Mr. Macfarlane draws some conclusions about the direction in which monetary
Talk given by the Governor of the Reserve Bank of Australia,
policy regimes are likely to evolve
Mr. I.J. Macfarlane, to the 26th Conference of Economists in Hobart on 29/9/97.
Introduction
It is a pleasure to be speaking at this year's Conference of Economists on a subject
which has been central to my own career. I thought of calling the speech "Monetary Regimes I Have
Known", but that would have given too historical an emphasis. While history is extremely important,
and provides a useful antidote to excessively abstract thinking, more is needed to satisfy the
Conference theme of "policy challenges of the new century". I have therefore attempted to respond in
a forward-looking way, by drawing some conclusions about the direction in which monetary policy
regimes are likely to evolve.
Historical overview
In broad outline, Australia's post-war monetary policy experience has much in
common with that of other countries in the developed world. Certainly the starting point -- a fixed
exchange rate under the Bretton Woods system -- was the same, and several of the subsequent phases
have been common to a significant number of countries. We can usefully divide the post-war
monetary policy experience in Australia into four main parts:
the fixed exchange rate period, which lasted until the early 1970s;
a period of monetary targeting between 1976 and 1985;
a transitional period which followed the demise of monetary targeting and lasted until
the early 1990s; and
the inflation-targeting regime, in place since around 1993.
While every country has its own particular story to tell, something similar to this
four-part schema, with suitable adjustments as to timing, could probably be applied to quite a wide
range of other countries over the same period. In making this classification of policy regimes, it is
wise to avoid being overly precise about dates. Sometimes regime shifts are quite dramatic and can
be precisely dated -- for example, the ending of US dollar convertibility into gold, and the United
Kingdom's exit from the European exchange rate mechanism -- but this is not invariably the case. In
Australia, the movement between regimes has tended to be evolutionary, and it is not always possible
or helpful to date them precisely.
How did these four regimes perform, and what were the critical factors that led to the
move from each regime to its successor? To answer these questions we need to have in mind some
criteria against which the performance of a monetary policy regime can be assessed. Most
practitioners and theorists would, I think, agree on two desirable characteristics of a monetary policy
regime. First, policy needs to provide a nominal anchor for the economy: the policy regime must have
the characteristic that it systematically resists excessive inflation or deflation, and thereby delivers a
satisfactory degree of price stability in the long run. The second objective is to provide a degree of
stabilisation in the short to medium term in response to shocks, which includes resisting adverse
shocks to output and employment. This objective might be met either through the capacity of a
regime to undertake deliberate policy responses when shocks occur, or through automatic stabilisers
inherent in the regime.
The fixed exchange rate period
The longest lasting of the four regimes, by a large margin, was the fixed exchange
rate, also known as the Bretton Woods system, or the gold exchange standard. At the start of the
post-war period, the Australian currency had already been fixed to sterling at an unchanged rate since
1931. Subsequently, there were only two major changes to Australia's international parities until the
1970s: the first, in 1949, when Australia followed a sterling devaluation against gold and the US
dollar, and the second, in 1967, when sterling was further devalued, but Australia did not follow.
Thus, Australia's exchange rate against sterling remained unchanged from 1931 to 1967, while the
rate against the US dollar -- which is more important for current purposes -- was unchanged from
1949 to 1971. As was the case for most other countries, the Bretton Woods system of "fixed but
adjustable" exchange rates was operated in practice in Australia in the 1950s and 1960s as a firm
commitment to fixed parities. The fixed exchange rate was effectively the linchpin of the monetary
policy regime.
While it is not possible to pinpoint an exact date at which this ceased to be the case,
parity adjustments became much more frequent after the next Australian dollar realignment occurred
in 1971. Rather than being the anchor of policy, the exchange rate henceforward was increasingly
viewed as an adjustable policy instrument. There were six parity changes in the years from 1971 to
the adoption of the crawling peg system in November 1976; and this more flexible system, in turn,
gave way to the float in December 1983. The history can thus be characterised as involving
essentially fixed parities up until 1971, followed by a gradual transition to greater flexibility and a
stronger internal policy focus in the years that followed.
An important characteristic of a fixed exchange rate system, of course, is that it
provides a nominal anchor, as long as the monetary policy of the country to which the exchange rate
is fixed is itself conducted in a way that is consistent with reasonable price stability. This was indeed
the case for most of the period up to around 1970. Under the Bretton Woods or gold exchange
standard, most currencies were pegged to the US dollar, whose value was in turn tied to gold. The
central role of the US dollar in the system placed a strong discipline on the macro-economic policies
of other countries. Unless countries were prepared to make significant unilateral exchange rate
adjustments, which happened only rarely, their inflation performances in the longer run were
effectively determined by US monetary policy.
Private Consumption Deflator
Four-quarter-ended percentage change
% OPEC I %
(Oct-73)
15 15
10 10
Australia
5 5
United States
0 0
-5 -5
1960 1962 1964 1966 1968 1970 1972 1974 1976
As I have argued elsewhere, this system worked reasonably well until the second half
of the 1960s. The United States for the most part conducted conservative monetary and fiscal policies
that kept budgets close to balance and inflation low, and this underpinned a period of sustained low
inflation in other countries. In Australia, apart from some periods influenced by sharp commodity
price movements, inflation was generally low and close to US rates.
This situation began to change from around the mid 1960s. Tax cuts in the 1964 and
1965 budgets, and subsequent increases in defence spending associated with the Vietnam War,
shifted US fiscal policy to an expansionary position. Inflation began to increase, albeit from very low
levels, after about 1965, and balance of payments deficits run by the United States meant that a
number of other countries began accumulating substantial dollar reserves. This fed the process of
money creation in these countries and relaxed the constraints on their domestic macro-economic
policies, with the result in many cases that inflation rates increased. Causes of the eventual
breakdown of the Bretton Woods system in the face of these pressures have been much debated, but
the core of most explanations is that the system lost its capacity to provide effective policy discipline.
This, in turn, reflected the loss of suitability of the US dollar as the system's nominal anchor, the role
it had played so effectively over the two previous decades.
It is interesting to note that the policy debate in Australia in the 1950s and 1960s paid
little or no explicit attention to the nominal anchoring role of the monetary regime. That is not
because the problem of inflation was thought to be unimportant -- on the contrary, the need to control
inflation was well recognised. Nonetheless the main focus, both of practitioners and of the economics
profession more widely, was on the second of the two roles of monetary policy that I outlined earlier,
namely its role in responding to shorter-term shocks. In fact, many commentators talked of monetary
policy as though it was totally discretionary and free to pursue whatever domestic objective it thought
most worthy (see next section on Phillips curve).
Perhaps the most important reason for this misapprehension was that the existence of
the long-run anchor was simply taken for granted. Policy did not need to focus on achieving a good
longer-run inflation performance because the fixed exchange rate regime delivered this result in a
semi-automatic fashion. In this environment it was natural to focus on shorter-term objectives, with
the balance of payments serving as an important barometer of the need for policy action: whenever
domestic demand was too strong, this would quickly show up in a payments deficit which needed to
be corrected by tighter policy, and vice versa. In this way, the policy regime ensured that actions
taken in response to short-term demand pressures had the effect of consistently tying the economy in
to the long-run anchor.
The eventual failure of the fixed exchange rate system to ensure continued good
macro-economic performance reflected a combination of circumstances. The expansionary shift in
US policy, to which I have already referred, meant that the external anchor became increasingly a
source of inflationary pressure rather than of price stability. This was the case not just for Australia,
but worldwide. In Australia's case, however, the effect was amplified in the early 1970s by the
related phenomenon of rising commodity prices, which had a disproportionate effect on Australia,
given our high commodity export exposure. The effect was to relax the balance of payments
constraint and allow a further loosening of domestic policy discipline, with the result that the rise in
Australia's inflation rate soon overtook that in the United States. The role of the 1973 oil shock in all
of this was also important, but it should be remembered that inflation in Australia had already
reached double-digit rates before the oil shock occurred.
The rise and fall of the Phillips curve
The early to mid 1970s was a period of re-evaluation of the earlier conventional
thinking about monetary policy, prompted by the experience of a number of years of rising inflation.
It is interesting to focus on the nature of that re-evaluation because it remains relevant to policy
today.
In the 1960s, the conventional thinking was summed up in the widely-influential
notion of a stable downward-sloping Phillips curve. Inflation was thought of in terms of
demand-driven processes that would move the economy along the curve, so that high levels of
demand would produce a combination of high inflation and low unemployment, and low levels of
demand the reverse. The role of policy was to manage aggregate demand so as to achieve a preferred
combination of outcomes, taking the position of the Phillips curve as given.
Of course, not all economists subscribed to this simplistic world view, but I think it is
a fair representation of the consensus among those economists who were most influential and among
a broad range of other policy makers, politicians and journalists. There was considerable confidence
for a time that policy could effectively manage the trade-off. Policy before about 1970 had been quite
successful: periods of clearly excessive inflation had been rare, and were quickly reversed when they
occurred. But there developed a general tendency among policy-makers in the late 1960s and early
1970s to try to exploit the trade-off to extract more growth, in the belief that the cost in terms of
inflation would not be too great.
The experience of the 1970s -- the simultaneous rise in inflation and unemployment,
and their persistence at high levels -- proved this understanding of the economy to be too simplistic
and an inadequate guide for policy. To a mindset based on the stable Phillips curve, the combination
of high inflation and high unemployment could not be readily explained. Indeed, it appeared
internally contradictory, since inflation was thought of as a symptom of excess demand while high
unemployment signalled that demand was deficient.
Two factors needed to be brought into the conventional model in order to understand
the 1970s experience. The first, which had been emphasised both by Friedman and by Phelps, was
the role of expectations. The short-run Phillips curve was to be thought of not as a permanent
trade-off, but as conditional on the expected rate of inflation. Expansionary demand conditions were
associated with higher-than-expected inflation, rather than high inflation per se, so the trade-off of
higher inflation for lower unemployment could only be exploited over the limited period in which
inflation expectations did not fully adjust to the new higher rate. In the longer run, when expectations
had adjusted, high inflation would have no stimulatory impact. In Friedman's words, "a rising rate of
inflation may reduce unemployment, a high rate will not". The operation of this principle had not
previously been observable because inflation had never stayed high for long enough to be built into
expectations.
The second, and related, factor to be brought into the conventional model was the
importance of supply shocks. These could be thought of as shocks which reduced the sustainable
levels of output and employment consistent with steady inflation. For much of the world the
quintessential supply shocks were rises in oil prices but, for Australia, the real wages shock of 1974
was probably at least as important. Recognition of the importance of supply shocks implied a
corresponding recognition of the limitations on what could be achieved through conventional
demand-management policies.
Although economic thinking has advanced in a number of ways since the 1970s, these
two basic lessons from the period remain relevant, and often need repeating. While the economics
profession was quick to take up the stable Phillips curve, it was also quick in dropping it as a policy
prescription. But there are still some in the policy debate -- particularly among politicians, lobbyists
and journalists -- who think of the economy in terms of a stable Phillips curve, and who would like us
to choose a higher inflation rate on the assumption that this would produce a sustained lift in growth
and employment. But that is not the choice we face. Higher inflation can deliver at best only a
temporary stimulus to growth and, in the longer run, is more likely to be detrimental.
The move to monetary targeting
In the light of the early 1970s experience, economists stopped assuming a stable
Phillips curve and started looking for ways to anchor monetary policy decisions. The Friedman
suggestion of a steady growth of the money supply sufficient to accommodate normal economic
growth and low inflation found favour in a number of countries. Several had been focusing on
monetary aggregates since the early 1970s and, by 1975, a number, including the United States,
Germany, the United Kingdom and Switzerland were announcing monetary targets. Australia
followed suit in 1976 by beginning to announce forecasts for the growth of M3. These were
subsequently announced each year in the federal budget until the practice was discontinued in 1985.
The nature of the targets was somewhat different to what is often assumed in the
textbooks or in the somewhat idealised notions of monetary theorists. In no country were targets
adhered to with the sort of mechanical precision envisaged in Friedman's Program for Monetary
Stability, the classic statement of the case for monetary targeting. They were usually seen as guides to
policy, and as vehicles for explaining the rationale of policy actions, rather than being binding
constraints on the policy-maker.
Monetary targeting regimes had a moderate degree of success in achieving their
intermediate monetary objectives, and somewhat greater success in terms of the ultimate objective of
reducing inflation. In the heyday of monetary targeting around the world, roughly from 1975 to 1985,
some substantial reductions in inflation were achieved. Australia's inflation rate was reduced during
this period, but was still a lot higher than the OECD average by the mid 1980s.
It would be a mistake to attribute the differences in inflation performance across
countries primarily to differing degrees of rigour in the pursuit of monetary targets. The countries that
brought inflation under control most quickly were not particularly more successful in hitting their
monetary targets than the rest. The general pattern, summarised in Table 1, was that countries
achieved their targets about half the time. Australia's success rate was a bit less than that, about a
third. On another measure -- the average deviation from the target midpoint -- Australia's record was
quite similar to that of several other countries.
Table 1: Monetary Targets and Projections
Average absolute Proportion of years
Country Period deviation from within target range (%)
target mid-point
Australia 1977-1985 2.6 33.3
Canada 1976-1982 1.3 71.4
France 1977-1996 2.5 50.0
Germany 1975-1996 1.8 54.5
Italy 1975-1996 2.7 31.8
Switzerland 1975-1996 2.6 47.6
United Kingdom 1976-1996 2.7 52.4
United States M2 1975-1996 1.5 63.6
United States M3 1975-1996 1.8 40.9
Source: Edey (1997)
The achievement of inflation reduction was a product not so much of the technical
merits of monetary targeting as of the general shift in the policy-making consensus towards inflation
control. What was critical was the willingness of the authorities to run policies that put a consistent
downward pressure on inflation over a period of time. But, that said, the targets did serve a useful
purpose. They focused policy on the need to anchor the nominal magnitudes in the economy, and
they helped in communicating the anti-inflation strategy to the public and marshalling public
acceptance of the required policy actions. The Volcker disinflation period in the United States was a
good example of how useful targets could be in this role. Alan Blinder described the monetary target
as a "heat shield" which enabled the Fed to maintain a much tougher disinflationary stance than the
public would normally have found acceptable. As a result the United States was able to make a
definitive transition to low inflation at an early stage.
Monetary targeting was always subject to two well-known problems, both of which
were important in the Australian experience. The first was the problem of controllability. The fact
that targets were often missed was an indication that close control was either not possible, or would
have required undesirable movements in the policy instruments. The second was the instability of the
relationship between money supply and the ultimate objective of policy such as inflation or nominal
GDP. It was this second problem that was decisive in causing most countries to abandon monetary
targeting as the basis of their monetary policies.
By the mid 1980s, the problem of instability was coming to the fore. The relationship
of money to ultimate objectives had always been imprecise, but had been judged to be sufficiently
stable to serve as a useful guide to policy. But the structural changes in the financial system that
followed deregulation were sufficiently large that this was no longer the case. In Australia, in the mid
1980s, the newly deregulated banks were able to win back market share from other institutions, and
the financial system as a whole began to grow more rapidly. To some extent, this was to be expected,
but it meant a lengthy period in which the behaviour of the monetary and financial aggregates
diverged from inflation or nominal income. In 1985, growth of M3 reached 17.5 per cent, at a time
when domestic inflation had been falling.
The problem was not unique to Australia. By the time our targets were suspended in
February 1985, many other countries had downgraded or abandoned them, for much the same
reasons. In the words of Canadian central bank Governor Bouey, "we didn't abandon the monetary
aggregates, they abandoned us".
The transitional period
The move away from monetary targets was followed by a period of transition when
policies became more pragmatic and there was a search for alternative guiding principles. Once
again, Australia's experience was by no means unique. Virtually all countries were downgrading
their monetary targets to one degree or another, and there was no immediately clear direction as to
what should be put in their place. Theory offered little help. Some of the alternatives being put up by
critics either had already proven unsatisfactory for us -- like a return to fixed exchange rates or forms
of monetary targeting -- or were unrealistically radical. Most countries with floating exchange rates
developed a pragmatic approach that, broadly speaking, tried to resist excessive inflation and to have
some stabilising influence on economic activity in response to shorter-term shocks.
Policy in Australia through this transitional period has been criticised for lacking a
clear conceptual framework and allowing too much scope for central bank discretion, and there is
some validity in these criticisms. In Australia, the policy "checklist", which entered the discussion for
a few years following the abandonment of monetary targets, comprised a wide range of variables
which were to be consulted in assessing economic conditions and making policy decisions. The list of
variables included interest rates, the exchange rate, the monetary aggregates, inflation, the external
accounts, asset prices and the general economic outlook -- in short, an amalgam of instruments,
intermediate and final policy objectives, and general macro-economic indicators. The checklist
conveyed the idea -- sensible as far as it goes -- that policy needs to look at all relevant information.
What was missing was some framework for evaluating that information and converting it into an
operational guide for policy.
Another way of expressing this is to say that monetary policy needed a "nominal
anchor". Pure pragmatism was not enough because it could lead to monetary policy aiming to achieve
a desired result for a "real variable", which in the long run would be self-defeating. For example, if
monetary policy was solely designed to achieve a given unemployment rate (as to some extent it was
in the late 1960s/early 1970s in many countries), it would be continually eased whenever the actual
unemployment rate was above the desired rate. But if the desired rate was too ambitious, this would
be a recipe for continued easing and, in time, continuously rising inflation. At the same time, there
would be no guarantee that monetary policy alone would be able to achieve the desired
unemployment rate if structural factors were important. Similarly, indeterminacy would arise if
monetary policy was directed at the current account of the balance of payments, as a lot of discussion
in the late 1980s seemed to suggest. If the current account was too large, should monetary policy be
tightened to reduce domestic demand (and imports), or should it be loosened to lower the exchange
rate and hence increase competitiveness?
These sorts of discussion led policy-makers and academics to again ask the question
about what monetary policy could achieve in the long run. The nearly unanimous answer was that it
could achieve a desired rate of inflation, but could not, of itself, achieve desired outcomes for real
variables like the unemployment rate, the rate of growth, or variables like the balance of payments.
Monetary policy can have an influence for good or bad on real variables, particularly in the short run,
but it was not appropriate to target it at these variables. As a long-run target, what was needed was a
nominal variable like inflation, nominal GDP or the money supply.
With the money demand function recognised as being unstable, and nominal GDP
being too abstract a concept for easy public perception, attention turned to monetary policy regimes
that centred on inflation. Two main alternatives presented themselves:
a system where the instrument of monetary policy was operated to achieve a desired
result for inflation, without the need for an intermediate target; or
a system where the exchange rate was fixed to that of another country which had a
good record of maintaining low inflation.
In short, the two alternatives which satisfied the condition of providing a "nominal
anchor" were inflation targeting or fixing the exchange rate (sometimes called the hard currency
option). Australia went down the first path, while most of Europe (including the United Kingdom for
a time) went down the second path by tying their currencies to the Deutschemark.
Some would argue that this two-way classification of the options is too narrow and
that monetary targeting remains a viable third option, at least for some countries. Germany is often
cited as an example. This view ignores the reality that the Bundesbank has moved a long way away
from strict monetary targeting in recent years, as is evident from the way they move their policy
instrument. There is evidence to suggest that prospective inflationary developments are more likely to
trigger a monetary policy move than is a deviation of money supply from its target.
Inflation targeting
Unlike the experience in some other countries like the United Kingdom or New
Zealand, where inflation targets came into force in dramatic regime shifts, the elements of Australia's
inflation-targeting regime were put in place gradually. There were a number of reasons for this.
While inflation targets had considerable conceptual appeal, the models adopted in the pioneering
countries - New Zealand and Canada - seemed to us excessively rigid with their narrow bands and
low target mid-points. The fact that these were the only working models available at the time tended
to polarise debate, and it took some time for the Bank to develop its own more flexible version. Also
important was the need to build public support, including political support, for a target, and again this
happened gradually rather than in a single, decisive act.
Some of the key elements of the inflation-targeting approach were in place quite early.
The conceptual basis of such an approach, with a focus on inflation as the policy objective, no
intermediate objective, interest rates as the instrument, and a transmission process that works via the
effect of interest rates on private demand, had been analysed in a number of pieces that the Bank
published in 1989, including its conference volume. What we now consider one of the key elements
of the policy framework, the explicit announcements of cash rate changes, with explanations of the
reasons for each change, began in January 1990. Over time, the Bank's published commentaries on
monetary policy and the economy became more detailed and developed a stronger inflation focus.
The numerical objective of 2-3 per cent inflation began appearing in public statements by Governor
Fraser in 1992 and 1993. The cumulative effect of all these developments was to establish an
inflation-targeting regime broadly comparable to those being developed in a number of other
countries around the same time. While there was no individual decisive event, international
comparative tables such as those published by the BIS date the change in Australia from 1993.
A final element was added with the joint statement on the conduct of monetary policy,
made by myself and the Treasurer on my appointment as Governor. The statement gave the
Government's formal endorsement to the independence of the Reserve Bank as contained in its Act
and to the 2-3 per cent target. It also provided for enhanced accountability through semi-annual
statements and parliamentary appearances.
Several other countries adopted inflation targets around the same time as Australia. A
recent survey by the BIS counts seven inflation targeters, making this currently the most numerically
popular regime among medium-sized OECD countries (Table 2). As had been the case with previous
regime changes, the immediate reason for change in many cases was either a breakdown of a
previous regime or dissatisfaction with its performance. In the United Kingdom, Sweden and
Finland, the trigger was the collapse of fixed exchange rate commitments in 1992. New Zealand and
Canada adopted their targets in a deliberate strategy of inflation reduction. Australia was somewhat
different in that there was no crisis that needed to be responded to, and the target was developed to
cement in place an inflation reduction that had already been achieved.
Table 2: Inflation Targets
Country Target adopted Current target
New Zealand March 1990 0-3%
Canada February 1991 1-3%
United Kingdom October 1992 21⁄2%
Sweden January 1993 1-3%
Finland February 1993 2%
Australia 1993 2-3%
Spain Summer 1994 0-3%
Source: BIS 1996 Annual Report, updated to incorporate recent changes to targets in the United
Kingdom and New Zealand
The move to inflation targeting completed a significant conceptual leap from the
regimes that had prevailed in the earlier decades. Instead of a focus on intermediate objectives, like
the exchange rate or the money supply, the operational framework of policy was now built around a
final
objective, inflation. In describing inflation as the final objective in this context, I should make
clear that inflation control is viewed as a means to an end rather than an end in itself. The reason
monetary regimes have been set up to aim for low inflation is that this is the best contribution
monetary policy can make in the longer run to growth in output, employment and living standards.
In principle, this approach re-establishes a clear nominal anchor while avoiding the
main problem of the intermediate-targeting regimes -- namely, that the target variables did not have a
sufficiently stable relationship with the final objectives. The approach also preserves, from the
transitional period that I described earlier, the common-sense notion of using all relevant information:
the difference is that there is now a clear criterion -- the impact on the inflation outlook -- for
assessing what the information means for policy.
Another property of inflation targets, not always well-recognised, is that they provide
scope for counter-cyclical action. This is automatically built into the policy framework if a central
bank takes seriously, as we do, both the upper and lower bounds of the target. When the inflation
forecast is above the target, the framework requires policy to be tightened, as was the case a couple of
years ago, and, when it is below target, policy has to be more expansionary, as at present. In this way
the policy framework incorporates a systematic resistance to cyclical demand pressures. I have
described this previously by saying that the policy aims to allow the economy to grow as fast as
possible, consistent with low inflation, but no faster.
Aside from these operational characteristics, an important dimension of the economic
rationale for inflation targets is their role as a discipline on the policy process. The academic literature
lays great store on this -- particularly in the time inconsistency literature -- although it tends to focus
rather too narrowly on the idea of constraining the policy-makers. The targets are seen as correcting
an inflationary bias that would otherwise arise from the temptation of central bankers to go for
short-term expansion. In this literature, rule-based regimes are said to be superior to discretion
because they allow pre-commitment to non-inflationary policies, and thereby overcome the assumed
short-termism of the policy-makers. Central bankers are very sceptical of this line of analysis because
we do not see ourselves as inherently inflation-prone.
But while I think this particular argument for a rule-based approach somewhat misses
the point, the ability to specify policy in terms of a relatively simple rule does have some important
advantages. In particular, simple rules provide a ready vehicle for accountability and for public
communication: they require policy actions to be explained in terms of a clear target, and they help
central banks to resist calls for excessively expansionary policies. Also important is that, over time, a
simple rule like an inflation target can provide a focal point for inflation expectations by making clear
what the central bank is aiming at.
One of the reasons that inflation targets have pro