August 2023

Essays

Brute Reserve: The wrong time to restrict the influence of the RBA

By Claire Connelly
Governor of the Reserve Bank of Australia Philip Lowe, Sydney, March 8, 2023

Governor of the Reserve Bank of Australia Philip Lowe, Sydney, March 8, 2023. © Bianca De Marchi / AAP Images

As central banks around the world assume greater responsibility for economic policy settings, especially in the face of climate change pressures, the RBA is being reduced to an inflation-buster

During the Covid crisis, central banks around the world – including the Reserve Bank of Australia (RBA) – worked collaboratively with their respective governments to take care of people through a range of different methods, ranging from mortgage and rent freezes and fiscal stimulus, to quantitative easing and the buying up of dodgy debt to take it off the books of the finance sector and prevent bank failures, business bankruptcies, and collapses in employment and spending.

Since the “end” of the crisis, many leading central banks, such as the United States Federal Reserve, the Bank of England and the European Central Bank, have devoted considerable time and resources to reassessing the role they play in economic policymaking, particularly as it relates to climate change. But where these bodies are moving towards assuming greater responsibility for economic policy settings, Australia seems to have taken the opposite approach, with the federal government waving through the findings of a review into the RBA that wants to curtail the influence of central banking on the Australian economy. Still, the outgoing RBA governor, Philip Lowe, announced in July that the bank would defer several of the major reforms proposed by the government-commissioned independent review until next year, first allowing Treasurer Jim Chalmers to make a decision about the end of his tenure.

Chalmers announced Lowe’s deputy, Michele Bullock, will become governor on September 18, and Bullock said she was “committed” to implementing the review recommendations while offering a “fresh perspective”. Lowe also flagged that in future the RBA board would meet only eight times a year, not 11, which ABC journalist Matt Bevan aptly described as “Working neither smart nor hard”. As recently as November 2022, Bullock had defended the RBA’s 11 annual board meetings, acknowledging that while it was “quite unusual” among central banks globally, it was a “particular advantage in uncertain times”, allowing for faster and more frequent evaluation of evidence “and recalibration if necessary”. Alternatively, she said, “we can achieve a similar rise in interest rates with smaller increments”.

Lowe delivered a bizarre spectacle in Senate estimates last month. In the space of three years, the focus has gone from inventing new ways of keeping people safe and out of poverty, to blaming inflation and rising rental prices on people’s unwillingness to take on flatmates, in the wake of a global pandemic no less. Lowe further noted in the RBA’s June statement that the “substantial slowing in household spending” has been uneven. “[S]ome households have substantial savings buffers, although others are experiencing a painful squeeze on their finances,” he said, a tacit admission that the distribution of wealth is now so uneven that interest rate rises are targeting the wrong people. Apparently the RBA is comfortable punishing the financially vulnerable while its rate rises are still barely touching the sides for people who share a disproportionate volume of the country’s wealth. It was curious behaviour from a central bank whose governor acknowledged back in November that interest rates are not especially effective at reducing inflation when they are being driven by supply-side factors.

In addition to recommending splitting the RBA into separate monetary and operational boards, the review criticised the central bank for controlling inflation via an analysis of the housing market, and for trying to drive up wages during the pandemic when it was still under-hitting its inflation target of 2 per cent, politely suggesting both practices be knocked off in the future. (This was before the RBA began its campaign to drive wages down via 12 consecutive interest rate hikes in 14 months, having waited several years too long to begin raising them after the 2008 global financial crisis – an issue the review has less problem with. High wages: bad. Low wages: good. Go figure.)

“The review makes clear that the RBA has only two goals: employment and inflation,” Macquarie University economist Ben Spies-Butcher says. “And then, we’re going to continue to define employment partly in terms of inflation.” He is referring to the premise known as the non-accelerating inflation rate of unemployment (NAIRU), which claims if unemployment falls too far it will push up inflation. It is a hotly contested concept because it’s difficult to estimate. The NAIRU suggests some unemployment is acceptable – a buffer stock of people left out of work – while proposing a stricter limit on inflation.

In addition, the review proposes removing the government’s power of veto over RBA decisions, further preventing the bank from responding in collaborative and coordinated ways with fiscal and regulatory policy. It also backs the government even further into a corner, discouraging it from enacting any policy that would tempt the wrath of the RBA to pass another rate rise. Additionally, it would remove the power of the RBA to direct bank lending, arguing that this was a power that existed prior to macroprudential regulation being shifted to the Australian Prudential Regulation Authority. In reality, this has long been a lever in the central bank’s policy toolbox, albeit one that has laid dormant for more than two decades.

Currently, one of the RBA goals is about promoting economic welfare of Australians, but it doesn’t explicitly mention future generations. To the credit of the review, it proposes making this explicit, albeit shifting that goal to an overarching purpose, rather than one of three specific goals. That constitutes “a downgrading, in my opinion,” says University of Sydney political economist Gareth Bryant. “It is currently still within the RBA’s remit to influence the allocation of credit in the economy,” Bryant says, “but it is this power the review recommends be officially removed from its governing documents, reducing the macroeconomic management tools at its disposal, leaving interest rates as its primary policy lever.”

Even more concerningly, Bryant says, those tools could be used to influence the allocation of credit in terms of climate concerns within the economy, to shift bank lending towards more green lending and away from fossil-fuel lending. “There is a strong case for the RBA to play a more active role in facilitating the decarbonisation and green transformation of the Australian economy.”

That’s right – climate change can be inflationary, if doing the right thing weren’t already reason enough to act. It can compound supply-chain crunches during times of prolonged drought or extreme weather events and shift agricultural patterns, impacting global trade and labour productivity. Transition risk – that is, managing decarbonisation adaptation in the economy – also brings inflationary potential, requiring significant investment to address workforce issues and the phasing-out of some existing productive infrastructure.

Analysis from the European Central Bank shows that the inflationary impact of climate change provides “strong incentive” for climate-change action to reduce and mitigate emissions. In forecasts up to 2035, it predicts food inflation of about 1 to 3 per cent every year. This isn’t just a future scenario; it’s already happening. The analysis shows that the heatwave that swept Europe last year (killing 61,000 people) increased food inflation on the continent by almost a full percentage point, and that increased frequency of chaotic temperature anomalies brings with it more short-term rapid price rises. The ECB warns that the impact of average warming and extreme weather conditions will increase considerably by 2060, “approximately doubling in comparison to 2035, if future emissions are not mitigated”.

A pessimistic scenario would see headline inflation impacts exceeding 4 percentage points per year across large parts of the world. And that’s before accounting for damage to infrastructure and production caused by tropical cyclones, sea-level rise and other extreme weather patterns. “Our assessment does not explicitly account for their effects and therefore likely underestimates the possible future inflationary impacts of climate change in this regard,” the analysis reads.

Yet, at a time when central banks around the world are beginning to recognise that adopting a “market neutral” position on climate change has the unintended consequence of supporting the fossil-fuel economy, with the RBA review, Australia’s central bank has effectively taken the opposite position.

The review states that the role of the RBA is much more narrow, concerned primarily with targeting inflation, and that issues such as climate change are best left to elected governments and fiscal policy. “[This] recommendation is coming at the wrong time,” Bryant says, “just when we’re starting to see central banks start to look towards what tools they have to manage climate risk. And now we’re potentially seeing a removal of one of those tools.”

And while Australian households are already feeling the pain, around 880,000 households are facing further financial pressure as they approach the “mortgage cliff”. Fixed-rate loans are due to expire this year, shifting from the rock-bottom interest rates that they borrowed at, to the variable rate dictated by the RBA, increasing repayments on the average mortgage by around $2000 a month. Australian households are more vulnerable to the impact of interest-rate payments than people in other developed countries because banks in Australia do not offer 30-year fixed rate home loans as they do in the United States, for example. So, while the US Federal Reserve may have recently increased interest rates even more dramatically than the RBA, those rates have a more direct impact on business and investment borrowing than they do on household income, by virtue of the fact that many mortgage holders are protected from rate rises by their fixed-rate home loans.


One of the big problems with both the independent review of the RBA, and the broader orthodoxy that governs both monetary and fiscal policy, is that we’re sort of not allowed to talk about the distributional consequences – or even causes – of inflation: that is, the different ways inflation affects, or is affected by, different sectors of the economy.

Analysis from organisations as radical as the Organisation for Economic Co-operation and Development, the International Monetary Fund and the Bank for International Settlements has demonstrated that corporate profits have contributed more to inflation than wages and other employee costs. The OECD’s research on Australia, in particular, contradicts the official view of the Reserve Bank and federal Treasury. It also stands in contrast to research by The Australia Institute’s Centre for Future Work, which demonstrates that rising profits, not wages, are driving the inflationary spike the RBA failed to predict.

Perhaps coincidentally, in mid July Treasury released a report to the Australian Financial Review under freedom of information claiming that decade-high pay rises will become the main driver of inflation, slowing the economy and lowering profit margins. Not “has become”. Not “is”. Will become. Yet, in reality, what this means is not that wages are inflationary, but that Australians lost 6 per cent of their purchasing power (that is, 6 per cent of their living standards), thanks to the profit-led inflationary surge during the pandemic, and now they want it back. It is entirely possible that in the course of catching up, an increase in wages will come to constitute, at that moment, more of the inflation that is occurring, but that doesn’t mean wages caused the whole problem. What it means is that wages have been slow to keep up with inflation.

“If the RBA response is to prevent wages from keeping up with inflation by raising interest rates, then what the RBA is saying is that the loss in real wages that resulted from that initial profit-led inflationary surge will be permanent,” says Jim Stanford, director of the Centre for Future Work. “And Australian workers will just have to suck it up and accept that they’re going to be 6 per cent poorer forever. That’s the alternative.” The only way to repair the damage inflicted on workers by the pandemic is for wages to grow faster than both prices and profits. “That does not mean that wages cause inflation. It means that we’re into the second chapter of this whole episode,” Stanford says.

In fact, in its February statement, the RBA acknowledged that supply shocks, rather than demand, have accounted for at least half the increase in inflation, including the war in Ukraine, pandemic-related supply-chain disruptions, and domestic supply restrictions resulting from extreme weather conditions. But in its own more complex in-house structural model of the economy that traces the propagation of price changes between sectors, the RBA finds that supply shocks account for three quarters of the recent inflation.

Additionally, the RBA’s own research, released in May under a freedom of information request, found that the impact of interest rates on inflation under three different scenarios was negligible, and that there was no need to continue increasing rates to further reduce inflation. Despite this, the RBA board still increased rates to 3.6 per cent in April and again in May to 3.85 per cent, and by a further 25 basis points in June. And while the RBA kept rates on hold at 4.1 per cent in July, still the highest level in 11 years, Governor Lowe has at times been bullish over the prospect of future rate rises, while at other times been more equivocal. His deputy and successor, Michele Bullock, has similarly hedged on rates. Last year, during her address to the Economic Society of Australia in Brisbane, Bullock recognised the unequal distribution of interest rate pain among Australian households, stating that it revealed the mounting “financial vulnerabilities” in the economy. However, in a speech delivered in Newcastle in June, she defended the necessity of temporary job losses to achieve the inflation target while at the same time signalled the RBA’s greater willingness, compared to other countries, to adopt a more gradual approach.

Under the RBA research’s most dramatic scenario, unemployment rises rapidly to 4.5 per cent, and in the other scenarios it rises slowly before reaching 4.5 per cent. “It almost seems like they’re not so much targeting inflation, they’re targeting unemployment,” says Greg Jericho, policy director at the Centre for Future Work. “They believe that the unemployment rate of 4.5 per cent is what we need to have to have steady inflation. That’s pretty much underlying all their thinking.”

In fact, Bullock recently stated that the RBA has an explicit goal of increasing unemployment to 4.5 per cent over the next 18 months in order to reduce inflation to the bank’s target band of 2 to 3 per cent. That means another 138,000 people would need to join the unemployment line, in addition to the already 515,900 Australians currently out of work, according to the latest ABS figures, while at the same time the government and opposition are claiming that the best form of welfare is a job.

“If you are going to use the NAIRU as a matter of public policy,” says Jericho, “despite the fact that it constantly moves and yet apparently is something that can be targeted, then it behoves us to treat the casualties of inflation targeting with dignity and actually give them enough money to survive while they are in a sense being unemployed for the good of the country.”


Economic historian Michael Beggs, at the University of Sydney, says that since the 1990s the RBA has been used to depoliticise macroeconomic policy and treat inflation as a purely technocratic problem. “The RBA has been constructed to … control inflation and find the level of unemployment compatible with that,” Beggs says. “I don’t think you can solve the problem of inflation that we’ve seen the last couple of years simply by having the RBA alone do something differently. What’s missing is a broader policy framework, recognising the distributional consequences both of inflation and of how we control inflation. Everybody knows there is distributional stuff going on here, but there is no way to solve those problems with monetary policy alone.”

Ben Spies-Butcher says much of the RBA review can be read as orthodox economists trying to push the central bank back into its box, having started to play a bigger role in economic management during the pandemic.

“From what I understand, this is one of the few economic crises in capitalist history where the stimulus packages didn’t just stop the poor getting particularly badly hit, they actually made the poor better off in many countries,” Spies-Butcher says. “Poverty reduced – that’s almost never happened before. Usually, this stuff is just about mitigating bad things, it doesn’t actually make things better. There seems to be a coordinated response across government and the RBA, an attempt to re-normalise expectations that it can’t normally do that, and that policy should prioritise inflation. The fact that we kept almost everyone out of poverty and housed everyone… we need to make clear that is not something that can normally happen, and re-establish austerity as a dominant approach.”

Spies-Butcher says that a lot of the Covid packages around the world were a means of bailing out Wall Street via Main Street, a response to the backlash against austerity following the 2008 global financial crisis. “Preventing mortgage defaults and keeping everyone in their houses still serves the liquidity purpose for the finance sector. That was happening everywhere, because the traditional tools weren’t working, largely because the austerity narrative had been so effective at convincing politicians they couldn’t use fiscal policies.”

Jim Stanford says the experience of the pandemic, and the quantitative easing that the RBA pursued for a brief time, showed that the power of credit can be used by public institutions to pursue public goals – rather than being monopolised by private banks, which create money out of thin air every day. “That let the genie out of the bottle,” Stanford says. “But now we are seeing the fast reassertion of monetary orthodoxy, with the RBA dusting off its very austere hymn book.”

There is a strong argument for adjusting the tools of economic policy, be it monetary, fiscal or regulatory, Spies-Butcher says, to fit the kind of economy we have. “That’s particularly the case when the relationship between wages and inflation that most of these tools are predicated on has clearly broken down. They are based on the fact that wages are supposed to be the main driver of inflation. Most of the economic models almost just build that into their assumptions, which is somewhat beside the point when key economic challenges, like asset price inflation [house prices] and climate are completely ignored. Wage growth is not a threat; rising asset prices and the need for rapid decarbonisation are, but they’re left out.”

So, what can be done to address inflation without punishing workers, the unemployed or mortgage holders? Well, scrapping the “Stage Three” tax cuts, primed to deliver $184 billion in taxation relief to some of Australia’s top earners, would certainly be deflationary. Other options include an increase to superannuation payments and price caps, or controls on things such as rents, energy, resources and consumer goods, coupled with competition policy to prevent profit gouging and encouraging greater redistribution. You could also scrap negative gearing on investment properties.

Australia is one of the few industrial countries not to have a rent control system to limit the power of landlords to soak tenants when market conditions allow them to do so. While price caps or regulation may seem like a radical idea, they could actually be quite helpful. We know that because we’ve already seen them in action. For example, the Australian government’s Energy Bill Relief Fund, which provides about $3 billion in electricity subsidies to some five million households, and the temporary price caps on wholesale gas, and working with the states to cap the price of coal used for electricity generation – together, these measures are expected to reduce inflation by 0.75 per cent. In September 2022, Western Australia had the cheapest energy in the OECD, as the Ukraine war and shortages caused energy prices to soar globally, thanks to its long-regulated controls on gas and electricity prices. “We also saw it happen during the pandemic with free childcare,” notes Greg Jericho. “If you look at the CPI figures, childcare went essentially to zero and it had a significant drag on inflation.”

University of Sydney economist Graham White says that only pricing and incomes policy can fight inflation, by addressing the uneven distribution of productivity gains of the past 30 years – if policymakers want to avoid a wage–price spiral taking hold while not forcefully slowing down the economy. “It’s about trying to take the stuffing out of inflation,” White says. “A mechanism for sharing productivity gains in a way that satisfies both wage earners and business owners – workers and employers – discourages either from trying to assert their will over one another, bargaining for higher wages, potentially resulting in higher prices.”

Given that inflation is already falling sharply (down to 5.6 per cent over the 12 months to May, from 6.8 per cent in April), there is no reason government can’t take price cap or regulation measures to reduce it further, without inflicting further pain on households.

But to adequately attack inflation via a pricing and incomes policy, monetary and fiscal policy cannot be inconsistent with each other or else it undercuts the entire purpose of the exercise. “Monetary policy and fiscal policy must be consistent with the goals of an incomes policy,” White says. “The three have to be consistent with one another, which is stating the blindingly obvious. But what is obvious and what’s economics is not necessarily the same thing.”

In this, the notion of a so-called independent bank then becomes rather awkward. If the review has its way, the RBA, the Australian Prudential Regulation Authority and the government will be further discouraged from talking to each other, and the central bank will be shown even further deference by governments and regulators discouraged from spending or making changes to lending standards. In blunt terms: policymakers and the public will forever be looking over their shoulder for the grim reaper that is the RBA coming to destroy livelihoods by hiking rates. The RBA is fast becoming a tool of policy paralysis.

In isolating our policy bodies from one another under the banner of independence, White says we have a “recipe for disaster”, not to mention a set-up that’s democratically problematic. “This is macro policy. It’s the province of the government of the day, warts and all, and it’s their responsibility. We elect politicians, they have the power, and we expect governments to take responsibility for the decisions at the end of the day. Not just fiscal policy, but also monetary policy.”

Nobody elected Lowe or the board. Most people couldn’t even tell you who these people are, these technocrats whose decisions our livelihoods and wellbeing depend upon. People are living in cars. We deserve to know the names of the people who helped put them there. And if we can’t have that, then the least they can do is work with the people we did elect to best serve our interests.


Given Australia is on the precipice of recession, our policymaking bodies should be pulling out all the stops to prevent that from happening. But it’s difficult to shake the feeling that they’re not working that hard to prevent it.

The RBA’s own research predicts that there is a 50 to 80 per cent chance of Australia falling into a recession, a period where the real output of the economy shrinks for two or more quarters in a row. Australia has never reduced the inflation rate so quickly and so rapidly – in this case from 7.5 per cent to 2.5 per cent – without a recession. On the other hand, it hasn’t happened yet.

“I hope that we don’t have one, because recessions destroy lives,” Stanford says. “Recessions have cascading effects. Output shrinks, causing businesses to lay off workers who in turn have to spend less to control their costs, causing a further slowdown in economic activity. Thousands of people will lose their jobs, many will lose their homes in the process.”

At least the last time Australia had a recession – the one “we had to have”, under Paul Keating – it came with buffers in place such as the social wage negotiated by the Prices and Incomes Accord. There are few such prospects on the horizon today. “After 30 years of inflation targeting and so-called independent central banks, workers are going to get nothing,” Stanford says. “It is absolutely clear. We’ll probably have a recession to get inflation back to 2.5 per cent. Workers will continue to see their share of the economic pie shrink. And employers and financiers will continue to have the power. That is the whole point of this system. There is no trade-off here.”

Yet the RBA continues to treat cost-passing and profit-seeking as neutral and passive, while treating wages and higher domestic costs as a potential inflation threat.

Prior to the release of the review findings, in its February statement the RBA highlighted that “firms have generally passed on higher costs to maintain their profit margins, and that aggregate inflation has been driven by the balances of demand and supply factors, rather than changes in firms pricing power”. Michael Beggs says that is basically a double standard. “Workers and households have not been able to pass on higher costs, and if they did that would be considered feeding a wage–price spiral,” he says. “But businesses are let off the hook. They’re seen as passive participants in the process, because they’re simply passing on higher costs to maintain their profit margins.”

Beggs says that in fact it’s really difficult to disentangle supply and demand factors for the very reason that inflation is – or should be seen to be – a distributional phenomenon. “Costs rise, and whoever is paying those costs hopes to be able to recover it by passing them on to the next person. So, the question then becomes, who is able to pass on their increases in costs and who is not? So far, firms – on average – have maintained their margins. But real wages have not kept up.

“If the RBA is right, that it doesn’t have power to counteract supply-side factors, then its role as it sees it is to dampen the further propagation of those shocks and hope that those shocks go away.”

There are signs that this has happened. Consumer price inflation has come back down slightly on a year-ended basis, but it’s too soon to tell. The RBA hopes that inflation has peaked and predicts that it should return to the target range by the middle of 2025.

But the big question remains: what if it’s wrong?

It seems as though the major supply shocks are over for now. If we’re lucky, we’ll soon see a return to normality, in which case workers might be prepared to take the hit to wages and loss of disposable income. But what if our luck runs out, and we face further supply shocks? It’s certainly a possibility. The Ukraine war could intensify, driving petrol prices back up. There could be another severe Covid variant, or a climate event that affects supply-chain distribution.

“One of the lessons of politics over the last little while is that the political consensus backing a technocratic solution can be lost,” says Beggs. “People won’t take the hit to living standards or their income past a certain point. It would be good for economists, technocrats and politicians who do believe in the current regime to actually take that seriously. Because if they don’t, and the distributional aspects of inflation get worse, and people react against the monetary policy regime, it’s not necessarily going to be in a way that the technocrats are happy with, obviously.”

Even if it can’t properly deal with the causes of inflation, the government, with the RBA’s aid or not, can still use policy to address the distributional effects. But finding an alternative way to deal with causes is a much trickier problem because of the perception that there are no credible alternatives on offer.

As Travers McLeod, chief executive of the Brotherhood of St Laurence, noted in his address at an event with Treasurer Chalmers in July, one in eight Australians is living in poverty, despite the country being the “richest land on the planet” with among the highest median wealth per capita. “The rest of this decade will make or break Australia,” McLeod said, calling for the government to be bold in its compassion for the people it serves.

But given that Chalmers plans to bank the surprise $19 billion surplus instead of using it to raise the rate of welfare payments such as JobSeeker, as recommended by the robodebt royal commission, its own Economic Inclusion Advisory Committee and countless others, the future’s looking bleak. Neither the RBA nor Treasury seem up to the task of addressing the profit-driven inflation that is wrecking Australia’s economy and the millions of households impacted by their policy paralysis. With Chalmers’ “hard heads, warm hearts” strategy, Australians are being left out in the cold.

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