Chalmers is more in touch with the economy than the RBA

Its easy enough to understand the treasurer’s criticism of the RBA in political terms. But the inflation target that is good for the central bank as an institution is not so good for the economy.

In today's Australian Financial Review. It's paywalled and I don't have access (I've been promised a PDF) so here's what I submitted, which may not be final.

Six months ago, Federal Treasurer Jim Chalmers was planning legislation to remove his own power (never used, but always available until now) to over-ride decisions of the Reserve Bank. Now, he has not only decided to retain this power, but has openly criticised the Bank’s interest rate decisions as “smashing the economy”.

It’s easy enough to understand Chalmer’s criticism in terms of the political interests of a government seeking to survive and retain power. The government is focused, to the point of obsession, on the “cost of living”, a nebulous term that can best be interpreted as “the reduced purchasing power of household disposable income”. 

For households dependent on wage income to service mortgages, increases in interest rates have reduced real disposable income in two ways. First, they have put downward pressure on wages, which remain well below their 2019 levels in real terms. Second, interest payments are unavoidable and therefore represent a reduction in disposable income.

Chalmers’ other concern is the weakness of economic growth and the possibility that this might tip over into recession, for which the government would be blamed. A dire warning is provided by the NZ Labour government, whose defeat was due in large measure to the recession that began in 2023, following steep increases in interest rates.

But it’s not only governments that are primarily concerned with survival and the retention of power. All long-lived institutions, including central banks, are driven by this imperative. The macroeconomic policy framework that has been in place since the early 1990s, in which interest rate adjustments are used with the aim of keeping inflation to a range of 2-3 per cent has greatly enhanced the independence and power of central banks. 

The only regular input from government is an official agreement negotiated every three years or so, which reconfirms the target.  The Treasurer’s power to override the Reserve Banks, a genuine if drastic option under the previous system, is effectively a dead letter, which is why the Review was keen to ditch it.

Inflation targeting has been great for central banks, but not so good for the economy as a whole. Complacency about low inflation in the early 2000s, characterised as a “Great Moderation” in economic volatility, led central banks to overlook or play down the dangerous imbalances that precipitated the Global Financial Crisis. Then, for much of the decade before the arrival of the pandemic, the policy was barely operative, with economic activity weak and official interests set at, or even slightly below, zero in much of the world. 

Finally, we had the burst of inflation as Covid restrictions were eased, and attempts by households to spend their accumulated savings ran into supply chain disruptions made worse by the pandemic. The model of inflation on which central banks operated, in which inflation was driven by wage pressure, failed to predict this outcome, leading to reassurances (soon falsified) that interest rates would remain low for some time.

In these circumstances failure to achieve a rapid return to the “normality” of 2-3 per cent inflation could produce pressure to change the target, or even to make the inflation targeting framework itself a matter of political debate. This is the last thing central banks want. The recent Review, while giving detailed attention to matters like the membership of the Reserve Bank Board, mentioned these issues briefly then put them in the “too hard” basket.

The Reserve Bank has expressed concern that, without a rapid return to 2-3 per cent inflation, expectations might form around current levels near 4 per cent. What is not mentioned is that a large proportion of the macroeconomics profession, arguably a majority, believes that a 4 per cent target would be optimal. In particular, it would give central banks more room to cut interest rates during recessions without hitting the (near) zero lower bound and resorting to unconventional policies of the kind used during the lockdown phase of the pandemic.

There is no real rationale for the current target range. The lower figure of 2 per cent was  the top end of a 0-2 per cent range plucked out of the air by New Zealand’s then Finance Minister Roger Douglas in 1990, as the lowest he could plausibly propose. New Zealand’s miserable macroeconomic experience since then seen most central banks choose a slightly less rigorous target.

As the late Jack Lang famously remarked to his then-protégé Paul Keating, “you should bet on self-interest, it’s a horse that is always running”. In the current dispute, both the government and the central bank are driven by institutional self-interest. But, for the majority of Australians, their own interest are closer to those of the government than those of the central bank.

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