The RBA’s November Board meeting considered and endorsed the internal review of its use of forward guidance, which has now been released along with the meeting minutes. The review concludes with a summary of the ‘Board’s preferred approach to forward guidance, building on some current practices and recognising lessons from recent experience.’ The most remarkable thing about this ‘preferred approach’ is that it is unchanged in any substantive way from previous practice.
The RBA acknowledges that its forward guidance could have been better communicated. But it contains very little analysis or recommendations of the ways in which forward guidance could be better formalised to help solve that problem. Communications strategy has always been a weakness for the RBA because its approach to monetary policy strategy is essentially improvisational. Improvisational policy does not lend itself to clear and consistent communication.
Central banks are always providing forward guidance in relation to the stance of policy. The only question is how formalised and systematic that guidance is. As the RBA notes, well-chosen forward guidance can be a powerful operating instrument in itself and enhance the effectiveness of monetary policy. Indeed, what the central bank says about the future stance of its operating instruments is arguably more important than the actual stance of those instruments. That begs the question as to why the RBA doesn’t make greater use of forward guidance at all times.
Typically, the RBA provides minimal guidance on the future stance of policy. It will sometimes communicate a bias to higher or lower rates, what it calls qualitative guidance, but mainly with a view to conditioning market expectations for a given meeting so that the announcement comes as less of a surprise. At its November meeting, for example, the RBA said it expected to be raising rates again in future, but also highlighted uncertainties around that expectation and said that interest rates were not on a pre-set path.
But this preferred approach means that the RBA is routinely forgoing the opportunity to enhance the effectiveness of its operating instruments by committing to an explicit forward interest rate path. It also creates confusion in as much as its economic forecasts are conditioned on market expectations for the official cash rate, which may differ from its own view of the appropriate path for interest rates. To the extent that it has a different view to the market on the future stance of monetary policy, it is put in the position of implicitly disowning its forecasts.
The RBA used more explicit forward guidance during the pandemic in order to substitute the expected duration for the magnitude of reductions in the official cash rate. The forward guidance was coupled with the yield target on the three-year bond. The yield target served as a backstop to the credibility of the forward guidance. If market participants wanted to take a different view to the RBA on the cash rate over a three-year horizon via the three-year bond, they had to fight the RBA’s balance sheet.
But as the review notes, the relationship between the forward guidance and the yield target ran both ways. The RBA could not qualify its forward guidance without blowing up the yield target. In the event, the yield target went first because the market found the guidance was no longer credible and the commitment to keep the cash rate unchanged out to 2024 sensibly gave way soon thereafter.
The review concludes that this was a blow to the credibility of the Bank, but the credibility of monetary policy is determined not by the stance of its operating instruments, but by macroeconomic outcomes. The yield target and forward guidance gave way because the RBA’s macroeconomic objectives had been realised. To criticise the RBA for that outcome is perverse.
Indeed, the scenario in which the cash rate was held steady until 2024 would have been a macroeconomic disaster. It is worth recalling that during the middle of 2020, the RBA canvassed the option of extending the forward guidance and yield target out to five years. Having already failed to meet its objectives in the six years prior to the onset of the pandemic, a commitment to hold the cash rate steady for five years from 2020 to 2025 would have implied a lost decade for the inflation target.
Of course, the RBA subsequently overshot its inflation target, but given where we were in 2020 and 2021, that is not the worst problem to have. We also happen to have the lowest unemployment rate since 1974 and record rates of labour market participation off the back of the worst macroeconomic shock in a century. I will take that outcome over the ‘steady rates until 2024 scenario’ any day of the week. The RBA is now being criticised for an early exit from a policy regime that succeeded too well.
The internal review of the yield target concluded that it lacked flexibility. Given that the forward guidance was coupled to the yield target, it is not surprising that the forward guidance also lacked flexibility. By contrast, the review of forward guidance notes the relative flexibility of communication around the bond purchase program. This is consistent with the conclusions of the reviews of the yield target and bond purchase program, as well as my long-standing preference for asset purchases over yield targeting.
The review contains very little discussion of the pre-pandemic US experience with calendar and state-based forward guidance. The clear lesson from the US experience was that state-based guidance is preferable. That experience should have already been internalised by the Bank before the pandemic. Arguably, the yield target locked them into calendar-based guidance even though the intention was that both the forward guidance and the yield target were state contingent policies.
The review is also notable for conceding that the RBA’s repeated references to stronger wages growth as a prerequisite for a lift in inflation and the cash rate served to muddy the expectational waters, even giving rise to the impression that the RBA had a wages target. But the real issue here is that the RBA had the dynamic relationship between wages and inflation backwards. Nominal wages growth depends on inflation, not the other way around.
A big problem for Australian monetary policy has been the extent to which the RBA has conditioned the inflation outlook on the labour market and wages growth, particularly in the period since September 2016. John Kehoe reports that ‘Lowe personally took it upon himself to put more emphasis on wages than some other RBA board member.’ The review’s timeline of its forward guidance shows the central role played by wages in the RBA’s communication.
But this was an accurate reflection of the RBA’s thinking. It was not the communications that was wrong, but the RBA’s view of the relationship between wages and inflation. This misunderstanding pre-dated the pandemic and explains much of the pre-pandemic undershoot of the inflation target. This error should be a key focus for the independent review panel.
The obvious conclusion to draw from the pandemic episode, as well as overseas practice, is to formalise forward guidance and publish an explicit forward rate path with endogenised economic forecasts as a matter of routine. The rate projection would change routinely, which largely solves the problem of having that guidance mistaken for a non-state dependent promise.
The RBA’s internal reviews of its yield target and its bond purchase program reached the right conclusions. In future, the RBA will resort to QE rather than a yield target if its usual operating instruments are constrained. But the review of forward guidance is disappointing in suggesting that the RBA does not need to change its existing ad doc approach to conditioning expectations for the future stance of the cash rate. Those expectations are fundamental to the effectiveness of monetary.
The key lesson from this episode is that the RBA should do more forward guidance, not less. Unfortunately, the commentariat have concluded the exact opposite. It will be interesting to see where the independent review panel lands on this.
RBA Governor Lowe is speaking to the CEDA annual dinner on Tuesday next week on a topic TBC. The RBA review panel will be fronting a CEDA event in Sydney on Thursday next week at a venue TBC (see the ad at the top of this post). Strangely, CEDA seems to still be shopping among its membership for a venue. It is possible the review panel will release its reflection on the consultations to date in advance of this event, along with the public submissions received.
Australia’s Q3 wage price index
The wage price index rose 1.0% over the September quarter and 3.1% over the year. This was slightly stronger than financial market expectations for a 0.9% rise and the RBA’s implied forecast of around 0.8% q/q, but in line with our model’s expectation (see previous post). Private sector wages rose 1.2% over the quarter and 3.4% over the year. This was the fastest quarterly private sector wages growth since the September quarter 2010 and the highest annual rate since the December quarter 2012.