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Review exposes the blunders of a broken structure

The cornerstone of the Reserve Bank of Australia (RBA) Review is the recommendation that monetary policy powers be taken from the RBA Board and instead be given to a dedicated monetary policy committee staffed mostly by external experts.

Some commentators have criticised this recommendation as a mere rearrangement of deck chairs, taking the decision of monetary policy from one bureaucratic committee and giving it to another, leaving little impact on the interest rates that Australian households end up paying.

I think this view reflects a profound misunderstanding of the RBA Review's findings. In fact the Review spells out in great detail why members believe the current structure has led to multiple policy errors that a panel of experts would almost surely not make.

In this article, I unpack just one part of the Review: the evidence for why the Board is so badly broken.

The broken guidance

The decision in October 2020 to issue a prediction that interest rates would stay at 0% for the next three years is the most universally agreed upon error by the RBA in recent times. Everybody including the Governor himself now admits it was a mistake.

So, how did this policy error get made? The RBA Review examines this decision in detail and finds that:

“The Reserve Bank Board did not receive any written briefings proposing calendar-based forward guidance before it was introduced by the Governor in a speech in mid-October 2020.”

So despite receiving no advice proposing the idea the Board decided to implement it anyway. Even worse, the Board had been actively warned about the risks involved in calendar-based forward guidance only one year earlier.

“The lack of written briefing for the Reserve Bank Board at the outset is notable given the RBA’s advice on forward guidance to the Board in 2019 which focused on the drawbacks and risks of calendar-based guidance.”

The Review concludes that

“… the introduction of calendar-based guidance was not treated in the same way as other policy shifts, and there was no documented discussion of the risks and implications of this shift. The lack of consultation reduced the opportunity for the Reserve Bank Board to debate, challenge and collectively own the decision.”

This is a stunning indictment of the current Board.

Despite being warned about the dangers of the three-year guidance, they implemented it anyway while failing to debate or discuss the very real risks around the policy - namely that that inflation would rise quicker than expected and they would be forced to break the guidance.

Which of course is exactly what happened. This decision was a massive unforced monetary policy error. How would this have been different under a board of expert monetary policy makers?

Well there are plenty of studies on the risks of time-based forward guidance if you know where to look. Any expert in monetary policy or macroeconomics would have known this. Moreover a committee of experts would have taken staffs’ advice placing more weight on staff recommendations and, if they disagreed with them, couched their disagreement using empirical evidence or macroeconomic research. If the Board had listened to the expert advice they had received they would never have given that guidance and would have avoided misleading the Australian people.

By contrast a monetary policy committee of experts would likely have avoided the most universally-loathed mistake the RBA has made in recent years.

270,000 jobs destroyed

The three-year forward guidance mistake, while high profile, ultimately harmed the RBA’s reputation more than it did the economy. A more costly mistake was the decision to keep interest rates too high over the period 2016-2019, a mistake which destroyed 270,000 jobs.

This was an error many years in the making, not in the heat of the Covid-19 crisis. Surely, this additional time would have enabled the Board to debate ways to solve the inflation undershooting and to get the unemployment rate back down to the NAIRU?

“The evidence gathered by the Review suggested that there was not a sufficiently deep ongoing debate around the strategy of accepting gradual progress towards the Reserve Bank Board’s targets. The Board papers contained only limited consideration of alternative strategies, whether because the executive chose not to put them forward or the Board did not ask for this material.”

I guess not. Despite killing hundreds of thousands of jobs, neither the RBA executive nor the external members of Board seriously entertained the idea of changing course.

The Review reports that in 2017, the RBA hired an independent overseas expert who:

“ ... equipped Reserve Bank Board members with the necessary information to genuinely explore and debate alternative viewpoints on the appropriateness of the policy strategy”.

Sounds promising! The expert report even acknowledged the costs of the approach of “Leaning against the Wind”, the underlying reason why the RBA destroyed so many jobs. So now that there were armed with a crash course in macroeconomics, did the Board turn the ship around and stop the RBA from suffocating the Australian economy?

“There is limited evidence in Reserve Bank Board papers or meeting Minutes that the question was re-examined in a meaningful way over the next 2 years.”

Oh well. Of course, the RBA did have access to a large internal source of expertise and dissent did exist among the RBA staff at this time. But alas:

“Alternative views among RBA employees and alternative policy choices – and their costs and benefits – were rarely presented.”

What a monumental policy error, driven by a completely broken policy process.

Would external experts have helped? Of course they would have. We know this because:

  1. The internal experts had diagnosed the problem, but were being muzzled.
  2. External experts were calling out the RBA in the press at the time.
  3. The only politician who held the RBA to account Andrew Leigh, was also the only former academic economist in parliament.

This is a clear example of a time when the RBA made a serious and persistent policy error, and we have evidence of who was the canary in the coal mine. It was academic macroeconomic experts who were the first to call out the RBA for making what was a profound policy error.

Ignoring the yield control problem

Perhaps the greatest evidence of Board failings is how the RBA executive ignored it during the collapse of Yield Curve Control. In October 2021, the RBA decided to effectively abandon the yield peg as it came under sustained pressure from financial markets. But amazingly, the Governor did not even check with the Board before pulling the plug on the programme and stopping all interventions! The Review states that:

“This raises governance concerns regarding … the ability of the Governor to stop implementing a decision of the Reserve Bank Board without first consulting them.”

The RBA was even aware of risks building up in their policy months earlier, but didn’t convey them to the Board.

“The Reserve Bank Board was not made aware of the views of some senior staff members shared with the Governor that the RBA should exit the yield target in mid-2021.”

Another example of internal experts being ignored, so that the Board could blunder into another policy error in their ignorance.

The list goes on

I am more forgiving of errors made in March 2020. It was a hectic time for everyone, central bankers included. But it would be remiss to not mention that the people who had access to all the internal documents still considered the policy process to be deeply flawed during this period.

There was little discussion of the risk involved in implementing yield curve control

“However, the Reserve Bank Board written materials gave little attention to how unusual a yield target was internationally or the fact that there was no international precedent for exiting from a yield target. The written materials also did not consider the plausible risk that the yield target might make it more difficult to change course if economic circumstances changed quickly.”

Meanwhile the risk seemed readily apparent to even a humble academic such as myself per my blog post from November 2020.

Or when it came to the design of the Term Funding Facility

“The Reserve Bank Board was not provided with, and on the available evidence did not demand, enough information in advance to fully debate and challenge the key design choices for the tools proposed by the RBA executive. For example, the term funding facility option presented to the Reserve Bank Board proposed to offer banks funding at a fixed interest rate. It was acknowledged in written materials that this approach carried some interest rate risk. But the risk was said to be small and warranted and was not quantified. The paper did not explore the option of offering an attractive floating interest rate, such as in the Bank of England’s otherwise similar program.”

Did this limited discussion matter? I am sure that academics would be far more familiar with the policy design used by other central banks compared to business executives whose experience is largely confined to the Australian economy.

Of course that expertise to consider these policy programs, and the risks involved, did exist

“The RBA developed a set of internal papers outlining more detail on the design of the yield target and term funding facility, but these materials were not provided to the Reserve Bank Board.”

But it was considered too hard for the Board.

“The RBA considered these materials to have a level of technical detail that was not required for the Reserve Bank Board’s decision.”

And it wouldn’t be an Australian institution if we didn’t have a case policy cultural cringe, this time in response to creating a quantitative easing programme of our own:

“The RBA highlighted in Reserve Bank Board papers that Australia stood out among its peers in not having an asset purchase program across the yield curve. The Review heard in consultations that part of the motivation for implementing the bond purchase program was to match its peers.”

You might think that we need to follow our peers to prevent the currency being depreciated, and you’d be right that was motivating factor:

“The RBA in part motivated decisions about [QE] in the context of the impact on the exchange rate.”

But did the Board see any modelling on the bond purchases impact on the exchange rate?

“However, no supporting analysis was provided to the Reserve Bank Board.”

I think we’ve seen enough.

The status quo must go

If you care at all about good economic policy, or even just good policy processes more generally, then the Review makes for eye-opening, depressing reading.

Time and time again, RBA staff members warned about impending dangers, but the RBA executive decided to keep their Board in the dark. In turn, the Board consistently failed to ask for further information or more detail about the risks involved until inevitably something went wrong and another unforced policy error surfaced.

Fortunately, we now know the truth and have a Government that seems willing to fix the problem. The status quo is broken and change cannot come soon enough.

 

Zac Gross is an Economics Lecturer at Monash University. This article is general information and the opinions are personal and not those of the University.

 

9 Comments
Ted Kramer
April 29, 2023

The review tends to support the view that changing interest rates is the only way to influence the levels of prices and employment.
The review did not consider sufficiently the influence of cooperation with other central banks and the effects on the exchange rate.
The review should have at least discussed the cost of the Bank's policies/forward guidance/forecasts in terms of the resulting misallocation of resources by businesses and households.
The review leaves me thinking/ that anyone believing government/central bank economic forecasts loves reading fiction. Only a politician would use it. The Bank has not been independent!!!!

Former Treasury policy maker
April 28, 2023

I might almost accept these criticisms. The handling of monetary policy in 2020 was problematic because forward guidance was a departure from the long-held approach which basically said, the Board met to discuss monetary policy and set the cash rate where they think it should be, but if in the future they think it should be something else then they'll change it, otherwise they'd have set a different cash rate at the meeting they just held.
But that was never enough for the short term focused financial market traders of bank bills and bonds, nor the headline grabbing media. The pressure to predict future policy was enormous. So they drifted into a bit of forward guidance against their better judgment. It took a step too far in 2020, without a doubt.
However, the appropriate response doesn't need to be to make wholesale changes to the decision-making process. The appropriate response was for the Government to say to the RBA, 'you make the best decisions you can and we'll have your back about the reality that you're operating in the same imperfect and uncertain world that we are; we suggest that you don't give forward guidance any more'. That would be enough!

How on earth is changing to the same system that stuffed up monetary policy in the ECB, BoE and Fed going to improve things? They actually set the path towards forward guidance that created the pressure on the RBA to follow suit.

The review has simply gotten it wrong.

Graeme
April 28, 2023

Correct.

I note that the writer is an academic economist.

Mandy Rice-Davies.

Mart
April 28, 2023

Graeme - Mandy Lifeboats more like ...

G Hollands
April 27, 2023

And the solution to this problem is to create another bunch of "experts" whose sole duty is to consider interest rates? Wow, let's just see how that works in practice shall we?

Neil
April 27, 2023

As for calendar based guidance, it was clearly a forecast not a guarantee. Many economists make forecasts that turn out to be wrong, and don't get sacked for doing so. Having said that, Mr Lowe is not just a run of the mill economist and it is acknowledged (with hindsight) that his wording could have been better given his role.

The final word is that not everybody listened to his guidance - how many people went and locked in fixed interest rates (despite his "guidance" of lower for longer)?

Paul
April 27, 2023

Interest rates were too high from 2016-2019? Scratching head on this one.

Paul
April 28, 2023

Rates from 2016 were deeply negative in real terms and inflation was leaking everywhere including a big run up in house prices in 2017-2018. Should they have been really cutting rates into this? To me the conventional economist view on this is deeply flawed and that is the crux of the issue. It's less culture, but more about a group adherence to a neo-Keynesian economic theory that has succeeded in pumping asset bubble after asset bubble over the past two decades.

Former Treasury policy maker
April 29, 2023

Paul, I question your historical information.

From 2015 until the outbreak of COVID, inflation was running at under 2% per annum. Consistently. AND house prices were all over the place during that period and the average growth rate from 2015-2020 was only 4-5% per annum.

The cash rate target dropped from 2.25% in 2015 to 1.5% before COVID. That is not by any measure 'deeply negative real'. And given that inflation had persistently run below the 2-3% on average over the cycle target, it is not at all surprising or wrong that the RBA should have sought to run with policy at that level to get things going.

If you're going to criticise the RBA then can I suggest you criticise on the basis of facts and evidence, not by making up your own version of history and combining it with nonsense about group adherence to neo-Keynesian economic theory. (Won't go into details, but if there's a group adherence to economic theory it's to the monetary theories of Knut Wicksell not to JMK.)

 

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