Analysis: RBA and Its Evolving Forward Guidance

• Published on
• 15 Oct 2020, 05:28 PM

By Sophia Rodrigues

(This exclusive analysis was first published on October 15 as a paid copy; it is now being made freely available)

The Reserve Bank of Australia is making a significant change in the way it operates monetary policy, and it suggests that not only will policy stay easy for longer but also its preparedness to utilize all available tools to achieve policy goals.

The shift is similar to Federal Reserve’s recent monetary policy review, with both central banks prepared to tolerate inflation above target band and employment above full employment level.

It essentially means the most important goal of monetary policy is jobs because only through that can central banks hope to drive up inflation in a post-pandemic world.

That was the highlight of Governor Philip Lowe’s speech on Thursday. Lowe was speaking at a Citigroup investment conference in Sydney on the topic, “The Recovery from a Very Uneven Recession.”

Lowe communicated the shift through his explanation on the RBA’s evolving forward guidance.

ACTUAL INFLATION, TIGHT LABOR MARKET

In the speech, Lowe referred to a change in the forward guidance that will result in RBA placing greater weight on actual, not forecast, inflation in its decision-making.

At the same time, there will be increased emphasis on jobs, and it will no longer be “progress towards full employment” or even “full employment.”

The emphasis will be on “tight employment” because only tight labor market conditions would ensure inflation is consistent with the target on a sustainable basis.

In the speech Governor Lowe repeated what the RBA said in the October monetary policy decision statement. “The Board views the high rate of unemployment as an important national priority.”

This means the focus of monetary policy is on ensuring people have jobs because only when more people have jobs, the labor market would become tight enough to cause inflation to rise to the target band.

The RBA would keep monetary policy easy not just until it sees progress towards full employment and not even until it reaches full employment, but until labor market becomes tight.

FULL EMPLOYMENT VS TIGHT LABOR MARKET

The difference between full employment and tight labor market is subtle but important. Full employment is an estimate and while it is well-understood the estimate could change as we move towards that level, there is a tendency to treat it as a goal.

A tight labor market, on the other hand, acknowledges that full employment is a real-time number, and will not be known until it is reached. So, the pursuit of a tight labor market goal can mean employment can breach what was previously understood as a full employment level.

Fed chairman Jerome Powell expressed this perfectly in his speech on August 27.

“Our revised statement says that our policy decision will be informed by our "assessments of the shortfalls of employment from its maximum level" rather than by "deviations from its maximum level" as in our previous statement,” Powell said.

“The change to "shortfalls" clarifies that, going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals,” he added.

INFLATION OVERSHOOTING

An increased emphasis on actual inflation is also an important change because it means for the first time the RBA is open to the possibility of inflation overshooting its target band.

Lowe said the RBA “will not be increasing the cash rate until actual inflation is sustainably within the target range. It is not enough for inflation to be forecast to be in the target range.”

Because monetary policy operates with a lag, waiting until inflation is within the target range means there’s a risk that it would overshoot.

But this is an outcome the RBA is prepared to accept because its ultimate focus is labor market and because it knows inflation is unlikely sustainably to rise until labor market tightens.

GETTING OUT OF LOW INFLATION TRAP

The evolution of the RBA’s forward guidance is a result of recent years of low average inflation, and the worry that it would remain low for longer in a post-pandemic world.

Lowe said that a longer term question the RBA is considering is how that inflation targeting framework is sitting in the current world and how it would become difficult to achieve average inflation target in the post-pandemic world.

“As it becomes more difficult to control inflation in a range, we will have to evolve how we operate monetary policy and the evolution of our forward guidance is part of the broader evolution that I expect over time to see more.”

Lowe stressed that the change in forward guidance does not change the RBA’s broad focus which is on price stability, full employment, and welfare of the Australian people.

--Contact: Sophia@centralbankintel.com