RBA’s rate forecast error a blessing in disguise
The defining moment in Philip Lowe’s governorship of the Reserve Bank of Australia (RBA) was in late 2021, when he indicated the RBA was likely to keep interest rates at just 0.1 per cent until 2024.
Lowe made this projection for interest rates through to 2024 because he was not confident that inflation would be sustainably within the RBA’s 2-3 per cent target range and, at the same time, that full employment would be locked in before then.
It revealed a lot about how the thinking of the RBA had changed and it was a constructive and welcome change.
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Indeed, the RBA forecasts - included in both its August and November 2021 Quarterly Statements of Monetary Policy - were for inflation to only gradually rise to 2.5 per cent by December 2023, at which time the unemployment rate was expected to be 4 per cent with wages growth just 3 per cent.
The bulk of market economists were in broad agreement with this assessment, as was financial market pricing.
In September and early October of 2021, with the cash rate at 0.1 per cent, the 3-year government bond yield was tracking around 0.2 per cent, with the 10-year yield around 1 to 1.25 per cent, although with a slight bias to higher yields.
In other words, financial markets and the vast bulk of economists and commentators were fully on board with Lowe’s outlook.
Lowe’s tactics in 2021 - signalling the RBA’s intention to set monetary policy with the inflation target and full employment at the forefront of its goals - was a change from how the RBA implemented policy in the period from 2017 through to early 2020.
It was the first step in repairing the RBA’s mindset and poor policy implementation that had predated the COVID pandemic.
RBA errors in the pre-COVID era
Even though Lowe’s 2021 forecast and guidance on the timing on when interest rates were likely to rise was wrong, that policy strategy ended what had been a period of poor implementation of monetary policy when interest rates were held too high for too long.
That was before the pandemic, which plunged the economy into its deepest recession since the 1930s Great Depression.
This error meant inflation was too low – indeed, it was well below target - and the unemployment rate was too high, at 5 per cent or more.
Philip Lowe’s Scorecard
The economic scorecard on the two critical elements of the RBA’s mandate at the time reflected badly on the central bank.
And it’s not as though there were few options for the RBA.
The official cash rate from mid-2016 right through to May 2019 was 1.5 per cent. It could have and should have been cut to boost growth and inflation, to create employment and lower the unemployment rate.
Lowe and the RBA board kept interest rates high for three years, even though it was forecasting low inflation to continue and for the unemployment rate to remain around 5 per cent.
The refusal to cut interest rates was based on what were, and still are, lame academic group-think sessions.
Rates were not cut to get inflation back to target or unemployment lower because, according to the RBA, it wanted to “lean” against rising house prices and to maintain stability in financial markets, even though markets would remain orderly if a well-signalled rate cut was delivered.
Welcome change in attitude
It seems that some lessons from the past have informed what is happening today. In fact, instead of being criticised, Lowe should be praised for this change of view in 2021, including his strategy to use monetary policy to try to hit the RBA inflation target and to get to full employment.
Even though in late 2021 Lowe’s expectation was that the conditions for higher interest rates were unlikely to be met until 2024, it represented a policy transformation that should be welcomed.
It is clear now that monetary policy will be set with a strong focus on the inflation target and the unemployment rate. This was certainly not the position prior to the COVID pandemic.
Lowe’s shocking forecast error on interest rates in 2021 could well be a great blessing for the long-run credibility of the RBA.
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