Glenn Stevens: The conduct of monetary policy in crisis and recovery
Address by Mr Glenn Stevens, Governor of the Reserve Bank of Australia, to The John
Curtin Institute of Public Policy and the Financial Services Institute of Australasia Public
Policy Breakfast Forum, Perth, 15 October 2009.
* * *
With economic prospects improving, people's thoughts naturally turn to the question "what
next for monetary policy?" Financial markets were the first to ask this question. Virtually as
soon as the cash rate stopped falling, the pundits started to speculate about the timing of the
first increase.
Initially, this change in market tone seemed a little premature. But it is now a year since the
dramatic financial events of September and October 2008 dictated a sharp change of course
for monetary policy. The question of how monetary policy will be conducted during the next
phase is therefore a reasonable one. It is understandable if it is also a rather prominent one,
following last week's decision by the Board to lift the cash rate by one quarter of 1 per cent.
The Bank has already conveyed a good deal of its general thinking, through its regular
statements after each Board meeting, the subsequent minutes, other written material and
remarks I have offered previously. Nonetheless, this is an appropriate juncture at which to try
to bring all this together.
So this morning, I intend to elaborate a little about the sorts of issues that have been
important for the conduct of policy in the past year and those that look like they will be
relevant in the period ahead.
First, however, it is worth recounting the framework for policy, the process that we go through
each month in reaching the decision, and the way that decision is implemented.
The policy framework
The centrepiece of the framework for monetary policy is a medium-term target for inflation.
This framework combines two important principles that both theory and practical experience
about monetary matters have taught us.
The first is that, in the long run, monetary policy is about the value of money - that is, prices.
Over long horizons, the size of the economy and its average rate of growth will be driven by
developments on the supply side - such as the availability of land and labour, the extent of
accumulation of real capital, technology, and the efficiency with which we use all those
factors. Monetary policy can't make those factors grow faster.
The second is that, in the short term, monetary policy changes do affect the real economy,
because they affect aggregate demand. If trend inflation has risen, for example, getting it
down again usually requires a period of slower growth in demand. But we don't want that
period of slower growth to be any longer or more pronounced than necessary. By the same
token, if as a result of some shock demand falls below potential supply capacity, the resulting
downward pressure on inflation may provide scope for monetary policy to be easier for a
time, which will help to limit the cyclical weakness in economic activity.
Our objective of keeping consumer price inflation to 2-3 per cent, on average over time,
strikes a good balance between these short-term and long-term considerations.
The "on average" specification allows deviations from the target in the short term, which are
often unavoidable anyway, but still embodies a commitment that those deviations will be
reversed in a reasonable period of time. It allows the economy's growth potential, determined
by productivity, labour force growth and so on, to be realised. At the same time, the explicit
numerical goal for inflation helps to anchor expectations of inflation and works to preserve
the value of money. As such, it is in our view fully consistent with, and gives practical
expression to, the objectives given to the Bank in legislation: the stability of the currency (that
is, its purchasing power); full employment; and the economic prosperity and welfare of the
people of Australia. It has bi-partisan support in the Parliament. It has also been, in practice,
over the 15 years we have been using it, the most effective framework for monetary policy
Australia has had so far.
The target is expressed in terms of the Consumer Price Index (CPI). This is, of course, only
one of a number of price indexes. But the CPI was chosen because: it is the best known and
accepted published price index; it is pretty reliable; and it presents fewer analytical problems
for this purpose than other measures of prices.
I now turn to the decision process.
The decision process
The Bank is continually examining a vast amount of statistical and survey information. There
are thousands of individual data series monitored by the staff in the Bank's Economic Group,
covering Australia and a number of other countries. An array of financial information from all
the major markets around the world as well as in Australia, is monitored on a daily basis.
This work is complemented by an extensive program of business liaison. A lengthy list of
contacts is maintained; about 100 organisations are spoken with in any given month. The
Financial Markets Group also maintains close contact with financial market participants in
Australia and elsewhere, and the Reserve Bank gains valuable intelligence as a participant in
both local and offshore markets.
In the lead-up to the Board's meeting, all this material is carefully evaluated. At a meeting of
the most senior officers in the week preceding the Board meeting, discussion occurs about
what should be recommended to the Board. Papers for the Board containing the factual
information available, the staff's judgements about issues of interpretation in the data, the
outlook and any topics of special interest are prepared. A four to five page paper, containing
a high-level summation of the issues for policy and the recommendation, is completed on the
Thursday afternoon ahead of the meeting. Board members receive the papers on the Friday.
At the Board meeting, the most senior staff present the key messages from the papers.
There is extensive discussion, and plenty of questions from the members about the material.
The Board, I can assure you, is no rubber stamp and its members are no group of shrinking
violets. They come from a diverse set of backgrounds. They bring their own experiences and
their own independently gleaned pieces of information about what is going on. The analysis
and arguments put by the staff and management of the Bank are well and truly tested. Any
weaknesses will quickly become pretty clear.
This discussion usually takes about three hours. It is, I would think, the most intense regular
discussion of the state of the economy that occurs anywhere in the country, as of course it
should be.
At the end of the discussion, the Governor, as Chairman of the Board, will sum up and
introduce the policy question. Each member has an opportunity to give their view and their
reasoning on the decision at hand. Typically, a consensus emerges, and the decision is then
taken.
It then remains to issue a statement. The Board meeting is not a drafting session - the
members are usually content to leave the precise wording to the Chairman, on the
understanding that the statement will be consistent with the discussion at the meeting. The
statement is then released at 2.30pm and the community is thereby informed very quickly
what the decision is and why we have taken it.
Subsequently, the draft minutes of the meeting are prepared. These are finalised after
members have the opportunity to comment on the draft during the following week, and are
released publicly on the Tuesday two weeks after the meeting. A few days after this, the
whole sequence begins over again. In addition to all the above, every three months the Bank
publishes an extensive analysis of the economy, financial markets and the issues for
Statement on Monetary
monetary policy. This document, the Policy, typically runs to about
70 pages.
All of this is already known. The point of recounting it is to reassure people that there is a
very careful, detailed and extensive process involved both in making the monetary policy
decision and in explaining it.
The transmission process
A lot of effort goes into the policy decision, as I have just described. But that only establishes
one interest rate in the economy - and a very specialised one at that. (For today's purposes
only, I am leaving aside the other channels through which monetary policy affects the
economy, such as the exchange rate, inflation expectations, the supply of credit and so on.
These remain important, but today it is the interest rate channel on which I want to focus.)
The "cash rate" is the rate for borrowing large parcels of cash, or settlement funds that are
held in banks' accounts at the RBA, overnight. This is a very active market, but only a very
small proportion of borrowing in the economy is actually conducted in this market. To have its
broader effect, monetary policy relies on changes in the cash rate affecting other interest
rates. Both today's cash rate and its expected value over the next six months to 12 months
form the anchor for the spectrum of interest rates in the economy.
But there are other factors at work as well. Term premia - the additional return that must be
paid when money is tied up for longer periods - and compensation for risk also can affect the
official yield curve and the structure of private interest rates.
For some years, these other factors were reasonably stable. Compensation for risk actually
tended to decline gradually, as a result of a very strong "search for yield" by investors and
heightened competition among intermediaries to lend. Hence in net terms loan rates slowly
fell, relative to the cash rate. On the whole, though, changes in the cash rate came to be
seen as driving most of the important rate changes in the economy quite precisely.
This was, historically speaking, somewhat unusual. In the past 18 months or so, in contrast,
a sharp reappraisal by investors around the world has seen compensation demanded for
accepting risk increase. As a result, the various market interest rates that intermediaries
have to pay to raise funds have, on occasion, moved independently of the cash rate.
The Bank has published an analysis of funding costs, which provides a useful framework for
thinking about these issues, so I won't go into them in detail.1 I will simply make a couple of
observations.
First, during the easing phase, interest rates for most borrowers still came down quite
significantly, because the cash rate changes were so large. For mortgages, floating rates in
the past year reached their lowest level since 1964. At the margin, the cash rate cuts were
larger than otherwise because the Board could see that spreads between intermediaries'
rates and the cash rate were tending to widen. Likewise in future decisions, the Board will
take careful note of any tendency for spreads to change.
Second, in Australia, housing loan rates came down much more than has been the case in
many countries. This was partly because of the prevalence of floating rate housing debt here,
but also because spreads on housing loans (relative to the policy rate) widened by less in
Australia than other countries. That is to say, monetary policy still works pretty effectively in
Australia.
The conduct of policy during the crisis
Going into the crisis, the global economy had been growing strongly. Global GDP expanded
by 5 per cent in 2007, which capped off several years of well above average performance.
The US economy had been slowing for a while as concerns mounted over the financial
problems, but even into the first quarter of 2008 global GDP was still expanding at 4 per cent.
Prices for most commodities were still rising; oil prices would not reach their peak until July
that year.
Our economy was operating at full stretch, with our terms of trade showing their largest rise
in 50 years and delivering a very large income gain to the community. Confidence was high;
firms routinely complained of labour shortages; inflation was tending to rise, worryingly so in
the second half of 2007; and demand for credit was strong.
In this environment, the Board was running tight monetary policy to contain inflation. We now
know (but could not know for sure at the time) that CPI inflation was on its way to 5 per cent.
Measures of underlying inflation, which seek to look through temporary factors, reached over
41⁄2 per cent. These outcomes were well above our target, and it could not be credibly
claimed that they were just due to temporary or imported factors. In fact, in late 2009, we are
still to see whether inflation will be consistently back to target over a period of time. We think
it will be, but, as yet, that remains a forecast.
The big rise in energy prices in the first half of 2008 crimped growth in advanced and
emerging countries alike, and most showed a significant softening in the June quarter of that
year. By then it was starting to emerge that demand in Australia was in the process of
moderating - though it is worth noting that domestic final spending still rose by 1 per cent in
the June quarter of 2008 and 5 per cent over the year to June, both very robust outcomes.
The Board was then in a position to start thinking about when it might be time to begin to
ease monetary policy, in anticipation of inflation starting to decline - even though at that
stage it had yet to reach its peak.
The easing phase began in early September. About two weeks later, the simmering financial
tensions in the northern hemisphere erupted into the most dramatic sequence of financial
events we are ever likely to see. The failure of Lehman Brothers is usually taken to be the
signal event. That is a reasonable assessment, even though the US Government takeover of
Fannie Mae and Freddie Mac actually preceded the Lehman collapse.
The ensuing sequence of crashing share markets, the huge financial strains, the need for
governments to support struggling banks, and so on, had a massive effect on confidence
around the world. As a result demand for goods slumped everywhere. Most economies went
into recession; in a number of cases these were severe ones.
This required a change in monetary policy thinking in Australia. Instead of the gradual easing
of policy that we had been expecting would occur, as inflation gently subsided, the Board
concluded last October that it needed to be more aggressive in lowering rates. Australian
households and businesses, understandably, began to react to events abroad. This meant
that there was likely to be a much weaker outcome for demand and output - and hence a
greater prospect of falling inflation - than had been expected up to that time. This change to
the outlook was reflected in revisions to the central forecasts prepared in the Bank. But the
Board responded to more than just those forecast changes. It responded also to the risk that,
in an environment of acute global financial strain and deleveraging, there could easily be a
much weaker outcome for economic activity even than the one embodied in the reduced
forecast.
Accordingly, the cash rate was reduced by a total of 300 basis points in the four months
leading up to the end of 2008. It was lowered further in the early part of 2009.
This "risk-management" approach, in which policy responds quickly to a situation where
there is an increased risk of a very adverse outcome, is fully consistent with the flexible
inflation-targeting framework.
Admittedly, a more conventional approach might have seen the Board ease policy more
slowly, waiting for more evidence of economic weakness and moderation of inflation. Such
an approach would have been defensible, particularly given how high inflation became during
2008. But the loss in economic activity would probably have been greater, and the risk of an
even larger contraction would have been unaddressed. Inflation might well have fallen not
only faster, but ultimately further, than we needed it to. The Board's view was that we should
move to limit the downside risks to economic activity, to the extent it was feasible to do so
while remaining consistent with the inflation target.
The Board had some earlier analysis available to it that proved to be helpful in coming to that
decision. A year earlier, for the September 2007 meeting, the staff had prepared some
scenarios for discussion. One of those was a sketch of what might occur if the financial crisis
escalated badly and the global downturn turned out to be much more severe than then
expected. The message from that work was that such an event, if it occurred, would probably
require a very rapid response from monetary policy, in the direction of lower interest rates.
That event did not occur for another year, but when it ultimately did, we were a bit better
prepared than otherwise might have been the case.
The conduct of policy in recovery
Along with the fiscal measures taken by the Government, the recovery in China, and assisted
by Australia's better starting point across several dimensions, this approach has had some
success in heading off the worst effects of a very serious international recession. Australia
has had an experience that, even if labelled a recession, was a pretty mild one.
That is, clearly, a good outcome in the circumstances.
Now that the risks of really serious economic weakness have abated, however, the question
arises as to how to configure monetary policy for the recovery. We have said that, over time,
interest rates will need to be adjusted towards a more normal setting as the economy
recovers. A step in that direction was taken last week. Of course, there are still important
matters of judgement in the timing and pace of how that is done. The global outlook remains
uncertain and the Board is very conscious of that.
The Board is also conscious, though, that a risk-management approach requires policy to be
recalibrated as circumstances change. If we were prepared to cut rates rapidly, to a very low
level, in response to a threat but then were too timid to lessen that stimulus in a timely way
when the threat had passed, we would have a bias in our monetary policy framework.
Experience here and elsewhere counsels against that approach.
None of this is to say that the economy is, at this moment, "too strong". It isn't. The point is,
rather, that the very low interest rate settings were designed for a weaker economy than we
are in fact facing. Plainly, the downside risks to which the Board was responding earlier have
not materialised.
This is not a problem. In fact, it is a very desirable situation. It is a welcome contrast to the
experience of a number of other countries. It is simply something we need to recognise in
setting monetary policy - which means not holding interest rates at very low levels when that
is no longer needed.
Conclusion
The period of greatest weakness in the Australian economy is probably past. Barring another
serious international setback, the economy is likely to continue on a path of gradual
expansion during 2010.
That being so, those of us involved in monetary policy must turn our thoughts to encouraging
the sustainability of that expansion. This is particularly the case for monetary policy given the
lags in its impact. In conducting monetary policy during this expansion, our objectives will be
the same as they were in the previous one: to keep inflation low; to react in a measured but
prompt fashion to changes in the risks facing the economy; and, in so doing, to play our part
in fostering a long, sustainable period of growth. Australia faces many challenges in the
future, but we can have confidence that these can be met. A sound monetary framework is
one of the foundations for doing so.