The failure of the RBA’s program of yield curve control and their not-quite-a-promise1 that interest rates would stay at near zero per cent until 2024 has led to claims that the RBA has “lost its credibility”. What does this mean? It sounds bad, is it a problem?
The notion of central bank credibility is derived from the experience of the 1980s and 90s when after a period of high inflation central banks around the developed world gave a new commitment to stabilising inflation at a low level - even if it meant causing a recession in the process. Central bank’s that announced and achieved their new inflation targets created a reputation as “credible” inflation targeters which in turn led to inflation expectations becoming well anchored close to the target rate in their respective economies.
In the three decades that followed central banks, including the RBA, largely kept that promise. Inflation was kept at a low level and inflation expectations were kept in check. This created a virtuous circle in which low inflation helped keep expectations well anchored and well-anchored expectations helped keep inflation low.
Has the collapse of yield curve control and breaking of the not-quite-a-promise to keep interest rates low thus destroying the RBA’s credibility potentially lead to a return to the 1970’s high volatility?
Multi-dimensional credibility
In reality central banks, like any large organisation, have more than just a single goal such as an inflation target (or even a dual mandate). The RBA actually has a multitude of desired goals:
Keeping inflation within the target bank.
Maintain the labour market close to full employment.
Keep the chance of a financial crisis low.
Prevent any major banks from failing.
Keeping long-run inflation expectations stable.
Help keep financial markets relatively efficient.
Have a low level of volatility for the AUD.
Maintain the ability to make credible promises about the future policy decisions and follow through on them.
Maintain a low cost and efficient payment system.
Help maintain an orderly market for Government bonds.
Minimise currency fraud & scams.
Maintain its independence from the Government.
Avoid any insider trading or the perception of insider trading.
Educate the public about economics.
Cooperate with peer central banks to maintain global financial stability.
Help aid smaller central banks in our region.
Maintain swap-lines with other central banks around the world
Export our world class banknotes around the world.
Keep nominal interest rates away from the zero lower bound.
Publish forecasts that are accurate and considered by the public to be accurate.
Maintain a cooperative relationship with both the government and treasury.
Maintain its reputation with academic economists.
Minimise disruption to the payments system from natural disasters.
Avoid breaking laws foriegn and domestic.
Preserve Australia’s monetary policy history.
Promoted the use of economics in the classroom
Promote competition in the market for payment services.
Supply banking services to the Commonwealth.
Liaise with businesses about the role of monetary policy and macroeconomic conditions.
Monitor and manage the trading of the AUD in financial markets in NY and London.
I could go on.
Sometimes these goals are in direct conflict. For example a floating (and thus occasionally volatile) Australian dollar is a key component of the RBA’s approach to keeping inflation within the target band and the labour market close to full employment. Since the 1980s the RBA has (rightly) valued its dual mandate over that of currency stability.
But many of these goals are more orthogonal in nature. A central bank can easily stabilise inflation while running the Reserve Bank of Australia Museum or provide aid to other central banks in our region while also producing credible forecasts. In these cases the RBA’s failures in one are unlikely to diminish their perceived capacity in others.
More concretely while one could argue that the RBA's bribery scandal associated with its exportation of polymer bank notes hurt the RBA’s reputation, I think most observers would agree that it did little to impede its credibility as an inflation targeter.
Rock and a Hard Place
In October 2021 the RBA faced a dilemma. It had provided strong guidance that interest rates were stay low for several years to come and had created a peg in the bond market to back up this view. But the macro picture was rapidly changing and it was becoming clear that keeping interest rates at zero per cent until 2024 would not be compatible with keeping inflation within the target band.
The RBA had to choose between two undesirable options.
Abandon the peg and unwind the time-based(ish) forward guidance, giving them the flexibility to raise interest rates early and keep inflation in check.
Keep their not-quite-a-promise and maintain their yield peg, even if it meant inflation rising well above the target band.
Faced with a direct tension between prioritising their commitments to the bond market (goals 8 and 10) or meeting their mandate for inflation (goals 1 and 5) they rightly chose the latter.
Abandoning yield curve control may have dented their credibility with the bond market, but it was a demonstration of their credibility to their inflation target. Had they kept interest rates at zero until 2024 there is little doubt that inflation would soon be heading into the double digits and long term inflation expectations would be a serious risk of becoming unmoored.
I am sure that if the RBA wanted to implement another target for the yield curve it would take a lot more work to convince markets that it was credible. The RBA’s credibility on this specific policy has been degraded (perhaps the accuracy of its forecasts too). But that is distinct from it’s credibility about it’s commitment to keeping inflation in check.
In fact by incurring the wrath of bond holders, mortgagees and the headline writers of the Daily Telegraph, Phil Lowe and the RBA demonstratively proved their commitment to not letting inflation overshoot the target. This was a costly signal to send and it’s part of the reason why long term inflation expectations remain well anchored today despite the recent surge in the price level.
The RBA is not a perfect institution and as I am sure the Review will discuss they have made mistakes. But abandoning yield curve control was not one of them - even if the timing was somewhat less than optimal.
While the RBA always made this a state-based commitment, it was widely interpreted as being a time based commitment.
I'd nuance the argument of whether the RBA's commitment to low rates was a state-based or time-based. I'd say it was probability-based. They not only said they'd raise rates if wages rose, they said rising wages were unlikely. Difference between getting in a car with someone who points to the wipers and says, I'll turn these on if it starts raining, and getting in a car with a professional meteorologist who points at them and says, i pretty much guarantee I won't be using these bad boys today!
They leveraged their credibility to make people believe a rate hike wasn't coming. That leverage drew on public belief they understand some of the relevant dynamics in the global economy and it blew up. So i'd add another dimension to the RBA's credibility: intellectual. That dimension is diminished.
We can believe they are committed to fighting inflation, but doubt their ability to see the enemy coming. It means all future state-based commitments and forecasts will be viewed more skeptically, including, crucially, their forecast that suggest inflation will be back in range soon. In that way it could marginally increase the chance ofun-anchored expectations.