the currency is too strong; that was the primary reason cited by the RBA for this latest cut.
In following this path, however, policymakers have actually destroyed confidence and put the economy on a weaker footing than it would otherwise be on. This easing cycle is three years old and rates were already at generational lows.
Have a think about why non-mining business investment is still so weak, why consumer spending is supposedly so fragile. There are no structural impediments, just a lack of confidence.
Unfortunately, each and every time the RBA cuts, confidence seems to get weaker as households and business begin to reassess the outlook.
It’s with that in mind that the exchange rate target being pursued could be formalised, perhaps by establishing a currency board. Under this arrangement, rather than having a fixed interest rate target at any given point (currently 2.25 per cent), the AUD-USD exchange rate would be fixed at a particular level (or the trade-weighted index). Interest rates would then simply move up or down automatically in order to reach that target.
Currency boards are widely regarded as being better suited to small open economies such as Australia that have difficulty sustaining an independent monetary policy. Under the circumstances, it would be naive to suggest that the RBA conducts an independent monetary policy.
With a fixed exchange rate, and in this world of competitive devaluations, interest rate fluctuations would then be largely unrelated to perceived economic conditions. The nexus between rate moves and weaker confidence would be broken.
The main advantage to this approach, however, is that it would clarify to the nation (and to the market and everyone else) what the true policy target is. As things stand, the country is beholden to a seemingly arbitrary and unknown policy goal. A month or two ago, the market was toying with a couple of rate hikes here or there. Subsequent data justified those positions. All of a sudden (and with no change to the economic backdrop), we’re facing a few more rate cuts. Households and business can be forgiven for feeling a little queasy about such an abrupt change.
So the government should stop the façade and just fix the exchange rate. We effectively have an exchange rate target anyway; it’s just that no one outside of the bureaucracy seems to know what it is. Maybe they don’t know themselves -- certainly the goalposts seem to move.
Back in 2012 under the previous Labor government, the target was put at US85c, a level swiftly described by the RBA as desirable. Then the target moved to US75c, a level subsequently adopted by the Coalition. Now that we’re nearly at that point, the focus has moved onto the trade-weighted index. A currency board would prevent this kind of chaos. It would introduce discipline (to both the government and the bureaucracy) and policy certainty in an uncertain world, a world gripped by competitive devaluations and the currency war.
It must be emphasised that this is only a second-best solution. Ideally we would live in a world with freely floating exchange rates. This is certainly preferable, and it’s clear that inflation targeting has served the country well.
But the reality is we don’t live in that world anymore. Inflation targeting has been dispensed with globally and currency manipulation is rife. The exchange rate is the target; the monetary system needs to change as a result.
Regardless of whether you view the RBA’s latest move as a positive step or not, one thing remains clear: it caught analysts and commentators completely off guard. Late last year, every economist was forecasting the next move would be up. There is a reason for that: global and domestic economies had been (and still are) getting better. It made sense to expect that the RBA would act to reduce the degree of monetary stimulus.
The problem is this unshakeable view in policy circles that the commodity price slump will lead to a disastrous fall in national income and jobs. That is, unless the exchange rate falls as well. This is crux of the current problem. Unfortunately, this simply forces the RBA to respond to whatever central banks elsewhere are doing. Consequently, there is no consistency in policy. Under this current ad-hoc approach, Australia’s institutions risk their credibility, financial stability, currency stability and inflation -- even if just asset price inflation. Changes clearly need to be made.