OPINION: Interest rates have to rise. But central banks must ask themselves again if they are targeting the right aspects of inflation for a changing era.
The review of the RBA announced by the Treasurer is a welcome development. Unfortunately, the review is being undertaken when Australia faces difficult economic conditions.
This approach is a normal review process rather than a response to public outcry in the face of major policy shifts and significant global economic shocks. The critical question is whether this should be reversed, but the review does not explicitly cover this issue.The terms of reference address a wide range of issues. However, the most important are: whether inflation-targeting is the best way to achieve the goals of the Reserve Bank Act and the Statement on the Conduct of Monetary Policy; the performance of the RBA in meeting its objectives; the governance of the RBA; and what instruments can be used by the RBA in implementing its mandate.
An inflation-targeting central bank should raise interest rates to reduce excess demand, bringing employment and inflation down to sustainable levels. An alternative approach for central bank mandates, such as targeting a measure of aggregate spending in the economy, is likely to be better at internalising the trade-off between unemployment and inflation. In a country such as Australia, where there are significant terms of trade shocks, nominal GDP is probably not the best target.
The fundamental monetary policy errors made in Australia in 1989 of excessively raising interest rates to target the current account deficit made sense under a fixed exchange rate regime, but had a perverse effect under a floating exchange rate by sucking in capital from overseas and further worsening the current account.The result was a recession Australia didn’t have to have, which caused high economic and social costs.
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