Monetary Policy in Australia

1
Monetary Policy in Australia

• Treasury Lecture
• Mardi Dungey
• 5-March-2004

2
Outline/Roadmap

• Role of monetary policy
• Historical background Australia
• Reserve Bank Act
• How could you run monetary policy?
• How is monetary policy currently enacted?
• Independence of Central Banks
• Interaction between monetary and fiscal policy

3
Role of monetary policy

• Monetary policy transmits credit conditions to
  the economy.
• The way in which this has been organised has
  varied over history
• Transmission Channels
• Changes in interest rates affect
• Expectations
• Channels via aggregate demand
• Bank lending channel
• Asset prices (savings and spendings)

4
Transmission mechanism as seen by the European
Central Bank (2001)
5
Historical Background

• Bank of England was founded in 1694
• Concept was to provide money for the government
  taxation required to fund the fighting associated
  with William of Orange around 150 million pounds
• a national bank capitalised by subscription, no
  repayment of capital, but an annual return
• Was associated with the increase in circulation
  of notes of exchange forerunner of modern bank
  notes

6
Central Bank

• A bank which is
• Banker to the Government
• Banker to the commercial banks
• Manages the currency and credit policy of a
  country
• From 1936 A Dictionary of Economic Terms

7
The Reserve Bank of Australia

• 1911 the Commonwealth Bank of Australia
  Established as a trading bank
• In 1920s and 30s CBA given
• Note issuing responsibility (from Treasury)
• Board established
• Exchange control (due to WWII)
• In 1959 the Central Banking functions preserved
  into the Reserve Bank of Australia
• 1983 abolition of exchange control function
• 1998 Wallis Report
• Separation of Australian Prudential Regulatory
  Authority (APRA)

8
RBA Act

• "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 the people
  of Australia and that the powers of the Bank ...
  are exercised in such a manner as, in the opinion
  of the Reserve Bank Board, 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."

9
Australia Currency Regimes

• conglomerate of currencies in early years
• fixed to the UK pound
• gold standard
• Bretton Woods, fixed exchange rates
• crawling peg (1976)
• float (December 1983)
• clean
• dirty

10
Australia Monetary policy regimes

• Gold standard
• Fixed exchange rate
• Floating exchange rate
• money supply targeting
• the wilderness years 1985-1989
• Ad hoc
• the checklist approach
• Current account debate
• Inflation targeting
• When did it officially start?
• Debate about official announcement in 1993 or
  1994
• Bank now likes to claim they were doing this as
  early as 1989

11
Gold Standard

• Paper currency and coinage is backed by physical
  gold reserves
• This gave control of the money supply
• How to fund expansion of the economy?
• Devaluation of coinage
• Explains why gold discovery was so important
• Explains the ultimate demise of Bretton Woods
• How to cope with expansion of gold supply?
• Sometimes didnt very well - inflation

12
Fixed exchange rates

• Sometimes its appropriate to form currency
  unions (the same exchange rate)
• Conditions for this are
• Similarity in response to economic shocks
• Similarity in economic shocks experienced
• Compatible fiscal policy/aims
• Compatible political policy/aims
• Successful examples
• United States, French Franc area in Africa,
  Australia
• This is often proposed for Australian dollar and
  New Zealand dollar, smaller components give up
  monetary autonomy it goes to maintain the
  exchange rate link.

13
Fixed exchange rates

• Sometimes we dont want to commit so much form
  a fixed exchange rate but without giving up
  seignorage of having own currency
• Risk of being seen as less credible
• Does give last resort of devaluing
• Advantages of reducing volatility (Bretton Woods)
• Disadvantage includes importing external
  inflation shocks (oil shocks)

14
Monetary Targeting

• Theory that the price level is ultimately
  determined by the amount of money in the economy
• If we have a fixed amount of output, then prices
  will be determined by the available, more
  will affect only the price level.
• M V P Y

output
Money supply
prices
Velocity of money
15
Monetary Targeting

• Prices then
• P M V / Y
• And because we dont know much about V, assume it
  doesnt change much
• DlogP DlogM DlogY

Growth in output
inflation
Growth in money supply
16
Monetary Targeting

• If output growth is determined exogenously
  (Quantity Theory of Money)
• then inflation is the result of increases in
  money supply
• Implication set guidelines for the growth of
  money supply to control inflation.
• This is what was done, primarily in the early
  1980s

17
What happened?

• The relationship between money supply and output
  turns out to be unstable
• Monetary targeting abandoned in Australia
  formally in 1985.

18
M3 Growth in Australia 1970-2003
19
US Money Supply Growth
20
US Short-term Interest Rates (Fed Funds)
21
US GDP Growth
22
Monetary Targeting

• So the instability between money supply measures
  and output led to the abandonment of this policy
• Sometimes people come back to it
• Discussion points
• What do we think of policies to fund tax cuts by
  printing more money?
• The dangers of monetary targeting are in its
  unpredictable nature
• Has been said We didnt abandon monetary
  targeting it abandoned us!

23
Inflation Targeting

• Current interpretation of the RBA Act, and
  current best practice in the world of central
  banking is inflation targeting
• Steady inflation is an equilibrium - rising
  inflation is that there is excess demand
• Idea is to match demand with supply capacity,
  but there are lags in process so need to be
  forward looking ocean liner analogy

24
RBA Act

• "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 the people
  of Australia and that the powers of the Bank ...
  are exercised in such a manner as, in the opinion
  of the Reserve Bank Board, 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."

25
Current Interpretation Statement on the Conduct
of Monetary Policy, July 2003

• The first two objectives i.e. the objectives set
  out in the Act lead to the third, and ultimate,
  objective of monetary policy and indeed economic
  policy as a whole. These objectives allow the
  Board to focus on price (currency) stability
  while taking account of the implications of
  monetary policy for activity and, therefore,
  employment in the short term. Price stability is
  a crucial precondition for sustained growth in
  economic activity and employment.

26
Current Interpretation Statement on the Conduct
of Monetary Policy, July 2003

• Both the Bank and the Government agree on the
  importance of low inflation and low inflation
  expectations. These assist businesses in making
  sound investment decisions, underpin the creation
  of new and secure jobs, protect the savings of
  Australians and preserve the value of the
  currency.

27
Current Interpretation Statement on the Conduct
of Monetary Policy, July 2003

• In pursuing the goal of medium term price
  stability, both the Bank and the Government agree
  on the objective of keeping consumer price
  inflation between 2 and 3 per cent, on average,
  over the cycle. This formulation allows for the
  natural short run variation in inflation over the
  cycle while preserving a clearly identifiable
  benchmark performance over time.

28
Key elements

• Price stability is the means to all ends
• Focus on medium term
• A soft-edge target band of 2-3
• On average
• Over the cycle
• Interpreting this is quite difficult

29
Australian Headline CPI Inflation 19702003
30
Australian inflation 1991-2003
31
What are some of the issues?

• Why 2-3? Why a band?
• Zero doesnt allow sufficient flexibility
• The evidence on inflation is that high inflation
  is bad, but little to differentiate moderate from
  low inflation in the literature
• An exact target is very hard to hit, allow for
  some deviations if this is short-run
• Does the Bank have asymmetric incentives?
• Its better to be under the target band than
  over it
• How do we assess performance?
• What is average? What is a cycle?

32
What do other countries do?

• Inflation targeters
• NZ (innovators)
• UK
• Canada (MCI)
• Euro area countries
• Nordic countries
• Chile
• More recently other developing countries
• Korea, Thailand, Peru, Philippines, Mexico, Czech
  Republic, South Africa, IMF Programs are very
  keen on this.

33
What do other countries do?

• examples of differences
• Sliding scales of inflation target, eg 8 for
  first 5 years, then 3 thereafter (Chile was like
  this)
• Harder targets, 2.5 /- 0.5
• More stringent penalties NZ, Governors
  position depends on staying within the band
• Targeting explict inflation forecasts (UK,
  Thailand)
• There has yet to be anyone abandon inflation
  targeting is this due to luck (and
  productivity growth) or is this really the key to
  stability?

34
What do other countries do?

• US does not specifically inflation target
  probably an amalgam of inflation and output
• Inflation and output are intrinsically related
  most models of inflation process are based on the
  concept of excess demand
• If there is insufficient capacity to meet unmet
  demand then prices will rise. This is called
  overheating often the capacity constraint is in
  labour markets.
• Now we often see central banks talking in terms
  of output gaps is output above or below some
  form of average performance, and inflation
  outcomes.

35
What should developing countries do?

• Argument about whether floating or fixed
  exchange rates are better for developing
  economies
• Post the Asian crisis the debate became bipolar
  either float or fix completely
• Recently, Calvo and Mishkin (2003) have argued
  that institutional structure is more important
  than choice of exchange rate regime

36
What else might be possible?

• Current academic literature talks about nominal
  income targeting
• Theoretically better if most shocks hitting the
  economy are supply shocks
• Has not been tested yet most bankers will tell
  you its not relevant its good to know what
  alternatives may be available in case things do
  break down.

37
How is Monetary Policy enacted?

• The Bank acts to equilibriate the money
  available for transactions in the economy with
  demand.
• Text books say that this is how monetary policy
  is enacted, by changing money supply to affect
  the interest rate
• THIS IS NOT TRUE
• Modern monetary policy works because central
  banks have credibility

38
How is Monetary Policy Enacted?

• Announcements of the RBAs desired interest rate
  in the short term market (for overnight funds)
  are made after each RBA Board meeting
• The market takes up those rates and passes it
  through to the economy
• Why do they do this?
• Because they hold funds in interest bearing
  Exchange Settlement Accounts with the RBA
• These accounts settle transactions between the
  banks overnight, and banks incentives are to
  minimise their balances in them. They are very
  sensitive to changes in the rates applied.
• Hence the RBAs credibility acts to pass the
  interest rates through to the economy the banks
  believe that the Bank will act to ensure the
  equilibrium of demand for funds and supply of
  funds at the announced interest rate.

39
Announcements

• Announcements have been made after each Board
  meeting for the past few years
• Board meetings held 1st Tuesday in the month
  except January
• It is not a requirement that the announcement
  take place then, used to be unannounced, then
  moved to announcements then to scheduled
  announcements
• Increasing shift to transparency
• But capacity exists to change things at other
  times

40
Transparency

• Transparency enhances credibility and
  accountability
• The quarterly publications by the Reserve Bank
  on conditions
• Semiannual statement on Monetary Policy to
  Parliament
• Periodic reaffirmation of the Understanding
  between Government and the RBA on the operation
  of Monetary Policy

41
Accountability

• How do we assess what the RBA does compared with
  what they say they do?
• This is a weird argument in some ways why do we
  disbelieve or retrospectively analyse the
  decisions outside the framework of the Bank
  decision makers?
• But a thriving industry in so-called Taylor rule
  analysis.

42
Taylor Rules

• Taylor rules Bryant-Henderson-McKibbin rules
• Idea that the nominal interest rate setting can
  be stylised as a response to deviations of
  inflation from target and deviations of output
  from potential.
• rt rt a (pt p) b ( yt yt)

Observed rate of interest
Natural rate of interest
Inflation rate less inflation target
Output gap
43
Issues

• Estimates have been made for Australia (de
  Brouwer and ORegan 1997)
• The more weight put on minimising deviation of
  output from target (b) the less output
  variability so reduces this cost
• There are a range of different frontiers by which
  taking into account output gap and inflation
  deviation from target dominate just taking into
  account inflation deviations
• So called dual approach Meyer- Federal Reserve

44
Issues

• The Taylor rule was really developed in an
  empirical exercise based on the US.
• Is it appropriate for small open economies?
• Some debate exists as to whether the exchange
  rate should also be included
• Should the central bank also respond to the
  anticipated effects on inflation of exchange rate
  changes ( a depreciation makes imports more
  expensive?)
• Critical to the outcome
• Source of the exchange rate shock
• Temporary or Permanent?
• Many of these issues covered in Calvo and Mishkin
  (2003)

45
Independence

• It is important for Central Banks to be
  independent of the Government for credibility
• Financing the debt (printing money)
• Making economically sound decisions on monetary
  policy
• Being unswayed by the political system

46
Independence of RBA

• In international comparisons of independence the
  RBA doesnt do that well why?
• In the legal relationship between Government and
  RBA, the Government has the right to overrule a
  monetary policy decision
• Never happened
• Its a very serious step, requiring tabling in
  parliament
• The Secretary to the Treasury sits on the RBA
  Board meetings

47
Independence of the RBA

• The RBA Board is made up of
• Governor Ian Macfarlane
• Deputy Governor Glenn Stevens
• Secretary to Treasury Ken Henry
• Six members appointed by Treasurer
• J Broadbent (1998-2008) financial markets
• R Gerard (2001-2006) business
• F Lowy (1995-2005) business
• D McGauchie (2001-2006) rural
• H Morgan (1996-2007) business
• W McKibbin (2001-2006) academic

48
What alternatives could exist?

• Board could be professionals
• Could be provided with professional staff eg
  Bank of England Monetary Policy Committee
• How would we do this? Thin market

49
Monetary Policy and Fiscal Policy

• Important to remember
• Cant aim for everything with one policy
• Importance of discretionary policy
• Currently
• Monetary policy uses interest rates to affect
  the economy
• Fiscal policy uses taxation and expenditure to
  affect the economy
• Co-ordination is important

50
Monetary and Fiscal Policy (simple and stylised)
51
Policy co-ordination

• Recent research points to difficulties in
  coordinating fiscal and monetary policy rules
• Monetary policy rules on inflation targeting
• Fiscal policy rules on debt or deficits (such as
  in European Union)
• Sometimes it can be impossible to get to the
  desirable better outcome because the use of one
  policy to make the move will come up against the
  binding rule on the other policy
• This is a serious problem for policy makers which
  must be faced.

52
Resources

• Butlin, S.J. (1986) The Australian Monetary
  System 1851-1914, Ambassador Press, Sydney.
• Butlin, S.J. (1968) Foundations of the Australian
  Monetary System 1788-1851, Sydney University
  Press, Sydney.
• Calvo, G. and F. Mishkin (2003) The Mirage of
  Exchange Rate Regimes for Emerging Market
  Economies, Journal of Economic Perspectives, 17
  (4), 99-118.
• Carew, E. (1988) Fast Money 2, Allen and Unwin,
  Sydney.
• Conan, A.R. (1953) The Sterling Area, MacMillan,
  London.
• de Brouwer, G. and J. ORegan (1997) Evaulating
  Different Policy Rules for Australia, in in
  P.Lowe (ed) Monetary Policy and Inflation
  Targeting, Proceedings of A Conference, RBA,
  Sydney, 244-276.
• ECB (2001) The Monetary Policy of the ECB,
  European Central Bank, Frankfurt
• Grenville, S. (1997) The Evolution of Monetary
  Policy From Money Targets to Inflation Targets,
  in P.Lowe (ed) Monetary Policy and Inflation
  Targeting, Proceedings of A Conference, RBA,
  Sydney, 125-158.
• Sinclair, D. (2000) The Pound A Biography,
  Random House, London.
• Winton, J.R. (1936) A Dictionary of Economic
  Terms, Routledge Kegan Paul, London.