Major macroeconomic policy reform is needed to reduce the reliance on monetary policy

There is some commentary emerging that is finally starting to question the reliance on monetary policy (setting interest rates) as the primary macroeconomic policy tool with fiscal policy forced into a passive role. In Australia, this debate has intensified in the last week following the hubris from the new Reserve Bank governor, who thinks her role is to sound like a ‘tough guy’ dishing out threats of ever increasing interest rate rises even as inflation falls. There was an Op Ed in the Sydney Morning Herald today (August 12, 2024) – Maybe only a recession will fix macroeconomic management – by the Economics Editor Ross Gittins, which challenges the current macroeconomic consensus. Some of this argument is acceptable. But when he advances his alternative proposal of “a new independent authority” to set monetary and fiscal policy, the reality is that this would be as bad as we have now. More on that later.

First, the Op Ed follows the RBA governor’s comments last week that a “near-term reduction in the cash rate does not align with the board’s current thinking”.

Ross Gittins writes that:

This is what worries me as the Reserve ploughs on, determined to ensure the inflation rate returns to the centre of its target range within a time that the Reserve itself judges to be the maximum time acceptable. This determination seems to be regardless of the source of the forces that are slowing the return to mid-target and making it “bumpy”.

This is one of the points I have been making since the inflationary episode began.

The inflation was initially driven by forces not sensitive to interest rate changes – the so-called supply constraints arising from the pandemic and the Ukraine situation, followed by OPEC’s price hikes.

Then as those forces abated, a new dynamic entered the picture – inflationary pressures created by the RBA interest rate hikes – for example, the dominant impact of rental price inflation.

While the initial effects of rising interest rates are likely to be stimulatory – via the differential impact on creditors and borrowers – eventually, a period of high interest rates will drive up unemployment.

I wrote about that in this blog post among others – RBA governor’s ‘Qu’ils mangent de la brioche’ moments of disdain (June 8, 2023).

The problem is that given the extended lags in the policy change taking effect, the authorities do not really know what is going on, often, before it is too late, which is why people are now getting upset with the RBA’s insistence that the direction of policy might be higher rates, as unemployment starts to rise.

Whatever the damage from the 11 interest rate hikes since May 2022, it is already in the system.

The RBA’s justification for not cutting rates, even though inflation has been falling consistently since December 2022, is that the inflation rate is not falling quickly enough.

There is no economic theory that outlines some optimal rate of disinflation.

The mainstream approach is that inflation can only be brought down by driving unemployment higher because they construct inflation as being the consequence of the unemployment rate being below their (unobserved) Non-Accelerating-Inflation-Rate-of-Unemployment (NAIRU) stability benchmark.

Never mind that all attempts to estimate the NAIRU from various data sources, using various econometric approaches always deliver estimates with wide confidence intervals.

In other words, the estimates might lead to the conclusion that the true NAIRU (accepting the concept for the moment) lies somewhere between an unemployment rate of, say (in some actual studies) of 2 to 8 per cent, which means it is useless as a guide to policy.

In the late 1970s, for example, Australian economists began asserting that the ‘natural rate of unemployment’ (NAIRU) had risen in just a few years from 2 per cent to 8 per cent without any notable structural shifts being evident.

Other studies have even wider standard error bands.

So the sort of variations in the unemployment rate that we typically observe could always be interpreted as being consistent with the current NAIRU (with 95 per cent confidence), which renders the concept without application.

While often denying it, the mainstream approach has become one where unemployment is to be used as the principal anti-inflationary measure.

Milton Friedman, one of the founders of the natural rate of unemployment idea, said in an interview in 1974 that:

There is no way of slowing down inflation that will not involve a transitory increase in unemployment, and a transitory reduction in the rate of growth of output … (quoted in the Guardian article – Inflation v. Civilization; Frances Cairncross Puts Questions to Professor Milton Friedman’, September 21, 1974).

The RBA has articulated that view in the recent period.

On June 20, 2023, the incoming governor of the Reserve Bank of Australia turned up in Newcastle, NSW and presented a speech – Achieving Full Employment – to a corporate audience where she explained how the NAIRU concept was motivating the RBA to continue increasing interest rates even as the inflation rate had been falling for the best part of 6 months.

She claimed that the RBA believed the NAIRU to be 4.5 per cent in Australia, and, given that the official unemployment rate was steady at around 3.5 or 3.6 per cent, it was clear to the Bank that there were inflationary pressures that had to be expunged by further rate hikes.

Hence, the RBA had to keep hiking interest rates to force the unemployment rate up to 4.5 per cent to stabilise inflation.

At the time, such an increase in the unemployment rate would have meant the RBA was deliberately trying to force more than 150,000 extra workers onto the unemployment queue.

As I have explained in the past, when she was making these prognostications, the official unemployment rate had been very stable for an extended period and below the RBA’s NAIRU estimate (which was revised during this period from 4.5 per cent to 4.25 per cent), while the inflation rate peaked (in December 2022) and then rapidly declined.

The RBA’s NAIRU logic was nonsensical.

With the official unemployment rate stable and below their NAIRU estimate, inflation should have been accelerating if their assessment of the NAIRU level was correct.

But the reality was that with the unemployment rate relatively stable and inflation falling, then the logical conclusion would have been that the official unemployment rate must have been above the NAIRU if that concept was applicable.

Which means that the RBA’s insistence on putting around 150,000 extra workers onto the unemployment scrap heap had no foundation even within their preferred theoretical structure.

Some months later, the RBA released its – Statement on Monetary Policy – February 2024 – which updates the public on current central bank thinking.

The analysis presented shows how unanchored the RBA had become from reality.

On the one hand, they told the public that their interest rate decisions were driven by the mainstream theoretical NAIRU concept; but then, on the other hand, they abandoned the concept when the data defied their ‘theories’.

In that ‘Statement’, the RBA claimed that their previous statements of the NAIRU should not be taken seriously:

Full employment cannot be observed directly or summarised by a single statistic. It also changes over time as the structure of the economy evolves. Any individual indicator, such as the unemployment rate, provides only partial information on the state of the labour market, while model-based estimates provide a broad guide of how the labour market stands relative to full employment. Given these limitations, the RBA does not target a fixed level of full employment.

The RBA also noted:

Each model estimate, however, is subject to considerable uncertainty … The wide range from this one model is typical of the range of uncertainty around the central estimate of other models. Model estimates also change over time as new data are incorporated. Over the past 20 years, for example, the estimated levels of unemployment and underutilisation consistent with full employment have drifted down in response to structural changes in the economy. However, this was less obvious at the time.

The arbitrariness of their NAIRU narrative became obvious when suddenly, within a space of a few months, they announced their NAIRU estimate had fallen from 4.5 per cent to 4.25 per cent, without any discernible justification being offered for the shift.

That 25-basis point difference just meant in their eyes that 40 odd thousand Australian workers were not required to join the unemployment queue in their quest for inflation stability.

Such is the monetary policy orthodoxy.

They should have been reminded by journalists in the press conferences of the estimates of how long unemployment would have to remain at (deliberately) elevated levels for the disinflation process to work.

In his 1968 Presidential Address to the American Economics Association on December 29, 1967 – The Role of Monetary Policy – Milton Friedman wrote:

I can at most venture a personal judgment, based on some examination of the historical evidence, that the initial effects of a higher and unanticipated rate of inflation last for something like two to five years; that this initial effect then begins to be reversed; and that a full adjustment to the new rate of inflation takes about as long for employment as for interest rates, say, a couple of decades.

So while they rarely articulate any specific timing, the mainstream orthodoxy thus endorses an anti-inflation strategy that would see elevated levels of mass unemployment and all the pathologies and waste that accompanies that state for perhaps a ‘couple of decades’.

Academic economists and central bank policy makers who have fallen into the thrall of this new paradigm didn’t blink at that prospect.

And they fall short of answering questions of how they could justify such inefficient use of productive resources (the unemployed) and the lost income that results.

Ross Gittins also raises the question about the quality of our democracy, when:

We now have a situation where the central bank has the most control over whether the economy is plunged into severe recession, but the only people the voters can punish for this are not the central bankers, but the government of the day … if the Reserve Bank decides inflation can’t be fixed without a recession or, more likely, miscalculates and leaves interest rates too high for too long, it won’t be Michele Bullock that voters punish, it will be Anthony Albanese and his government.

This absurd period of masquerade about RBA independence allows the elected government to depoliticise economic policy and shift accountability to a body (the RBA Board) that we have no control over.

So while Gittins might think it is unfair for the government to be taking the heat right now for the ridiculously high interest rates, he should acknowledge that the whole farce is the government’s creation.

They chose to pretend that fiscal policy is subservient to monetary policy and that they had no say in the latter for political reasons.

Now it comes back on them – tough.

They could change that and subsume the interest rate decisions back into Treasury, which would force the polity to take responsibility.

Gittins acknowledges how “unfair and ineffective it is to make the manipulation of interest rates the dominant instrument for managing the strength of demand” and suggests an alternative approach:

We need another, much broader-based instrument that could be used as well as, or in place of, interest rates. Temporary changes in the rate of the goods and services tax are one possibility, but I’m attracted to the idea of temporary changes to the rate of compulsory superannuation contributions.

The two instruments – one interest rates, and the other budgetary – could be controlled by a new independent authority.

In other words, restore fiscal policy to its prime location as the most direct and effective way to manipulate demand.

Note: the current conduct of monetary policy is even more ineffective than usual because the inflationary causes were not due to the ‘strength of demand’.

Would I support the creation of “a new independent authority”?

Absolutely not!

It would be stacked with mainstream economists who would make the situation even worse.

Conclusion

The only reasonable way forward is for governments to declare fiscal policy must drive the show and for them to take full responsibility for the decisions and their outcomes.

Their advice should come from a professional public service with a diversity of input.

That way the politicians cannot duck when it hits the fan.

That is enough for today!

(c) Copyright 2024 William Mitchell. All Rights Reserved.