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The RBA’s new Statement on the Conduct of Monetary Policy

The release of the Statement on the Conduct of Monetary Policy agreed between the Treasurer and the RBA Board marks the next step in the response to the RBA Review earlier this year. The changes are in line with the Review recommendations. We expect the February post-meeting communication to include unattributed votes and much more detailed forecasts.

Recently a parliamentary committee released a report into a central bank’s performance. It concluded that the central bank in question had made significant errors in its conduct of monetary policy in recent years. It expressed concerns about a ‘perceived lack of intellectual diversity’ in the central bank and a culture of ‘insufficient challenge’. It critiqued the overly broad and vague mandate, arguing that a ‘democratic deficit has emerged’, where ‘critically important economic decisions are delegated to unelected officials’. The report therefore called for a five-yearly review of that central bank’s remit. 

While this might sound familiar in the context of the RBA Review released earlier this year, the report was in fact by the UK House of Lords Economic Affairs Committee, about the Bank of England. Making an independent Bank of England work better (parliament.uk)

The RBA has also been through the review process recently, with very similar findings and recommendations. Today’s release of a refreshed Statement on the Conduct of Monetary Policy marks a further step in the response to that review; the previous Statement was released in September 2016, when the previous Governor took over. There are few surprises in the new document, but several noteworthy changes. 

The first comes in the first paragraph. Rather than recording the common understanding of the Governor as Chair of the RBA Board, and the Government, the new Statement frames this common understanding as being of the Board as a whole and the Government. This lines up with the thrust of the RBA Review’s recommendations to make the Board have more ownership and accountability for monetary policy decision rather than centring all the focus on the Governor.  Other changes in this vein include the publication of unattributed votes, and of Board papers with a five-year lag. This shift also presumes that the Board will have more capacity to challenge the Governor and staff.

A further layer of challenge comes from the changes to the appointment process for Board members. Currently nominations come from a register of ‘eminent candidates’ maintained by the Secretary of Treasury and the Governor. The new Statement adds an ‘independent third party’ to the group maintaining a ‘shortlist of candidates’ who should have the ‘right balance of skills and experience to best discharge [the Board’s] functions’. The RBA Review suggested that the third party could be an outside expert, but they could also be a past Board member or the Chair of the Governance Board. Since the Governor is to be the Chair of the Governance Board, this third nominator needs to be an outsider. The Statement was not the place to give examples of who that could be. If not a former Board member, though, the creation of this role removes somebody from the pool of potential Board members.

Similarly, the expert advisory group on monetary policy to be convened by the Board presumes that there are enough such (unconflicted) outside experts available to serve. Expect at least some of these experts to be drawn from overseas, and so be less expert about the differences between Australia’s institutions and those abroad.

The revised Statement does not change the RBA’s flexible inflation target in a material way. The 2–3% band is validated, with the Statement declaring that ‘all outcomes within the target range are consistent with the Reserve Bank Board’s price stability objective.’ In the very next sentence, the Statement goes on to say, ‘The Reserve Bank Board sets monetary policy such that inflation is expected to return to the midpoint of the target.’ This could be interpreted as mandating that policy should always be set so that the endpoint of the inflation forecast should be 2.5%. Since that is not currently the case, some observers might think this implies that the RBA now needs to get inflation down faster than its recent statements imply, with hawkish implications for interest rates. 

In our view that would be a misreading of the intent of this change. The length of the RBA’s published forecasts has been defined by the capacity of its past forecasting technology. As modelling approaches have improved and expanded, it is entirely possible for the RBA to publish a longer horizon for its forecasts and show inflation returning to 2.5% on a longer trajectory. 

We can therefore expect the RBA to start publishing longer-run forecasts, at least from time to time. In doing so it will need to decide how to represent uncertainty around those longer horizons. These RBA currently does this by showing error bands around its forecasts based on its own past forecast errors. This is good practice, but it cannot be done for forecast periods that go beyond the length of its past published forecasts. A new, perhaps hybrid, approach must be found.

Along with longer forecasts, the Statement announces that the RBA has agreed to publish more detailed forecasts, including assessments of potential output and full employment. It should be noted that in the past the RBA has not tended to emphasise the unobserved concept of potential output and the output gap in its communication. This shift will bring it more into line with practice at some other central banks. How that fits in with the intent to reduce groupthink remains to be seen.

Consistent with the recommendations of the RBA Review and the proposed changes to the Reserve Bank Act, the Statement clarifies the Bank’s full employment objective to be ‘sustained full employment, which is the current maximum level of employment that is consistent with low and stable inflation.’ This is essentially the NAIRU (non-inflation accelerating rate of unemployment) from economic theory. The Statement’s recognition that ‘full employment is not directly measurable and changes over time’ is therefore welcome.

The financial stability responsibilities of the RBA have been revised as well, though the substance of the section is little changed. The Statement does not mention the RBA’s role as chair of the Council of Financial Regulators and the text could even be read to imply that the RBA need not be a member. While we do not regard that as the Statement’s actual intent, it is an interesting omission.

Since the publication of the previous Statement in 2016, the RBA has joined the ranks of central banks that have used unconventional policy tools such as Quantitative Easing (that is, buying bonds and other assets). These policy tools sparked considerable concern in the House of Lords report, but in the Australian context, the Government has been content for the Board to ‘use its judgement to determine what these tools are, when they are needed and how they are to be deployed most effectively.’ To ensure transparency and accountability, in the Statement the Board undertakes to ‘communicate a framework to guide the use of additional monetary tools, including the benefits, costs and risks associated with available tools.’ No timetable is set for the publication of this framework. Much of this work had already been done and articulated in speeches and other public documents. We can nonetheless expect to see more formalised and structured documents capturing any new analysis on these issues.

The other main set of changes in the Statement relates to the role of Treasury. For all the language added to the first section about the importance of the RBA’s independence, the Review and the new Statement tighten the relationship between the RBA and Treasury. Some of this is welcome, for example the commitment to work together to better understand the joint effect of monetary and fiscal policy. Setting out an explicit responsibility for the Secretary to the Treasury to ‘provide independent insight on the outlook for the economy and fiscal policy’ is also welcome as good practice. But there are other areas where the increased role of Treasury has less obvious benefits. For example, the Statement sets out that there shall be a review of the RBA’s monetary policy framework and tools every five years. Unlike other central banks’ regular reviews, this will be done jointly with Treasury. This sits uncomfortably with the concerns expressed by the House of Lords about the Bank of England being overly dominated by UK Treasury perspectives and former Treasury staff.

Based on the revised Statement, we expect to see more detailed – and possibly longer – forecasts in the February Statement on Monetary Policy, and unattributed votes in the February decision statement. The formation of the expert panel and independent member of the Board appointment panel will probably take a little longer.

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