The Board Behavioural-ing Badly

It's the vibe

At the October Board meeting the RBA took (almost) everyone by surprise by increasing interest rates by only 25bp - half the 50bp that was expected. In the Board minutes that followed one of the justifications for the policy swerve was the idea that:

“Drawing out policy adjustments would also help to keep public attention focused for a longer period on the Board’s resolve to return inflation to target.“

What the RBA Board seems to be stating is that a slower increase in the cash rate will somehow increase the public’s confidence in inflation returning to target. If this seems odd to you, you are not alone.

Indeed this statement seems based on little to no science and instead entirely on vibes and gut feelings.

Tightening, Fast or Slow

Consider two different paths for the cash rate over the next few months.

In one scenario the RBA increases interest rates by 50 basis points each meeting for the next three meetings reaching a peak of 4.10% (roughly the expected peak according to market pricing). Alternatively they could increase interest rates by only 25 basis points for the next 6 meetings, reaching the same level but taking twice as long.

Which approach would have a more contractionary impact on the economy? Which would represent a “stronger resolve” to returning inflation towards its target?

Macroeconomic models, previous RBA statements and basic common sense all tell us that the first approach would be better at taming the current high rate of inflation. If you want to reduce the rate of inflation you need to increase nominal interest rates and delaying those increases will only keep inflation higher for longer.

If you really want to convince the public that you have a strong resolve to return  inflation to 2-3% the answer is to lift interest rates by 75 basis points! Reducing the rate of interest rate increases to 25 basis points will if anything lead people to question the RBA’s resolve. The Board even admits that stating that

This [decision to increase by 25bp] might in turn prompt an unhelpful reaction in inflation expectations and financial markets, if the community came to question the Board’s resolve to reduce inflation.

Bad Behaviour

What the Board implicitly seems to be implying in this statement is that there is some sort of behavioural effect occurring when the RBA lifts interest rates.

One possible interpretation is that each time a newspaper headline reads “RBA Hikes Interest Rate” consumers take additional notice and tighten their belt - regardless of the size of the hike. According to this theory six 25bp hikes might generate more headlines and thus more belt tightening than three 50bp hikes.

However the only way this makes sense if households respond more to the headlines than to the fact that their mortgage payments have risen! In my opinion this is quite unrealistic. Newspaper headlines may nudge people marginally, but I am very sceptical that they would be enough to offset the direct effects of a lower than otherwise cash rate.

It is akin to bailing out a sinking boat with a smaller bucket on the basis that spending more time tipping water out of the hull will help stop the boat from going under.

More importantly there is zero economic evidence for this sort of behavioural gut feeling on monetary policy.

A Repeat Offender

This is not the first time that the members of the RBA’s board have gone on a misguided, vibes-based lark when setting monetary policy. In July 2019 the minutes asserted that lower interest rates may hurt business and consumer confidence, perhaps by signalling the economy was worse than it looked. This was cited as a reason why they were reluctant to lower interest rates even though inflation was well below the target band and the unemployment rate far too high. 

While there is some economic theory that such a “confidence effect” might exist the Board was citing it as a reason to guide policy despite having no evidence that is actually true. We know this because in the subsequent years the RBA published multiple research papers on the subject and found that no empirical evidence for it at all. The conventional view that interest rate cuts stimulate the economy is backed up by a mountain of evidence including the RBA’s own research.

The idea that cutting interest rates would cause people to lose confidence in the economy has now been thoroughly debunked by the RBA’s research department - but only after it was used to justify the RBA’s biggest policy error in decades. Most damningly research from other countries debunking the idea existed well before 2019. The RBA Board should have known better.

In 2019 and 2022 the RBA Board sketched out paper-thin behavioural stories about the Australian economy in order to justify their inaction,  rather than doing their job and fulfilling their mandate.

Sky’s the limit

The most galling part of this story is that even if it were true (ie that 50 basis point hikes weren’t as effective as two 25bp increases) it would not provide a good justification to slow the pace of interest rate increase. 

There is an arguable case for “saving your ammunition” as a central bank if:

1. The headlines generated by RBA decisions have their own additional impact on the economy, and

2. That the zero lower bound poses a significant constraint on monetary policies ability to stimulate the economy and,

3. The economy is weak and you are getting close to the zero lower bound.

Under those three conditions you can make a reasonable argument that a central bank should preserve its ammunition when attempting to stimulate the economy. You have a limited number of cuts in your arsenal, it may make sense to spread them out to maximise the power of the headlines that they may generate.¹

However, there is no upper limit to the nominal interest rate. The RBA can keep on hiking interest rates to infinity and beyond. If for some kooky behavioural reason 50 basis point increases aren’t quite as effective as two 25 basis points increases then that doesn’t pose any meaningful constraint on the RBA’s ability to tighten policy. One only needs to increase interest rates a bit more to offset whatever behavioural effect is lost from increasing interest rates at a rapid pace.

Original Sin

Given the opacity of the RBA Board’s minutes it’s not possible to attribute where this view came from. It is merely stated that members “noted” the argument. But I find it inconceivable that this was an idea promulgated by the staff. It is instead far more likely that the source of this unscientific fake-news is the amateur central bankers who comprise the majority of the RBA’s board. I suspect the Research department is now furiously searching for a method to scientifically test this vibes-based idea just as they did with the “confidence effect” mooted in 2019 - an endless game of whack a mole!

It is one more reason why the ongoing review of the RBA should recommend removing amateurs from the monetary policy setting committee of the RBA. Monetary policy is a difficulty policy problem. Fortunately we have 1000s of research papers on the subject trying to explain how it should be done. The RBA should be staffed with experts who will use this research and won’t run the Australian economy on the basis of gut feelings and vibes.

1. For what it’s worth I don’t believe 1 or 2 are true.