i j macfarlane : monetary policy and financial stability talk by mr i j macfarlane, governor of the reserve bank of australia, to ceda annual dinner, melbourne, 16 november 2004. * * * it is a great pleasure to be here again in melbourne addressing ceda ’ s annual dinner. this is the fifth time i have done so, and it is like returning to be with old friends. i usually talk about some aspect of monetary policy, and will do so again tonight, starting with something very familiar and then moving to newer territory. when we look back to fifteen or twenty years ago, the thing about monetary policy that stands out is the lack of clarity about what it was expected to achieve. that is, what should be its ultimate objective, and therefore what should it be accountable for? this lack of clarity applied both inside the reserve bank and outside it. i am sure some of you are familiar with the wide variety of objectives for monetary policy that were put forward at the time. as well as the familiar aims of low inflation, low unemployment and good economic growth, there were those who felt it should also be aimed at improving the balance of payments, promoting investment or limiting the growth of credit or some other monetary aggregate. others put forward the view that it should aim to rein in the growth of asset prices. we now recognise that there are a lot of good economic arguments against having such a wide set of aims, but i will not go into those tonight. instead, i will say a few words about accountability and independence. a government cannot be expected to allow independence to its central bank unless that bank is also accountable to it and to the wider public. that is, the central bank must be able to be judged on whether or not it has achieved its agreed objective. when there are half a dozen objectives, this becomes impossible because there is very little chance that the optimal outcome for all these variables could be achieved at the one time. if the central bank was held accountable for failing to achieve one objective, it could always defend itself by saying that its efforts were directed at one or more of the other objectives which it viewed as more important at the time. thus, the old system failed the test of being accountable, and hence there was a reluctance to fully recognise the independence that was essential for the ultimate success of monetary policy. it is true that the reserve bank act specified multiple objectives for monetary policy, but the bank had failed to articulate a clear framework for setting priorities among these

of credit and, until recently, an excessive rate of growth of house prices. i can understand people ’ s concerns and their desire for better and better economic performance, but i hope they are not pinning too much faith in monetary policy because there is a limit to what it can be expected to perform. in essence, monetary policy has one instrument - it can set the path of short - term interest rates. over the past dozen years or so, it has set a path which has achieved the outcomes for inflation, growth and employment which i have just outlined. what would have happened if, instead, we had aimed our monetary policy at one of the other objectives put forward, say a substantially lower growth of credit. i am not sure whether we would have been able to achieve this, but i do know that the attempt to do so would have required setting a path of interest rates which was significantly higher than the one we did. this, in turn, would have meant that the outcomes for inflation and economic growth would have been lower than we actually achieved. i do not think this would have been a good economic result, and it certainly would have violated the letter and the spirit of our agreement on accountability. as i said earlier, a central bank cannot be accountable for everything, and our monetary regime recognises this, while at the same time choosing the right objective to be accountable for. this, of course, does not mean that we ignore credit and asset prices. movements in these variables can affect the future path of the economy and the evolution of inflation. so we need to study them closely, understand the forces driving their movements, and the risks that they pose. but they are not appropriate targets for monetary policy. i hope that what i have just said does not leave you with the impression that we have a very narrow interpretation of our responsibilities. if that has happened, it is unintentional and is because i have only spoken so far about our monetary policy responsibilities, but we also have a duty to do what we can to ensure financial stability. financial stability means the avoidance of financial shocks that are large enough to cause economic damage to the real economy. it should not be forgotten that many central banks, including most notably the us federal reserve, owe their origins to the desire to avoid financial crises - the monetary policy functions only came later in their life. at the reserve bank, our financial stability responsibilities are handled in several ways. for a start, we run the high - value wholesale payments system,