Chapter Two of the RBA review is certainly less spicy than chapter one. But is nonetheless quite important as it goes beyond past mistakes and sets out how the RBA should be setting monetary policy for the future.
Broadly, the review endorses much of the status quo. The flexible inflation target with a two to three percent target ranged is unchanged, and the status quo of targeting some combination of inflation and labour market slack is re-endorsed.
So what are the differences that the RBA review suggests?
Repealing the LAW
First, the review recommends removing financial stability as a core aim of monetary policy. The Reserve Bank of Australia will still have a role in terms of stabilising financial stability, but it will be much more a role of coordination and communication rather than a goal that is pursued with its monetary policy tool set.
This is a massive improvement on the status quo as financial stability concerns were the fundamental cause of the undershooting in the pre-pandemic period (and the associated employment losses) and is not supported by the expert research on the topic. This was also one of the more common recommendations amongst submissions, so while it's great to see it on the page and hopefully implemented, it's not a surprise to see it in the review.
Hard labour
The second recommendation covers the re-emphasis on the labour market as the second core target or goal of monetary policy.
Targeting full employment has always been a part of the RBA's mandate, both in theory and in practice. The RBA has always considered slack in the labour market as a part of the monetary policy framework even if, from time to time, that framework has been implemented in a less than perfect manner.
However the review does suggest that RBA should be more explicit about how this mandate shows up in its monetary policy considerations, including outlining what the RBA's view on full employment is. Hopefully, this will lead to frequent updates on their best estimate of the NAIRU with confidence intervals.
The review also recommends more transparency and explicit statements about how the RBA is balancing its two goals. While the RBA review shies away from giving the RBA an explicit timeline over which to hit its inflation target, it does suggest that the RBA itself should clarify when and how long it expects to meet its inflation mandate and explicitly outline how it's weighing the trade-off to the extent one exists with its second mandate for full employment.
Hitting the bullseye
A third change, and one that I suggested, was a shift away from a thick target band in which any inflation rate between 2 and 3 per cent is deemed to be acceptable, towards an explicit focus on the midpoint of the target band.
This effectively moves the RBA's inflation target from a range to a point with confidence intervals. This is beneficial for a couple reasons.
First, aiming for the middle of the target band increases the degree of accountability of the RBA. There is a substantial difference in an Australian economy inflation at 2 percent vs one inflating at 3 percent. A small but sustained change in the level of inflation is often consistent with very large differences in the output gap.
A RBA that constantly runs the inflation rate at 2% could well be running the economy too slow, putting the level of aggregate demand at too low a level, and the same could be said if they kept inflation at the opposite end of the target band. Focusing on the midpoint is more likely to get the RBA closer to fulfilling its mandate of both stable inflation rates and full employment.
This also makes sense from the perspective of a risk-adjusted approach to monetary policy. If the RBA only aims for the very edges of the target band, as it has often done in the past, then it only takes a small error in forecasting or an unexpected shock to tip the rate of inflation outside of the target band. Thus breaking the RBA's mandate for inflation.
Repeated forecast errors and a focus on the edge of the target band were both features of the 2016-2019 undershooting. So focusing on the midpoint is a subtle, but important improvement over the status quo.
Planning for zero
The final recommendation in Chapter 2 is that the RBA should be more explicit about what unconventional monetary policy tools it will use in the future when, not if, the economy hits the zero lower bound.
We now have considerable experience both in Australia and overseas about what these unconventional policies look like. However, there still remains considerable uncertainty about what policies the RBA would choose to pursue the next time we hit the ZLB. This matters because the best time to design such a policy is when you have the time to have an active discussion, conduct research, and communicate your plans well before the next downturn hits. I imagine many of the flaws in the yield curve control program and bond purchase program could have been avoided if the RBA had announced and discussed these plans well before March 2020 when they had to be implemented in a rush, in the midst of a crisis.
Even today, when we've had several years of experimentation with these policies, it's still unclear what the RBA will do next time.
Certainly, yield curve control is unlikely to make a comeback given the messy way it ended. The same is true of strict time-based forward guidance. Even the bond purchase program and the term funding facility were less than perfect implementations of monetary policy, given the large balance sheet losses both programs accrued and indeed the relatively small positive impacts on the economy that are estimated to occur.
Given the RBA's patchy record with unconventional monetary policy during the Covid -19 crisis, it's not clear what they would choose to do the next time the Australian economy is at the zero lower bound.
My suggestion would be to emphasise state-based unconventional monetary policies, widen the set of assets that are purchased in the RBA's assets program and to judiciously use negative interest rates in certain programs. Having said that, these are all just ideas that should form the beginnings of a conversation. But it's a conversation that the RBA should have well before the next crisis hits.
In short Chapter 2 goes beyond the mistakes of the post to outline what the RBA of the future should look like. All of the recommendations are a solid ideas, well support by both the evidence and many of the submissions. Here is hoping they all get enacted.