The Reserve Bank of Australia needs to be congratulated for publishing research which implicitly confirms that it made a mistake when setting monetary policy in the period mid-2017 to early 2019.
Not that the research explicitly says that, but the RBA Discussion Paper, Cost-benefit Analysis of Leaning Against the Wind, written by Trent Saunders and Peter Tulip, makes the powerful conclusion that by keeping monetary policy tighter in order to “lean against” the risk of a financial crisis, there was a cost to the economy that is three to eight times larger than the benefit of minimising the risk of such a crisis eventuating.
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The costs to the economy includes lower GDP growth and higher unemployment, that lasts for at least for several years.
A few terms first.
According to the Saunders/Tulip research, “leaning against the wind”, a term widely used in central banking, is “the policy of setting interest rates higher than a narrow interpretation of a central bank’s macroeconomic objectives would warrant due to concerns about financial instability”.
In the RBA’s case, the “narrow interpretation” of the RBA’s objectives are the 2 to 3 per cent inflation target and full employment.
In the context of the period since 2017 and despite the RBA consistently undershooting its inflation target and with labour underutilisation significantly above the level consistent with full employment, the RBA steadfastly refused to ease monetary policy (cut official interest rates) because it considered higher interest rate settings were appropriate to “lean against” house price growth and elevated levels of household debt.
Indeed, it spoke frequently and with force that “the next move in interest rates was likely to be up” such was its concerns about financial instability of high house prices and elevated levels of household debt.
According to Governor Phillip Lowe, the RBA has been worried about how households might react to high indebtedness.
But his speeches cite no research or evidence to support these claims.
Like many other researchers, Saunders and Tulip measure financial instability as a repetition of the banking crisis of 1990 or the GFC.
These were terrible events, but Saunders/Tulip find that monetary policy has negligible effect on the likelihood of them recurring. (In contrast, research finds that macroprudential policy has big effects on this probability.)
Saunders/Tulip found that the RBA's monetary policy raised the unemployment rate around 0.5 percentage points higher over a two to three year period relative to a more orthodox policy.
They also note that many other economic variables will be impacted, such as inflation, income and the budget deficit but they do not quantify the size of the impact.
How did this affect our economy?
To judge the veracity of this research, one can look at how the economy has performed in recent years.
What has happened to labour utilisation, inflation, wages and GDP growth over the period the RBA has kept monetary policy tight to lean against house prices and household debt?
Economic theory and research, like the Saunders/Tulip paper, is often criticised for being fine in theory, but impractical in the real world.
It is telling that the findings are supported by hard facts about the how the economy has performed as the RBA, under Governor Phillip Lowe, has chosen to keep policy tight to foster financial stability.
At one level, the RBA appears to be successful.
House prices have fallen by around 10 per cent since the middle of 2017 and household debt has stabilised.
But this has demonstrably come at the cost of weaker GDP growth, a rise in labour underutilisation and a slump in credit growth.
In the last three years, the RBA has consistently undershot the 2 to 3 per cent inflation target, with annual underlying inflation averaging 1.8 per cent.
The most recent data show annual underlying inflation hitting an equal all time low of just 1.4 per cent.
At the same time, the labour market remains weak with labour underutilisation (underemployment plus underemployment) still over 13.5 per cent (by comparison, it is under 8 per cent in the US).
This significant degree of labour market slack is the key reason why wages growth remains mired close to record lows.
The Saunders/Tulip findings are showing up in the hard data.
The counter-factual argument
The counter-factual argument, which Saunders/Tulip do not explore, but seems obvious to conclude given their published findings, is that if the RBA adjusted monetary policy according to the inflation and labour market data, official interest rates would have been cut to 0.5 to 0.75 per cent around two years ago, GDP growth would now be materially stronger and the labour market tighter.
To humanise the policy error, 0.5 percentage points on the unemployment rate is approximately 35,000 people.
At its simplest level, the error on monetary policy had added these 35,000 people to the ranks of the unemployed.
The human and economic cost of leaning against house prices and household debt has been significant, even if the risk of a financial crisis is, perhaps but by no means certainly, lower.
Has the RBA started to change its strategy?
Perhaps the Saunders/Tulip research hit the desks of the RBA Board before it was published.
There have been two further interest rate cuts in the past two months and talk that the next move in interest rates is up when inflation and the labour market are weak is a distant nightmare.
Whether these interest rate cuts are enough to see the economy return to full employment and make up for lost time, is not yet clear.
If they are not, and if the RBA has learnt a lesson from its policy error, it will cut interest rates below 1.0 per cent and may look to other monetary policy levers to get the economy back on track.
Perhaps the final word should go to Saunders and Tulip. They conclude their paper:
“Leaning against the wind might have benefits that are not apparent to researchers.”
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