Second Mandate Syndrome

The mandate for full employment has been consistently overlooked, until now.

One of the biggest misconceptions about the Reserve Bank of Australia, among many contenders, is the idea that the RBA does not have any target or consider the employment rate when setting monetary policy.

This belief is surprisingly common among journalists, politicians, and even some economists. The most recent example is Prof Jeff Borland, who shared the latest episode of The Money with me. In his section on the concept of full employment, Jeff described the recommendation that the RBA would consider full employment goal of monetary policy as a significant innovation, but this is not a fair description of the status quo.

Wherever you look within the RBA, the concept of full employment and the labor market is front and centre. It's written into the Act, the Statement on the Conduct of Monetary Policy, and the models the RBA uses on a daily basis. Below is the rule for the cash rate which includes both difference between the unemployment rate and the NAIRU (LURGAP) and the unemployment rate (LUR):

The RBA has a goal for full employment, which it actively pursues, as evident from its minutes and policies.

A common misperception

So why does this misunderstanding persist? One reason is that that the RBA's goal for full employment isn't constant over time, and the RBA constantly emphasises the uncertainty of this target. It's perhaps understandable that people don't believe the RBA targets the unemployment rate if it's infrequently discussed and mostly in vague terms.

This vagueness is somewhat understandable. If a central bank announces a hard target for the unemployment rate that it is not consistent with it’s inflation target it can quickly get into strife. Imagine driving a car and having a target for both speed you are travelling and the number of revs the engine is doing. If you calibrate both targets well everything will be fine - but if you misalign the two targets you will be forced to choose between the two (at least in the short tune).

The reviewer has recommended that the RBA should be more explicit about their estimates of the Non-Accelerating Inflation Rate of Unemployment (NAIRU). The RBA recently disclosed that its estimate of full employment was around 4.25%, although they acknowledged the uncertainty due to the chaotic post-COVID economy. On The Money Jeff Borland suggested a target of 3.5% for full employment. This is obviously a substantial difference.

Resolving the full employment target is challenging, but not impossible. The RBA should publish its best estimate of full employment, including confidence intervals, and regularly update it once the pandemic's inflationary effects subside. But this will always be a hazy estimate at best (indeed if you ask Adrian Pagan it might be impossible to identify at all!)

More practically what does this mean for monetary policy in Australia? Well clearly the first priority should returning inflation to target over the next couple of years. However once inflation has normalised the RBA should attempt to slowly increase aggregate demand to test just how far we can push the labour market similar to the US in 2018-19 - the . This might take several years, but it's essential not to pre-commit to a more optimistic number until there's time to find out for sure.