The Reserve Bank of Australia’s pandemic response and the New Keynesian trap

The Reserve Bank of Australia (RBA) has been overly wedded to a New Keynesian conception of the monetary policy transmission mechanism, in which the official cash rate is seen as the main instrument for policy implementation and the main measure of the stance of monetary policy. The ‘effective lower bound’ on the official cash rate became an artificial, selfimposed constraint on the RBA’s initial response to the Covid-19 pandemic. By contrast, a monetarist conception of the monetary transmission mechanism would have encouraged more rapid adoption of alternative operating instruments. Reserve Bank of Australia Governor Phillip Lowe characterised the Covid-19 pandemic as the worst shock to the Australian economy in 100 years. Yet the bank’s initial response to the pandemic in March 2020 was limited, seeking to exhaust the possibilities of its pre-pandemic operating instruments. While Australia’s fiscal policy response was in line with that of other advanced economies, its monetary response, measured by the expansion in its balance sheet, lagged that of its G10 peers. Only in November 2020 did the RBA resort to alternative operating instruments to play catch-up with other central banks. In the intervening period, Australia’s fiscal and monetary policy mix saw the Australian dollar outperform its G10 peers—a classic case of open-economy crowding-out. 1 United States Studies Centre, University of Sydney; stephen.kirchner@sydney.edu.au. The author’s newsletter can be found at stephenkirchner.substack.com. AGENDA, VOLUME 28, NUMBER 1, 2021 106 This article will argue that the RBA was overly wedded to a New Keynesian conception of the monetary policy transmission mechanism, in which the official cash rate is seen as the main instrument for policy implementation and the main measure of the stance of monetary policy. The ‘effective lower bound’ on the official cash rate became an artificial, self-imposed constraint on the RBA’s initial pandemic response. In contrast, a monetarist conception of the monetary transmission mechanism would have encouraged more rapid adoption of alternative operating instruments. Before the pandemic, Governor Lowe signalled his reluctance to embrace alternative operating instruments, questioned their effectiveness and hinted vaguely at unwelcome costs associated with easier monetary policy (Lowe, 2019). Both before and during the pandemic, Lowe called on federal and state governments to do more with fiscal and structural policy, implicitly conceding that macroeconomic policy settings were inadequate, even though the RBA itself had scope to do more. The RBA eventually embraced quantitative easing (QE), from November 2020, with an aggressive program of longer-duration outright Commonwealth and semigovernment bond purchases. The RBA conceded that its failure to expand its balance sheet as had other central banks had put upward pressure on the exchange rate. While the RBA has committed to maintaining what it sees as accommodative policy settings until its inflation and full employment objectives are met, this commitment to the duration of accommodation has been allowed to substitute for the more aggressive policy action that would see the RBA meet its objectives more quickly. Extended periods of low interest rates are indicative not of ‘easy’ monetary policy, but of a monetary policy that is too tight. This article concludes with suggestions for improving the performance of Australian monetary policy—in particular, a nominal income-level target informed by a monetarist conception of monetary policy transmission. Pre-pandemic monetary policy and the ‘Lowe gap’ The RBA has failed consistently to meet its inflation target since the end of 2014. While small inflation target misses in any given quarter are unlikely to be consequential, a persistent multiyear miss gives rise to long-run drift in the price level relative to expectations conditioned on the inflation target. The long-run drift in the price level means the expectations for nominal income that inform long-term nominal contracting have been disappointed. THE RESERVE BANK OF AUSTRALIA’S PANDEMIC RESPONSE AND THE NEW KEYNESIAN TRAP 107 The ‘Lowe gap’ is defined as the excess of a ‘trimmed mean’ measure of the (log) CPI over a counterfactual inflation target–consistent path for the period since Lowe became RBA Governor in the third quarter of 2016.2 Note that because the RBA was undershooting the inflation target before then, this starting point understates the long-run drift in the price level due to the RBA’s inflation target misses. In the first quarter of 2020, the Lowe gap was –3.9 per cent. In the period since, it has widened to –4.4 per cent, as of the second quarter 2021. Note that even if the RBA were to return inflation to the target range—something it has pencilled in from the middle of 2023—the price level will be permanently lower relative to a target-consistent counterfactual growth path. This is the sort of permanent nominal shock that flexible price-level targeting—what the US Federal Reserve calls average inflation targeting—seeks to offset. Targeting a forecast for the level of nominal GDP aims to avoid the long-run drift in nominal outcomes that can occur under the RBA’s let-bygones-be-bygones approach to inflation targeting (Kirchner, 2021). At its February 2020 meeting, just before the onset of the pandemic, the RBA Board decided to leave its official cash rate target unchanged at 0.75 per cent. The headline consumer price index inflation rate for the previous quarter was running at 1.8 per cent. Inflation had been below the target on most measures since the end of 2014 and was expected to remain so over the bank’s two-year forecast period. The unemployment rate for December 2019 was 5.1 per cent—virtually unchanged from a year earlier and above the RBA’s estimate of the full employment rate of around 4.5 per cent, having never recovered the lows around 4 per cent seen before the 2008 Global Financial Crisis. The RBA Governor told a parliamentary committee a few days later ‘there is a risk that further cuts in interest rates could encourage further borrowing. If people borrow more, then perhaps down the track we have problems’ (Lowe, 2020a). Lowe’s remarks were typical of numerous statements he made since becoming governor that explicitly traded-off the inflation target and full employment objectives against apprehended financial stability risks (Kirchner, 2018). Monetary policy during the pandemic Within weeks of Governor Lowe’s testimony, the Australian and world economies suffered a massive shock as the Covid-19 virus became a global pandemic. The RBA’s initial response to the pandemic shock was to lower the official cash rate target by 50 basis points in two moves over the course of March 2020, to 0.25 per 2 See Stephen Kirchner (2021). The Widening Lowe Gap. Institutional Economics, 29 July, stephenkirchner. substack.com/p/the-widening-lowe-gap. AGENDA, VOLUME 28, NUMBER 1, 2021 108 cent—a rate it had previously argued was an effective lower bound (ELB) given the floor of the usual 25-basis-point corridor around the cash rate target would then be 0 per cent (Lowe, 2020b). The reduction in the target cash rate was accompanied by a commitment (or forward guidance) not to raise the target ‘until progress is being made’ to restoring full employment and returning inflation to the target. This was little different to the RBA’s previous, pre-pandemic guidance, which was already committed to keeping interest rates ‘low’ for an extended period based on the same criteria. The ‘progress being made’ commitment was ambiguous, although stronger than the guidance usually offered by the bank. Any prospective improvement in the economy could be interpreted as ‘progress’ and see markets pricing in a premature increase in the cash rate, even in the absence of a change in the target rate. The RBA reinforced this commitment by undertaking to intervene in the bond market to keep the three-year bond yield close to 0.25 per cent, compared with a then prevailing market yield of around 0.50 per cent—an approach sometimes dubbed ‘yield curve control’ (YCC) or ‘yield curve targeting’ (YCT). By offering to buy government bonds at an implied target yield, the target effectively became the market yield, although Governor Lowe indicated the intervention was not a strong peg like that normally applied to the cash rate, allowing some flexibility. The aim of the yield curve target was to hold down the front and middle parts of the yield curve that serve as the risk-free benchmark for most retail and wholesale lending rates in Australia. It was complemented by a Term Funding Facility (TFF) designed to ensure banks could borrow at this rate. If the RBA’s commitment to hold the cash rate at 0.25 per cent ‘for some years’ were fully credible then intervention on the three-year bond would be unnecessary, and that mostly proved to be the case. After some initial outright bond purchases, the RBA did not intervene in the secondary bond market between early May and early August 2020, when threeyear yields rose modestly, triggering renewed intervention. Governor Lowe explicitly nominated three years as the likely time frame for keeping the cash rate at 0.25 per cent, reinforcing the loose peg on the three-year bond. Longer-term interest rates were still largely market-determined, although the RBA intervened heavily in the bond market in March 2020 to maintain liquidity amid a global bond market sell-off as investors sought to raise cash. The RBA’s preference for YCC reflected its aversion to both negative interest rates and major balance sheet expansion via large-scale asset purchases—the two main policy instruments that could have been employed in addition to forward guidance and instead of a yield target. Governor Lowe all but ruled out both options in a speech in November 2019 (Lowe, 2019), saying both options were very unlikely, raising the reputational c