Mr. Macfarlane examines monetary policy developments in Australia during
Text of the Shann Memorial Lecture given by the
the last quarter of the twentieth century
Governor of the Reserve Bank of Australia, Mr. I.J. Macfarlane, in Perth on 15/9/98 (exluding
bibliography).
1. Introduction
It is an honour to be invited here tonight to deliver the Shann Lecture. As is
customary when giving a memorial lecture, I have re-acquainted myself with the writings of the
man whose memory we are honouring. It is noteworthy that for most of his working life he held a
Chair at this University in History and Economics, as opposed to Economic History. This
allowed him to range over a broad area, both as a scholar and as a polemicist.
His scholarly reputation rests mainly on his economic histories, and I am pleased
to record that he also wrote a fine piece on monetary policy in 1933 called "National Control of
Banking".1 His best known work, "The Boom of 1890 - and Now", was not much more than a
pamphlet, but was extremely important in establishing his reputation among the wider public.
Written in 1927, it was an account of a period about 40 years earlier - a period that was recent
enough to matter, but too long ago to have figured in people's working lives. I see a lot of value
in this type of work, and have even tried my hand at a similar piece myself.
Tonight, I would like to move to a more recent era and to a narrower topic, by
examining the development of monetary policy over the last quarter of the twentieth century. In
doing so, I intend to cover not only the institutional changes, but, where relevant, the intellectual
cross-currents and the political influences that were at work. It may seem strange to give a
prominent role to political influences, because the end point we have now reached in our
monetary policy framework in Australia is not dissimilar to that of a number of countries that
have had very different political developments. But even though the end points are similar, the
sequence of events in the Australian development has been unique, and political influences have
played a role in that sequence.
2. The starting point in the mid-1970s
Around the world, the mid-1970s was a very unhappy period for
macroeconomics - to find a worse period in terms of economic mismanagement, we would have to go
back to the 1930s. In the 1930s a severe deflation was let loose on the world economy, while in
the 1970s it was a severe inflation. To make matters worse, even though the inflation of the
1970s was initially tolerated because it was thought to be helpful in pushing unemployment
down to very low levels, it ended up having the perverse effect of yielding a higher level of
unemployment. The word stagflation was coined to describe this period.
The experience of the Australian economy in the mid-1970s reflected these
unfortunate worldwide developments to the full. The underlying rate of inflation reached 20 per
cent by early 1975 and was in double digits again in the early 1980s. Unemployment rose from
1.4 per cent at the start of the decade to 6.5 per cent by 1978. While the unemployment rate rose
further in later decades, it was the 1970s that transformed Australia from a low to a high
unemployment economy.
All macro-economic policies came in for severe and justifiable criticism at this
time, monetary policy being no exception. A similar phase of self-examination occurred in all
OECD countries, and there was intense debate about monetary policy in the economic literature.
In this lecture, I would like to examine how this debate evolved in Australia and how it led to
changes in our monetary institutions, our guiding economic principles, and the responsibility for
decision-making. I intend to concentrate on these three main areas:
• First, changes to the institutional structures which formed the underpinnings of the
money supply process - regulations on banks, methods of government debt
financing and the exchange rate regime. Changes to these features amounted to
fixing up the underlying "engineering" of the monetary system.
• Second, changes to the guiding economic principles which determined whether
monetary policy was on the right course.
• Third, changes to the "governance" of the monetary policy decision-making
process.
From the above description it may still not be completely clear exactly what the
difference is between these three main areas of change. Perhaps it will be a little clearer if I
employ a metaphor. If we were to picture monetary policy as a ship, the first of these changes
was to stop it leaking, the second was to equip it with a more reliable navigation system and the
third was to work out who should be at the helm.
3. Fixing up the underlying "engineering"
I do not wish to spend a lot of time describing how the monetary ship was made
seaworthy because there are already some very good accounts available.2
At our starting point in the mid-1970s, most observers agreed that loose monetary
policy had been a major factor behind the rise in inflation, and that it needed to be tightened.
Unfortunately, there were significant structural deficiencies in the system which meant that no
one could be confident that a tightening could be achieved with any reliability.
The first deficiency was that the system relied heavily on direct controls on banks,
including interest rate ceilings imposed on banks' deposit and lending rates. This meant that,
even if monetary policy was successful in limiting the expansion of bank deposits and lending
(and it was by no means clear that it would be), the tightening of conditions would not extend to
the non-bank financial intermediaries. It was this group - merchant banks, building societies and
finance companies (formerly called hire purchase companies) - which were usually the fastest
growing providers of finance.
The solution to this problem was to remove the interest rate ceilings and allow
banks to compete on equal terms with other providers of finance.3 This meant that if banks were
short of liquidity they could raise interest rates and compete for funds with other intermediaries
who, in turn, would probably have to match them. In this way the tightening of conditions would
be spread across the whole financial sector. Interest rate ceilings on deposits were removed in
December 1980 and on smaller business loans in April 1985. With the removal of the ceiling on
loans for owner-occupied housing in April 1986, the last of the interest rate ceilings was gone.
The second deficiency in the system was that there was no mechanism in place to
ensure that the budget deficit was financed entirely by borrowing from the public. Any shortfall
in borrowing from the public was automatically met by the Government borrowing from the
Reserve Bank, a method of financing which is colloquially known as "printing money" or
"monetising the deficit". In order to stop these unintentional monetary injections into the system,
the Government needed to move from its existing system, where it set interest rates on
government bonds and issued only the amount of bonds that the market wanted to buy (the "Tap
System"), to a new system where it sold the amount needed to finance the deficit at whatever
interest rate the market demanded (the "Tender System"). This move occurred in 1979 for
Treasury notes and in 1982 for government bonds.4
Finally, the fixed, quasi-fixed or occasionally changed exchange rate regimes that
Australia had used over the post-war period introduced another element of unintended monetary
injections or withdrawals into the system. Under all these systems, the Reserve Bank had to clear
the foreign exchange market at the end of each day. If there were more buyers of Australian
dollars than sellers, this effectively represented an injection into the Australian money supply.
This meant that if monetary policy was tightened in Australia with a view to slowing the growth
of the money supply, its effects could be offset through the foreign exchanges. This is because
the tightening of monetary policy would raise Australian interest rates relative to other countries,
and attract money into Australian dollars. In the first instance, this could be offset by Reserve
Bank open market operations, but in the long run it could be self-defeating. This problem was
overcome with the floating of the Australian dollar in December 1983.
These three changes were effectively completed by the mid-1980s. Even though
one of them - the float of the currency - was a massive change to Australia's economic structure,5
the three changes were seen by economists as largely technical in nature, and there was little
dissent in the economic community. Also, there was no political polarisation with one party
supporting and the other party resisting the change. The Campbell Committee, which reported in
September 1981, had been an important influence in establishing a consensus for change. This
Committee had been set up by a Coalition Government, but most of its recommendations were
implemented by a Labor Government.
4. A better guiding principle
The move to greater exchange rate flexibility, which, as explained above, had
begun well before the float, meant that monetary policy needed a new guiding principle (or a new
navigation system, to quote the metaphor used earlier in this Lecture). Instead of having an
external guide (the fixed exchange rate), a satisfactory internal guide had to be found. This
process, beginning in the mid-1970s, took Australian monetary policy from a system based on
pure discretion, to monetary targeting, and ultimately to the present system of inflation targeting.
The changes were not always smooth and there were some important gaps along the way which
have never been satisfactorily explained. I would like to retrace some of this ground tonight. In
doing so, I hope to skip lightly over the periods that have been covered fully before and
concentrate on those that have been neglected.
From 1945 to 1971 the Australian dollar was pegged against the US dollar, and
this effectively formed the centrepiece of Australian monetary policy. If our economic conditions
got too far out of line with those in the United States it would imperil the exchange rate, and so
fiscal and monetary policy would have to change in order to prevent it. It is a simple system, and
one that still finds favour in a number of quarters around the world. The best known current
example of this system is the Exchange Rate Mechanism of the European Monetary System,
which is scheduled soon to go a step further into monetary union with a single currency (the
euro) and a single central bank - the European Central Bank.
Our link with the US dollar was broken in 1971, and thereafter the discipline
exerted by a fixed exchange rate dissipated; once the link was broken the first time, it was no
longer "sacred" and could be broken again. Although we retained a pegged exchange rate system
in one form or another until 1983, parity adjustments became increasingly frequent. We were
effectively on our own with no clearly enunciated guiding principle behind our monetary policy
until monetary targeting was introduced in 1976. This period of four-and-a-half years could
therefore be regarded as one where unconstrained discretion was the underlying basis of
monetary policy.6 Since it was also the period when inflation accelerated most quickly and
reached its highest level, it confirmed the general suspicion among monetary economists that
something more than pure discretion was needed. Some guiding principle, or rule, that limited
the capacity for discretion in monetary policy was essential to keep it from falling under the
influence of expediency or succumbing to populist pressures for an excessively expansionary
stance.
(a) The period of monetary targeting
By January 1976 that guiding principle was found when Australia fell into line
with a large number of other industrialised countries by introducing a monetary target. This
move, which coincided with the election of the Fraser Government, had strong support from the
Reserve Bank and the Treasury. Within the Bank, the Research Department had been heavily
influenced by academic monetarism, as evidenced by much of their research output in that period
and the choice of visiting overseas scholars.7 At the top of the Bank, the Governor and Deputy
Governor were supportive of the new regime, but retained a degree of scepticism and a
recognition of the need for some flexibility.8
The Australian system of monetary targeting was based around an annual target
for M3, which was not unusual by world standards. What was unusual was that it was set by the
Treasurer on the joint advice of Treasury and the Bank. Another unusual feature was that the
Bank always preferred to use the term "conditional projection" rather than target. Its success, as
measured by how often it was met, or by the size of over-runs, was not very different to
experience elsewhere.9 This degree of success was somewhat surprising considering that for
most of the period over which it operated the underlying monetary "ship" contained all the leaks
and distortions referred to in the previous section.
The era of monetary targeting lasted for nearly nine years (from April 1976 to
January 1985), which roughly coincided with the period which Goodhart describes as "the high
water mark of international monetarism".10 I do not propose to examine its strengths and
weaknesses at any length because I have done so elsewhere, as have others.11 Suffice to say that
it did bring some order to Australian monetary policy and was a big improvement on its
predecessor. Nevertheless, it had only limited success in its central task of reducing inflation, and
as time went on its inherent weaknesses began to show. The logic of monetary targeting
presupposes a stable statistical relationship - the demand for money - which implies that inflation
is ultimately linked to the rate of growth of the money supply. This relationship, as in other
countries, was never very precise over short periods, but that could be tolerated if it retained its
long-run stability qualities. In time, particularly as a result of financial deregulation, the long-run
relationship started to become unstable. At some point, M3 targeting had to be abandoned.
(b) The replacement for monetary targeting
In the event, monetary targeting was discontinued in January 1985. The immediate
reason for it was the extent of overshooting that was occurring during 1984, which seemed to
indicate the effects of financial deregulation rather than a major rise in incipient inflation. Also
of importance was the fact that Treasurer Keating had made no secret of his lack of enthusiasm
for this approach to monetary policy.12 Even so, the decision to discontinue targeting was seen by
some as precipitate, and many in financial markets were unprepared for the change. The Bank
was criticised for not having produced a convincing body of work containing the evidence for the
change in policy regime. Some of this criticism was justified, but to prove the breakdown in a
long-run relationship always takes a long time.13
To allay the fears of those in financial markets who thought that the end of
monetary targeting meant a return to unconstrained discretion, the Bank looked for an alternative
framework which it could use as the basis for its monetary policy. As a result, the so-called
"checklist" was born. Its birth was announced in May 1985 by one of my predecessors, and its
most detailed exposition was given in his 1987 Shann Lecture.14 In the event, it proved to have a
short life and there was little further mention of it after that time. The checklist contained a
number of economic variables that were to be taken into account in setting monetary policy. Up
to a point, it was useful in conveying the sensible idea that monetary policy needed to look at a
wide range of indicators, not just one. Its problem was that it did not have a sufficiently
well-thought-out economic rationale or any criteria for determining which indicators were more
important. In particular, it failed to distinguish between the instrument of monetary policy,
intermediate targets and ultimate targets (an essential framework that is to be discussed in the
next section). They were all in there, along with at least one variable that did not fit into any of
these categories.
The checklist was introduced in haste - barely four months after the end of
monetary targeting. It had not undergone close economic analysis within the Bank, and had not
been exposed to prior public scrutiny through research papers. In defence, it has to be said that
the circumstances of the time were very turbulent; in 1985, the currency was plunging, bond
yields were rising and there was a loss of confidence in Australian macro-economic policy and
serious doubts about the sustainability of our external position. There was a feeling something
had to be done. Nevertheless, an important lesson was learnt from the episode - no central bank
should commit itself to a new monetary policy regime until it has researched the subject
thoroughly and established its credibility with reference to the economic literature and overseas
practice.
(c) A new period of discretion? The Reserve Bank and its critics 1988-1993
With the short-lived "checklist" period over, the Bank entered 1988 with no
articulated framework for monetary policy, but a determination not to introduce a new one in
haste. At first, there was little pressure from the markets, the press or the economic community to
deliver a new framework because by 1988 the currency woes of 1985 and 1986 seemed well
behind us. But that mood soon changed as critics began to focus on the fact that Australian
inflation had not returned to relatively low rates as it had in most OECD countries. It is this
period of intense criticism - roughly from 1989 to 1993 - that I would like to cover in some
detail. I trust I can do this safely now because we are far enough past this period for it to have
lost its political sensitivity, but close enough to still remember the details.
The main charge of the critics was that Australia was still an inflation-prone
economy, and that its central bank was never going to be able to improve the situation while-ever
it relied on unconstrained discretion as the basis of its monetary policy.15 The critics also
attacked the Reserve Bank for a lack of independence. Other high inflation countries such as the
United Kingdom (which was opting for membership of the European Monetary System) and
New Zealand and Canada (which were opting for inflation targeting) were doing something
about "stiffening up" their monetary policy frameworks, but Australia appeared to be doing
nothing. To make matters worse, in the eyes of the critics, the newly appointed Governor
Bernie Fraser - was known to be a close associate of Treasurer Keating, and they therefore
assumed his appointment would result in a reduction in the Bank's independence, already
perceived as being too little. This was another subject where they also had some suggestions, but
I will save the discussion of central bank independence until the next section. For most of the
critics, there was no alternative but radical reform of the legislation to create a new type of
central bank subject to some form of binding monetary rule.
Many of the critics were also influenced by academic thinking which held that
discretionary monetary policy would inevitably fail. Discretion was held to be destabilising, and
to have an inevitable inflationary bias which could only be corrected by the imposition of a rule
on the central bank. These conclusions, deriving mainly from the writings of Friedman and other
members of the monetarist school, received empirical support from the events of the 1970s and
1980s.16 This debate is usually called the "rules versus discretion" debate, and those supporting a
rule generally got the better of the argument. They were reinforced by the newer sophisticated
writings of the rational expectations school, and in particular by its introduction of the concept of
"time inconsistency", which purported to show that there was a technical reason why only a rule
could contain inflation.17
While there was a degree of agreement among the Australian critics about what
was wrong with Australian monetary policy, there was less agreement about what rule should
replace the existing system. The critics proposed a wide range of alternative models, including a
currency board, monetary base targeting, a return to targeting broader monetary aggregates,
various forms of commodity standards, and a combination of inflation targeting and central bank
independence.18
Within the Reserve Bank there was some sympathy for an important part of the
critics' case; it was conceded that monetary policy based entirely on discretion was intellectually
and practically unsatisfactory, and it had been associated with high inflation in country after
country. We also agreed that something better was needed, but most of the concrete proposals
could be dismissed as impractical. There were no practical working models of strict monetary
base control or commodity standards, and monetary targeting and fixed exchange rates had
already been rejected as unsatisfactory for Australia.
The difficulty arose with respect to the inflation targeting proposals. There was
recognition within the Bank that this was the most promising approach, but political
circumstances contrived to make our participation in the debate marginal at best. This was
because from about late 1989 onwards the most vocal proponent of the view was John Hewson,
first as shadow Treasurer, then as the Leader of the Opposition. This had the effect of forcing the
Government into defending its record on monetary policy and hence the existing institutions and
approach. It was a great disappointment for the Bank that this debate was politicised19 before the
economics profession had time to explore it fully in an objective non-partisan way. But it would
be unfair to criticise either of the two political protagonists for this - there is nothing wrong with
them being quicker off the mark than the economics profession.
The Bank had long agreed with its critics that Australia's high inflation rate was
an obstacle to sustained economic development and that monetary policy would have to play the
16
Friedman (1968), Brunner (1980) and Poole (1980) are good examples of this literature.
17
See Kydland and Prescott (1977) and Barro and Gordon (1983).
18
Hartley and Porter (1991) proposed either a monetary base control regime or a currency board. Hanke,
Porter and Schuler (1992) favoured a currency board. McTaggart and Rogers (1990), Sieper and Wells (1991)
and Makin (1993) supported monetary base targeting, while Weber (1994) supported targeting M1.
Commodity standards were proposed by White (1989), Dowd (1990) and Evans (1994).
19
I have reviewed the files in our Press Office for this period, and am still surprised at the huge amount
of material they contain. Although only the most important pieces have been kept, the Hewson
versus Keating controversy over the Reserve Bank is detailed in literally hundreds of press cuttings,
excerpts from Hansard, competing press releases and media interviews. The files confirm that
Dr Hewson initially criticised the Bank in late 1989 for being too close to the Government and called
for greater independence and more emphasis on medium-term anti-inflationary policy. This general
critique was made more concrete in mid 1991 when he proposed legislative changes to ensure
independence and the single objective of inflation, plus the introduction of an inflation target of 0 to
2 per cent. It was this proposal that became part of the "Fightback" package in late 1991 which
formed the basis of the Opposition's 1993 electoral platform.
major role in remedying the situation. During 1988 and 1989, the Bank's research efforts were
taking it towards a model that had a lot of similarities to those which underlay the New Zealand
or Canadian style inflation targeting.20 Our research had taken us down a path that led to the
same general framework as those models, (and of the model of inflation targeting we eventually
adopted in 1993). It is summed up in the schematic framework below:
Table 1: Schematic Framework for Monetary Policy
Possible Instruments Possible Intermediate Possible Ultimate
Targets Targets
Overnight interest rate* None* Inflation*
or or or
Money base Money supply Nominal GDP*
or or
Exchange rate (Real GDP)
or
(Employment)
or
(Balance of payments)
In August 1989, which was just before the subject had become politically charged,
I was able to summarise our views to an international audience of central bankers as follows: the
cash rate is the instrument of monetary policy,21 there is no intermediate objective,22 and the
ultimate objective has to be a nominal variable such as the rate of inflation or nominal23 GDP
(the asterisked elements in Table 1).
While we accepted some of the arguments of our critics, and we shared a common
framework with the most practical of the alternative models put forward, there were still some
major differences. First, and most importantly, we believed that we could achieve what our
critics wanted - a return to a low inflation environment - without radical overhaul or a complete
rewriting of the Reserve Bank Act. In a sense, we believed that reform from within was possible
and that this would gradually return Australia to being a low inflation country. Secondly, we
believed that the early overseas formulations of the inflation targeting/central bank independence
model were too rigid in several ways:
• There was a tendency to suggest that the single objective of low inflation meant
that central banks should pay no attention at all to other economic variables. We
felt that there are a number of circumstances where, even if primacy is given to
maintaining low inflation, the effects on output and employment had to be taken
20
Some of this was presented in a conference held by the Reserve Bank in June 1989; see Macfarlane
and Stevens (1989) and Edey (1989). See also Grenville (1989).
21
"For all intents and purposes, the cash rate is our instrument." Macfarlane (1989).
22
"No-one can dispute the need for an instrument, or for the ultimate aim of monetary policy to be
made clear. The one part of the trilogy that is not self-evident is the need for an intermediate
objective. It is the part we have come to doubt, and ultimately to discard." ibid.
23
"We have no desire to dispute the widely-held proposition that the ultimate objective of monetary
policy should be a nominal variable such as the rate of inflation or the rate of growth of nominal
income. A system which operates directly from instrument to ultimate objective still has to contend
with the fact that there is a long interval between the movement in the instrument and the resulting
change in the ultimate objective. For this reason, actual inflation is not a good guide for monetary
policy; leading indicators of inflation are much more useful." ibid.
into account and had to influence monetary policy actions. The best central banks
overseas, moreover, clearly behaved in this fashion.
• There was a tendency for proponents to understate the output and employment
costs of the initial reduction in inflation. This was because they relied on the
conclusion from the rational expectations school that credible disinflations would
be relatively costless.
We were worried that if central banks were to be judged only by inflation results,
•
there would be a tendency to over-achieve, i.e. they would be very reluctant to
allow inflation to rise, even if only slightly and for short periods, but would
readily accept circumstances that pushed the economy in the deflationary
direction.
• Because New Zealand and Canada had chosen 0-2 per cent as their target, that had
become the numerical norm in discussions of inflation targeting. We regarded this
as probably too low, and certainly too narrow a range.24 No country had achieved
this sort of inflation performance over any significant time interval in the past 50
years. We did not like the concept of a "hard-edged band", particularly the early
formulations which suggested some decisive action occurring whenever the band
was breached.25
During the early 1990s, particularly between the 1990 and 1993 elections, the
Bank had to keep a pretty low profile in the debate because of the political constraint alluded to
earlier. Governor Fraser made a number of speeches which defended the Bank and its monetary
policy. In some of these he also questioned the more extreme versions of inflation as the single
objective, and disputed the view that central bank independence meant that there should be an
adversarial relationship between the central bank and the Government.
During this period, the lack of a monetary policy framework that could command
widespread support had its costs. It meant that each of the monetary policy easings of 1990 and
1991 were met by the charge that they were only done for political reasons (lowering interest
rates was presumed to make the Government more popular). There was clearly great distrust of
monetary policy, the Government and the Reserve Bank - or, in modern parlance, a lack of
credibility.
It is interesting that virtually all of the serious criticism of the Bank in this period
was coming from the perspective that it was too soft on inflation.26 Hence the proposals for
reform were all aimed, in one way or another, at eliminating the supposed inflationist tendencies.
Yet, while all the debate was going on, inflation was actually falling to its lowest level for a
generation. In some senses, it was this that ultimately proved decisive in confirming that it was
possible to return to a low inflation environment without radical change to the Reserve Bank or
its Act. It was this economic development that ultimately ended the debate in our favour.
Having said that, I do not want to suggest that we foresaw the whole development
and were always confident of the result. We, like our counterparts in other countries, were
surprised by how far and how quickly inflation came down at the beginning of the 1990s. We
also did not forecast the depth of the 1990/91 recession. But once inflation had come down, we
felt that there was a high likelihood that it would stay low during the subsequent phase of
economic growth. We also felt that an inflation target would help to bring about that result.
(d) The introduction of inflation targeting
As I have already suggested, much of the intellectual groundwork for the
development of our inflation target had been laid well before its introduction. The crucial step
required to turn this into reality was the adoption of a published numerical target. For reasons
already alluded to, it was some time before this step was taken. Not only was the issue highly
politicised, but there was a strong presumption (by both the critics and proponents of inflation
targeting) that an inflation target had to be "0-2", which the Bank felt would have been too
restrictive. Although we had a general aim of getting inflation down, we did not follow the New
Zealand or Canadian sequence of announcing, in advance, a planned reduction to a particular
range over a specific time period. As it turned out, that sequence was reversed in our case
inflation was reduced, and a commitment to keep it low as then put in place.
The process of establishing that commitment in the public arena was itself a
gradual one. Governor Fraser in 1993 referred in two speeches to the objective of keeping
inflation around 2 to 3 per cent27. The initial flavour of these remarks was that inflation had
reached a trough in the early-1990s recession, and that the Bank wished to ensure that it did not
rise appreciably during the recovery. This commitment was expressed increasingly firmly with
time.
In developing our inflation target, the Bank was encouraged by the examples of
other countries such as the United Kingdom and Sweden, which adopted inflation targets in 1992
and 1993. These showed that alternative, less rigid inflation targeting models could gain
acceptance. Both countries specified targets higher than the original "0-2" model.28 Our own
choice of a 2-3 per cent figure was based partly on pragmatic considerations.29 Inflation had
declined to a trough of 2 per cent, and the main priority was to stop it rising too much from there.
There was also a respectable body of academic opinion to suggest that it was optimal to aim for
something in the low positive range rather than too close to zero.30
Th