Monetary policy settings: hawks, doves and the seat of the pants

By Nicholas Gruen

Thursday September 20, 2018

What’s at stake in monetary policy?

The most obvious answer is “jobs and growth” – to coin a phrase.

The idea is that, by meeting its target of low and steady (2-3%) inflation, the RBA tries also to keep us as close as practicable to full employment. But, as we’ve realised since the GFC, there’s also “financial stability”. And right now they’re in some tension. For years the RBA has been reluctant to cut rates because low-interest rates were what blew the financial bubbles that got us into this GFC problem.

Indeed, there’s been no shortage of people telling us that cutting rates as far as we already have is crazy. But there’s something else at stake. Economic ‘hawks’ and ‘doves’ are performing their respective self-images. All pundits like to think of themselves as evidence-based. Even so, those animal names came from military strategy. Hawks are serious and tough. What they have to say may not be nice, but they’re not afraid to tell us to take our medicine. They’re rigorous chaps.

Doves let in a little more love. Why some of them could even be chapettes (my spell-check suggests “chapattis” but I’ll just let that bit of algorithmic misogyny go through to the keeper). So how much is the debate a psychodrama between hawks and doves, and how much is it a careful weighing of the costs and benefits according to the evidence?

Weighing of the costs and benefits?

I’ve only read those complaining that rates are too low en passant as it were. I’ve not read them closely. So it enables me to propose a test which, in the full glory of my ignorance, has some claims to objectivity. Here’s one commentator quoted by Gene Tunny which prompted me to pose my test:

…the RBA had recklessly underestimated the impact of its 2012 and 2013 rate cuts on house price growth and credit creation, which would precipitate a bubble and the need for unprecedented regulatory constraints on lending…

What I find unsatisfying about this is that it doesn’t paint the story as a dilemma which can only be solved by weighing pros and cons of the alternatives. It suggests that there’s One True Path which, at least in principle, is pretty clear (perhaps the author sketched out the considerations I’m suggesting – I genuinely don’t know, the article is behind a pay-wall).

It seems to me that thinking this thing through needs to consider at least two things, both relating to that old vice of economists which is weighing costs and benefits, but in two different ways.  

First, if higher interest rates now will lower the risk of financial instability later, how much will they lower it, what are the benefits of so doing, and what are the costs?

The one attempt to do this that I’m aware of was by Lars Svensson. In this paper, the former Riksbank Deputy Governor, compared the costs of higher rates– increasing unemployment by around 1.2 percentage points – with its benefits – the marginally smaller likelihood and severity of a possible future downturn. The result? The costs of higher rates outweighed the benefits 200 to one. The Riksbank subsequently reversed policy pioneering negative repo rate – relatively successfully.

Now you can disagree with Svensson’s figuring, but not I think with his basic approach, which is to weigh the costs against benefits. So who’s doing that in the Australian debate? (This is a genuine, not a rhetorical, question by the way.)

“You can object to how low the RBA went – down to 1.5% – but its current policy takes us where I’m talking about. And it seems like a pretty good way to blow bubbles.”

Second, I don’t think the choice is a simple one. Even if we rate financial stability as much more important than maximising short and medium term economic activity, the ‘hawks’ accept, I think that rates should still be relatively ‘accommodating’ as the RBA likes to say – or ‘low’ as they say in the papers. So, erring on the side of higher rates for financial stability’s sake keeps rates low for longer than cutting them more aggressively to get the economy growing again as fast as practicable whereupon they’d be on the ‘up’ and heading towards normality.

This is, in fact, the situation we’re in and to which I’ve been objecting for years. You can object to how low the RBA went – down to 1.5% – but its current policy takes us where I’m talking about. And it seems like a pretty good way to blow bubbles. In what seems like policymaking by improvisation, rather than from the textbook, for about five years or more now, official forecasts have been for inflation not to rise out of its band and for unemployment to rise, flatline or fall far more gradually than it would with more aggressive policy.

So if you’re thinking of borrowing to invest, it looks like rates will stay low for a long time. At first blush this seems more likely to blow bubbles than getting rates down to zero, with a quite substantial exchange rate response, so that we can get them heading up as soon as possible – to keep those borrowing to invest a little more focused on downside risks in a year or two?

My guess is that this more direct and aggressive approach lowers the risk of blowing bubbles. But that’s all it is. My guess. The RBA’s research division is bigger than mine. Have they done any work on this? I don’t think we’ve seen any. Have any of the hawks arguing for higher rates done it or even canvassed this conundrum?

I mentioned this to an RBA board member at the RBA dinner in Melbourne last March. I asked if this question had ever been raised on the board. They said no, but that it was the best question they’d heard in a year or so.

What concerns me here is not that the bank might be wrong, but that the bank in its public accounting for its decisions and its publication of research papers doesn’t seem to be leading this discussion or trying to really structure that discussion so that we can have the best chance possible of getting to the right answer. It’s all much more by the seat of the pants.[1]

Temperamental, not evidence-based

My conclusion is that the choices we’re making are temperamental – not evidence-based. You have hawks who think we shouldn’t have cut as much as we have. You have textbook fuddy-dovvies like me who think we should cut as aggressively as we can to get back on a strong growth path both to maximise jobs and growth and minimise the risk of financial bubble blowing. And you’ve got the RBA sitting on the fence, with the seat of its pants doing double-time.

Oh and here’s one more test of whether what we’re seeing is reasoning by weighing the evidence or reasoning by temperamental leanings.

If people really are concerned about the prospect of bubbles, wouldn’t this also lead them to be arguing for more expansive fiscal policy so we can get this risky period of low-interest rates behind us and nip any bubbles in the bud as soon as we can – as well as returning the budget to surplus once we’ve restored the economy closer to capacity? Well fancy that? ‘Hawks’ on monetary policy seem to be ‘hawks’ on fiscal policy and likewise with doves.

If I’m right what a pity it all is that the debate about monetary policy owes more to psychodrama than careful thinking and weighing of the evidence. You could say the same for the rolling disaster of economic reform I recently lamented in all those areas where it’s difficult to weigh the evidence – all those areas pervaded by market failure in which we decided nevertheless that policies that were more ‘market-oriented’ were best.

[Footnote 1]: I refer to it as policy making by the seat of the pants not because I think one should never improvise – we’re deeply ignorant of what the right thing to do is, so that will call for lots of improvisation. The problem here is that the RBA’s public justification and analysis of its own conduct agonises about, but doesn’t clearly articulate the issues and the trade-offs that are being made. When I put my argument for erring on the side of aggressive easing to a member of the RBA Board at an informal gathering a year or so ago in the form of a question, they said to me that it was the best question anyone had asked on the subject – and confirmed on further questioning that it had not been elaborated for discussion in any board meeting.

This article was first published on Club Troppo.

Postscript: Since this article was first published, I received an update on relevant research from specialists in the area.

The IMF (2015), ‘Monetary Policy and Financial Stability’, Staff Report:

“The question is whether monetary policy should be altered to contain financial stability risks. Should it lend a hand by temporarily raising interest rates more than warranted by price and output stability objectives? Keeping rates persistently higher is also possible, but more costly. Based on our current knowledge, and in present circumstances, the answer is generally no.”

Gorea D, Kryvtsov O and Takamura T (2016), ‘Leaning Within a Flexible Inflation Targeting Framework: Review of Costs and Benefits’, Bank of Canada Staff Discussion Paper 2016-17:

“Overall, the estimated benefits of a leaning adjustment tend to be smaller than its social losses.”

Pescatori A and S Laséen (2016), ‘Financial Stability and Interest-Rate Policy: A Quantitative Assessment of Costs and Benefits’, IMF Working Paper:

“Should monetary policy use its short-term policy rate to stabilize the growth in household credit and housing prices with the aim of promoting financial stability? We ask this question for the case of Canada. We find that to a first approximation, the answer is no — especially when the economy is slowing down”

Ajello A, T Laubach, D López-Salido, and T Nakata (2016), ‘Financial Stability and Optimal Interest-Rate Policy’, Working Paper, Federal Reserve Board:

“We have analyzed how the central bank should respond in normal times to financial imbalances in a stylized model of financial crises. For the version of the model that is calibrated to match the historical correlation of credit booms and financial crises in advanced economies, we find that the optimal increase in the policy rate due to financial imbalances is negligible.”

These reach similar conclusions to Svensson.

Overviews/summaries of the research include the following:

The FOMC (2016, pp. 2-3):

“The staff presented several briefings on a special topic, the relationship between monetary policy and financial stability… Most participants judged that the benefits of using monetary policy to address threats to financial stability would typically be outweighed by the costs associated with deviations from the Committee’s employment and price-stability objectives induced by such actions; some also noted that the benefits are highly uncertain.”

Bernanke B (2015), ‘Should monetary policy take into account risks to financial stability?’, Blog post, April 7, 2015:

“Again, the bottom line is that large increases in the short-term rate based on financial stability considerations alone would involve costs that well exceed the benefits”

Vítor Constâncio (ECB Vice-President) (2018):

“monetary policy should not respond to financial stability concerns” 

Franklin Allen, Charles Bean and José De Gregorio (Independent Review of BIS Research; 2016, pp19, 24):

“It has been mainly researchers outside the BIS who have sought to quantify the costs and benefits, e.g.: Ajello et al. (2015); Gourio et al. (2016); and Svensson (2016). Moreover, that body of work generally suggests the cost-benefit calculus is rather unfavourable to LAW unless the costs of financial crises are really very large indeed.”

For a relevant case study, see Financial Times:

“Tactic of ‘lean against the wind’ has failed Sweden; The Riksbank erred when it tightened policy to fight a housing bubble”

The BIS and the RBA seem to disagree with these views, though, to my knowledge, they’ve not released any serious analysis supporting those views.

About the author
Inline Feedbacks
View all comments

The essential resource for effective
public sector professionals