The review of the Reserve Bank (RBA) has determined that “certain choices and judgements” made the central bank more likely to misjudge the level and persistence of inflation in Australia.
These choices and judgements may have also made it more difficult for the RBA to pivot to rate hikes once signs of inflationary pressures began to emerge, according to the review.
“With the benefit of hindsight, the RBA was overly focused on its view that evidence of wage growth would be needed to achieve sustainably higher inflation,” the review said.
“The RBA did not weigh highly enough risks that were becoming evident in other countries or the possibility that firms’ pricing behaviours could change in an environment of widespread price increases.”
Papers provided to the RBA board throughout 2021 contained little discussion regarding the risks posed by non-wage sources of inflation, the review suggested, and also lacked meaningful assessment of the degree of spare capacity in the economy.
“This led to insufficient attention being paid to upside risks to inflation during this period,” it said.
The review acknowledged that the RBA was not alone among global central banks in its misjudgement of inflation and could not have anticipated wars and natural disasters.
But it concluded that the RBA’s forecast models had fallen short “in an environment of large and persistent supply disruptions, and when monetary and fiscal policy interactions were important”.
Furthermore, the review suggested that the RBA’s decision to introduce a three-year yield target, as well as its controversial forward guidance that interest rates would remain unchanged until 2024, may also have contributed to its hesitancy to act.
“These policies may have affected the openness of the RBA to respond to early signs of inflation by upgrading the inflation forecasts given this may have required earlier changes to the RBA’s forward guidance,” it said.
Overall, the review concluded that the central bank’s flexible inflation targeting framework has “generally worked well” since being adopted in the early 1990s. However, some “modest improvements” were proposed among the 51 recommendations of the review.
“Australia’s existing monetary policy and financial stability frameworks have served Australia well in recent decades,” the review said.
“The monetary policy framework of an independent central bank undertaking flexible inflation targeting is well suited to the future challenges Australia can expect to face. However, greater clarity in the framework would support greater accountability for the RBA.”
The “relatively modest changes” to the framework, as recommended by the review, include clarifying the RBA’s monetary policy objectives and toolkit, how the bank operates and explains its framework, and how monetary policy interacts with other branches of policy.
The review recommended that the RBA should have “dual monetary policy objectives” of price stability and full employment with equal consideration given to each.
It also suggested that the RBA should retain its existing flexible inflation target of 2 to 3 per cent but remove reference to achieving this target “on average, over time”.
“The reference to ‘on average, over time’ makes it harder to say whether or not the target is being met, limiting accountability, and should be dropped,” the review stated.
“Instead, the RBA should be required to explain how it is using its flexibility. This should include how quickly it is aiming to return inflation to around the midpoint of the target, its assessment of full employment, and how, if at all, financial vulnerabilities or other considerations have factored into its decision.
Responding to the release of the review on Thursday, RBA governor Philip Lowe said that he particularly welcomed the panel’s support for the current monetary policy framework.
“Australia was an early adopter of flexible inflation targeting and this approach has served the country well. The 2–3 per cent target range is understood in the community and helps anchor inflation expectations,” he said.
“The flexible nature of the inflation target is also important, and the panel has some helpful suggestions as to how we can be clearer about how, and when, this flexibility is used.”
