After reading this Australian article, I looked for the relevant US diplomatic cable, largely because the paper cannot be assumed to quote things accurately or in context. I found something else that worried me though. Here’s two excerpts, with my emphasis.
Although the Board had intended to wait a few months for the new expansionary rate to flow through the economy, [Reserve Bank Assistant Governor for Economics] Edey said the Board agreed that further deterioration in the global economy merited another aggressive cut in February. The Board decided to pause on cuts in March, in part to give the Reserve Bank enough ammunition down the road in case the economy spirals into deeper recession.
Steven Kennedy, Chief Macroeconomic Advisor to PM Kevin Rudd, told us April 1 that he and his Treasury Department colleagues are increasingly frustrated with the RBA. Praising the Bank’s initial response to the global financial crisis, Kennedy said that the RBA’s aggressive approach helped reassure markets and complimented the Government’s stimulus packages. He complained that the RBA is “schizophrenic” in that the Banks simultaneously believes that Australia will be hit hard but that it should hold off on further rate cuts in order to “keep its powder dry” in case things get worse.
This is what disturbs me. I hope it’s just the diplomats projecting a typically American love of guns and thus gun analogies onto others. When it comes to monetary policy “keeping your powder dry” doesn’t make any sense.
Instead lets use a differing analogy of a central banker driving a car along an undulating road. Her task is to keep to a constant speed. In Australia under inflation targeting this speed is 2-3% CPI growth, but it could be steady growth in nominal GDP if you are so inclined. At boom times the car is heading down a hill and goes faster, with higher credit growth and inflation. The banker eases off the throttle. In bad times the car hits a climb and starts to slow, and the banker puts her foot down in order to maintain a constant speed. On any given slope there is an appropriate level of throttle for the desired speed.
Now imagine the car has hit a steep slope. She obviously responds by opening up the throttle. But she is unsure about whether the slope will get steeper still. Should she refrain from pushing the accelerator too much so she can push it harder if the slope does get steeper? Should she be saving accelerator just in case?
That wouldn’t make any sense. If the road gets steeper it won’t matter if she is able to push the pedal down from a higher starting point. If a pedal to the floor can’t make the car go fast enough up the hill, it doesn’t matter how early or late you pushed it there.
Similarly, there is no model I know of that would explain why, with a given macroeconomic climate, a given interest rate would be more stimulative provided it had followed a drop. If things got worse, why would you get better credit growth, consumption and investment by dropping the cash rate from, say, 2% to 1% than you would have seen if it was already 1%. Given the macroeconomic climate, it is either sufficient or it is not – whether people borrow, lend or invest enough at that rate isn’t related to whether it was a big change from last month.
As it turned out all this didn’t matter in 2009, thanks in no small part to a stimulus that remains an astoundingly successful piece of applied macro and its counterpart in China. More monetary easing wasn’t required.
Yet I’m still troubled by this cable. If the cables accurately reflect Edey’s and Kennedy’s words, why would a RBA staff member use the ammunition analogy to describe their method, and why would a government adviser think it was an accurate description of the RBA’s thinking. Recently I suggested that more recent policy decisions made sense under a “least regret” policy suggested by Stevens in 2003. This approach would also call for a policy setting based on uncertainty about the future, but in the circumstances of 2009 it would have meant the direct opposite of the gunpowder analogy’s logic. Lest things get worse it’s much better to drop rates too far than too little as getting into a liquidity trap is far easier than getting out.
It might make no sense, but the idea of higher rates as “more ammunition” is popular amongst media commentators. Some of whom were prepared to credit the RBA with foresight for having higher rates than the North Atlantic central banks . They may as well have credited Howard with foresight with his profligacy – a cunning plan to prod the RBA into higher rates in 2007 so they had ammo stores. If a bad recession had eventuated in 2009 would those same commentators have been assuaged that further cuts mean that the RBA was “doing something” and refrain from criticism?
I really, really hope that the RBA board weren’t allowing a political considerations about media coverage enter considerations of policy. But the papers had already been feral, and the alternative is that they actually believed the silly gunpowder analogy, and that’s more troubling.
Independence is meant to help stop this kind of thing, but it also creates its own kind of politics. At the end of the cable Kennedy is described as believing that the board is worried about not looking independent enough. But choosing policy settings based on whether they look sufficiently distant from elected government is as bad as choosing them to endear oneself the the government. In both cases it divorces the decision from it’s ideal objectives.
In 2009 this turned out not to matter. I hope it doesn’t end up mattering.