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INTERVIEWS
WITH ECONOMISTS
An
interview with the Reserve Bank of Australia, conducted by Professor
John Taylor
Professor
John Taylor interviewed David Gruen (Head, Economic
Research Department, Reserve Bank of Australia) in September 1999.
Can you
describe how the members of the Reserve Bank Board reach a decision
about whether to raise the interest rate (the cash rate)? Do they
get advice from economists? Do they take a vote? Is there typically
much disagreement? How much knowledge of economics do they need
to make good decisions? Is it much more than in a first-year economics
course?
Before each meeting, the members of the Reserve Bank Board receive
written economic analyses, prepared by the Reserve Bank staff,
about developments in the domestic and foreign economies, and
in financial markets. This analysis also includes the Bank's recommendation
concerning interest rates; that is, whether the cash rate should
be moved and, if so, by how much. At each meeting, the Board also
receives verbal presentations from senior Bank staff. The Board
discusses the evidence, the outlook, and the recommendation. The
discussion is wide-ranging, with different views canvassed. There
is sometimes disagreement among members, but the aim is to reach
consensus. A vote is rarely taken.
Members bring a range of skills and experience to the Board. Many
members, though not the majority, have formal training in economics.
Whether or not they are trained economists, they all have access
to economic analysis, both from the Bank and from outside sources.
The Reserve Bank seems to increase the 'cash rate' when the
inflation rate rises. For example, in 1994 the Reserve Bank raised
the cash rate by nearly 3 percentage points from 4.75 per cent
to 7.5 per cent as the inflation rate rose. Is this a typical
reaction of the Reserve Bank to inflation? Can we expect the Reserve
Bank to increase the cash rate by this amount if inflation rises
in the future as it did in 1995?
The Bank aims to pre-empt changes in inflation. When inflation
is expected to rise above the medium-term target of 2 to 3 per
cent, policy is tightened to reduce the extent of the rise, and
ensure that it is temporary. (The same comment applies, with signs
reversed, when inflation is expected to fall below the medium-term
target.) The aim is not, however, to eliminate all variability
in inflation, because the Bank also seeks to reduce fluctuations
in output, to the extent possible without compromising the medium-term
inflation target.
It should be noted that it is the outlooks for inflation and economic
activity that matter, not their current values. Of course, this
outlook is informed, to a considerable extent, by assessments
about the current state of both prices and output. In 1994, the
cash rate was raised to 7.5 per cent because inflation was expected
to rise above 3 per cent. The interest rate increases occurred
before inflation actually rose. In the event, underlying inflation
did rise above 3 per cent in 1995, but only temporarily.
The reaction of the Reserve Bank will be similar in future, in
the sense that the medium-term inflation target is the guiding
principle for the Bank's monetary policy, as it was in 1994. If
at some time in the future, with an unchanged cash rate, inflation
is expected to rise above the target, then policy will be tightened.
The magnitude of the tightening would depend on judgements at
the time about what was appropriate.
The Reserve Bank cut the cash rate from 7.5 per cent in 1996
to 4.75 per cent at the end of 1998. To what extent were these
cuts due to a decline in the inflation rate and to what extent
were they due to other events such as the international financial
crisis? What effect did this decrease in the interest rate have
on the economy and the exchange rate?
The cuts in the cash rate were primarily due to a changing outlook
for inflation. The first cut, from 7.5 per cent to 7, occurred
in July 1996, when the latest reading of year-ended underlying
inflation was just above 3 per cent. The Bank judged, however,
that inflationary pressures were abating, and eased monetary policy.
The rate of underlying inflation did subsequently fall, and the
Bank continued to ease policy so that, by the end of July 1997,
the cash rate stood at 5 per cent.
Most of the easing, therefore, occurred before the severity of
the Asian financial crisis became apparent. (The crisis began
in mid-1997, and gathered intensity through the second half of
1997 and into 1998.) A range of evidence, including research conducted
at the Bank, suggests that changes in the cash rate have a material
effect on economic growth for, perhaps, two to three years. Most
likely, therefore, the easings in 1996 and 1997 allowed the economy
to sustain more rapid growth in the two years after the onset
of the crisis than would otherwise have been possible.
One would presume that the lower cash rate would also have been
associated with some depreciation of the exchange rate. Over this
period, however, movements in the exchange rate appear to have
been dominated by the unfolding crisis in Asia. One piece of evidence
supporting this view is that the Australian and New Zealand currencies
behaved very similarly in the two years following the onset of
the crisis, despite significant differences in monetary policy
settings in the two countries over that time.
The inflation rate in Australia has been much lower and much steadier
since the Reserve Bank adopted inflation targets. Are the targets
the main reason for the better inflation performance?
The inflation target is one of the reasons for the better performance.
But it is probably not the only reason. After all, inflation in
the second half of the 1990s has been lower and more stable in
almost all OECD countries, regardless of whether they are inflation
targeters or not. How the alternative monetary-policy frameworks
respond when a sizeable inflation shock comes along will be a
much sterner test.
The inflation target should help to improve the stability of the
macroeconomy if it helps focus inflationary expectations in the
community on the target rate. The inflation target also provides
a framework for monetary policy that combines some of the advantages
of monetary-policy rules with some of the advantages of discretion.
Furthermore, it focuses debate within the Reserve Bank on what
policy can and should achieve, arguably leading to more coherent
and consistent policy.
I would argue that the Australian inflation targeting framework
has led to good monetary policy outcomes at three important stages
of the current business cycle: when inflationary pressures were
building in 1994, when they were subsiding in 1996–97, and
during the Asian crisis, when Australia was hit by a significant
external shock.
It is also of interest to note that the Australian inflation target
was introduced after inflation fell to its current low levels,
rather than beforehand as was the case in some other inflation-targeting
countries. The Bank held to the view that the transitional output
costs associated with creating a low-inflation environment would
not have been materially affected had an inflation target been
announced when inflation was still high. The then Governor, Bernie
Fraser, expressed this view in a speech in 1993: 'to my knowledge,
no country has reduced its inflation by incantation'.
In 1996 the Reserve Bank and the Government (1) stated that
'The Government recognises the independence of the Bank' and (2)
described procedures which allow 'the Government to determine
[monetary] policy in the event of a material difference'. How
can the Reserve Bank be independent if the Government determines
policy when there is a big difference in views? Are there any
examples since 1996 where, in fact, the Government determined
policy?
The two quotes in your question are from the Statement on the
Conduct of Monetary Policy, issued jointly by the Australian Government
and the Governor of the Reserve Bank in August 1996. The paragraph
you quote goes on to provide an answer to your question.
'Section 11 of the Reserve Bank Act prescribes procedures for
the resolution of policy differences between the Bank and the
Government. The procedures, in effect, allow the Government to
determine policy in the event of a material difference; but the
procedures are politically demanding and their nature reinforces
the Bank's independence.' In fact the procedures are so politically
demanding that they have never been used.
At a general level, it is worth making the point that governments
retain ultimate authority for monetary policy under most conceivable
institutional arrangements in all countries. In countries with
independent central banks, this independence is usually defined
by an Act of Parliament. Most Acts contain some type of 'override'
by the government in extreme circumstances. For example, in New
Zealand and the UK, the government can raise or lower the inflation
target. Even if this proviso were not available, the government
of any such country could amend the Act, if it so chose. This
is also the situation in Australia.
The decisions of the Reserve Bank have a big effect on people's
lives. Higher interest rates make it more difficult to buy a home
or a car. Changes in the cash rate also affect the price of stocks
and foreign exchange. It is no wonder that every move you make
is scrutinised in detail by newspapers and television. What is
it like to have such great responsibility and to have your every
move studied in detail by hundreds of journalists and then reported
in newspapers the next day?
Being part of an institution responsible for making important
economic decisions makes my job, and the jobs of those with whom
I work, more interesting and rewarding. To the extent that I can
contribute to a somewhat better understanding of aspects of policy
or the functioning of the economy, that is all for the good. But
I would not want to overstate my contribution. The responsibility
for decisions on interest rates rests, of course, with the Governor
and the Reserve Bank Board.
As an aside, let me quibble with a detail in your question. Australia
is not such a large country that hundreds of journalists study
the Reserve Bank's every move in detail. Tens of journalists,
perhaps!
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