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Macroeconomic frameworks need urgent review

07 May 2020

The COVID-19 crisis has caused a global rethinking of fiscal policy, and Australia must be part of that, Warwick McKibbin, Richard Holden, and John Quiggin write.

The focus on achieving budget surplus and reducing public debt has given way to large targeted fiscal measures aimed at sustaining Australian households and business through the pandemic. With the Australian government able to borrow for three years at 0.25 per cent and for 10 years at 0.85 per cent the interests cost of these measures is small and they lay the foundation for an economic recovery post COVID-19.

As part of a coordinated macroeconomic response, the Reserve Bank of Australia (RBA) cut rates to effectively zero and embarked upon a bond-buying program to keep three-year bond rates at 25 basis points. This is a good start. But, as with fiscal policy, the entire monetary policy framework needs rethinking. This was clear before COVID-19 tested existing macroeconomic frameworks. It is even clearer now.

The current monetary policy regime in Australia is ‘inflation targeting’ – keeping inflation in a band between two and three per cent over the cycle. Inflation targeting served Australia well for a long period from its adoption in the 1990s. It defeated the wage-price spirals of the 1970s and 1980s where the expectations of high inflation caused high wage demands, which in turn led inflation to be high.

The rationale behind inflation targeting by central banks focused on setting stable price expectations for consumers, businesses and markets. The target was set by trading off the costs and benefits of inflation. The RBA put it this way:

“The Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of two to three per cent, on average, over time. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.”

The question that needs urgent attention is: what is the appropriate monetary framework in a post-COVID-19 world?

The world in 2020 is very different to that of the 1990s and 2000s. Well before COVID-19 struck it was clear that many countries, including Australia, were suffering from what Former United States Treasury Secretary Larry Summers—picking up on an old idea due to Alvin Hansen—termed “secular stagnation”.

This is the idea that the so-called ‘equilibrium real interest rate’—the real interest rate consistent with a stable macro economy for countries like Australia—has fallen substantially in recent decades and is now probably negative. This is due to an increasingly large volume of global savings chasing fewer large-dollar investment opportunities. Technological disruption, large demographic shocks, the emergence of large developing countries into the global economy all contributed.

Not surprisingly, Australia has been below the two to three per cent target inflation band for the entirety of Governor Philip Lowe’s term. The inflation target is no longer credible—yet credibility is its raison d’etre.

Inflation has been stubbornly below, rather than above, the target rate in recent years. This was a problem that was not envisaged when inflation targeting was introduced in the 1990s. But it makes the achievement of a sufficiently negative real interest rate impossible.

The nominal interest rate can be pushed a little below zero, as has now happened in many countries, but only to around 0.5 per cent. Combined with inflation below two per cent, the real interest rate cannot go below negative 2.5 per cent.

COVID-19 will only make this worse. Evidence from 15 pandemics dating to 1347 suggests that COVID-19 will put further downward pressure on the equilibrium real interest rate. Depressed economic conditions are also likely to push down the rate of inflation, given constant policy settings.

In light of these considerations, rather than targeting inflation, a better approach would be for central banks, including the RBA, to target some measure of nominal income such as the level or growth rate of nominal GDP. This is still a clear policy rule that can be used to anchor expectations, like inflation targeting, but it has several advantages compared to inflation-targeting.

First, targeting nominal GDP is more robust to imperfect knowledge of the economic environment. A central bank following nominal income-targeting does not need to have real-time knowledge of potential output, whereas an inflation-targeting bank does, and imperfect knowledge can lead to policy errors.

Second, it allows the economy to adapt better to productivity shocks. Consider a fall in productivity (equivalent to a rise in input costs). An inflation-targeting central bank would tighten policy in response to rising inflation. A central bank following a nominal GDP target would combine the rise in inflation with the fall in real GDP and not tighten policy. It might even cut rate if the expected fall in real GDP is larger than the expected rise in inflation. The resulting outcome for the real economy would be better.

Third, in a severe crisis when real interest rates need to fall sharply to stabilise falling output, a nominal GDP target automatically allows expected inflation to rise well above the long-run inflation goal, without damaging policy credibility.

The global economy, including Australia’s, will be transformed after COVID-19. Fiscal policy is already beginning to adjust to that reality. The monetary policy regime that served many countries well, including Australia in the 1990s and 2000s was probably obsolete pre-COVID-19, but it certainly is now. It’s time for central banks including the RBA to use this moment to move decisively to a regime that is more suited to 2020. The core of that regime should be a new monetary framework with a target for nominal income.

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