In my Review of the Economics Society’s Budget Night I mentioned that Professor Neville Norman controversially called for the Reserve Bank’s monetary policy role to be put on hold and the cash rate to be fixed. Such a statement cannot be left without further investigation, and therefore I have interviewed Professor Norman to find out exactly what his reasoning is.
First though, we need to look at what the RBA is trying to achieve by reviewing and adjusting the cash rate on a monthly basis. The aim is to analyse macroeconomic data and use this information to stabilise the business cycle (reduce swings in economic activity in the Australian economy). This is done to avoid the boom and bust cycle where periods of high growth marked by high inflation are followed by recessions, possibly even depressions, bringing with them high unemployment and suffering for citizens. The idea is that as the economy enters boom conditions the RBA lifts interest rates, increasing the cost of money (making loan repayments more expensive), thus reducing business investment and household spending. Conversely, if the economy is slowing down and heading towards recession the RBA drops interest rates, encouraging businesses to borrow and invest and reducing the cost of home loan interest repayments, leaving consumers with extra spending money. For this process to work the RBA has to be highly skilled at reading the economy, including lagged effects from previous fiscal and monetary policy decisions, and demonstrate the ability to accurately forecast changes in the economy so that they can act well in advance.
Professor Norman has undertaken preliminary research, which takes a retrospective look at RBA interest rate decisions to determine how often it gets it right. He looked at 26 quarterly periods from March 2006 through to June 2012, and labelled these periods according to whether or not, and in which direction, the Australian economy had deviated from its normal GDP growth rate (specified as 3% per annum). Professor Norman asserts that econometric evidence shows that, due to lagged policy effects, any attempt to correct the economic cycle needs to be made using forecasts one year in advance otherwise there is simply no point in the RBA being active . Therefore the economic activity four quarters ahead of a given decision was then used to rate the accuracy of the RBA’s monetary policy decisions. Astonishingly his results revealed that the bank only got 4 of its past 26 decisions right, that is, moving rates up when the economy was heading into boom times or moving rates down when a slump was coming. Fourteen of the 26 decisions proved to be wrong, the opposite to what was required, while the remaining 8 decisions were deemed to be ‘OK’ given that they held rates constant when economic activity was reasonably close to trend.
Professor Norman is highlighting the major problem that instead of achieving the RBA’s objective of stabilising the business cycle it can, and often does, end up further destabilising the Australian economy. To illustrate, if the RBA dampens the economy by raising interest rates (because they forecast boom conditions) when in fact the economy is heading into a slump, as was the case during the onset of the GFC at the end of 2007 and the beginning 2008, it will actually reinforce the economic downturn.
My short interview with Professor Norman explores why he believes the better alternative is to fix rates, and what the potential consequences of such a change would be. Enjoy. (Running time 7:52 minutes)