Monetary policy and the third way

The guiding mission of the Reserve Bank is highlighted in its charter below:

It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank ... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:

• the stability of the currency of Australia;
• the maintenance of full employment in Australia; and
• the economic prosperity and welfare of the people of Australia.

Unfortunately neoclassical orthodoxy has meant that the only tool the reserve uses is the price of money or interest rate changes to achieve these goals.

Thus the reserve bank is in a perpetual balancing act between fighting inflation and maintaining full employment and has restricted itself to using one lever.

This is an important aspect when considering the debate occurring within central banks worldwide as to whether monetary policy should be used to intervene in the economy when asset bubbles arise.

There are two alternative views: first, that it is too difficult to determine when an asset bubble is occurring therefore the central banks should not attempt to intervene in the economy but be prepared to instigate loose monetary policy to enable quick recovery. The alternative view is that preventative action is better than trying to kick start the economy after a sector has collapsed.

The first view was the strategy used by Alan Greenspan and the Federal Reserve after the dotcom boom, it was also the strategy used in Japan in response to the collapse of the commercial property asset bubble. Many economic commentators view the loose economic policy (low interest rates) after the dotcom boom and the 9-11 attacks has being central in the misallocation of risk in the recent Great Financial Crisis.

The second view is that if an asset bubble emerges that central banking authorities should take action by increasing the cost of money (raising interest rates) to return that market to more rational position. The difficulty in that proposition is that raising interest rates to correct a market outcome in one sector can have consequences in other sectors. If there was an asset bubble occurring in the residential property sector, raising interest rates to reduce speculative investments in that sector will also deter investment in other sectors like manufacturing or agricultural sectors. This will bring the Reserve Bank into conflict with its charter to promote full employment.

Additionally raising interest rates will have other consequences it can lead to capital inflows if the differential in interest rates becomes attractive to foreign investors. Often this inflow can be into the sector with the asset bubble thus causing greater asset inflation hampering the monetary authority’s efforts at controlling the asset bubble. Another consequence is the higher interest rate differential can lead to currency appreciation, particularly if this attracts capital inflows. The currency appreciation typically hampers manufacturing and agricultural exporters who have already been disadvantaged by the higher cost of debt financing.

It should not be a surprise to note the Anglo-American neoclassical economies have seen declines in their manufacturing sectors when the monetary policy is solely utilising the price of money as the only monetary tool. The abandonment of quantitative controls has meant that policy options within the monetary framework are limited.

But there is a third way. That is recognising that by using quantitative controls of money that central banks can take a precautionary stance to reduce the formation of asset bubbles in particular sectors without flow-on effects to other sectors or trading off the charter goal of full employment.

Essentially the Reserve Bank can change the ratio of reserves that licensed banks are required to keep with the Reserve. This can be arranged in an arrangement of a general ratio or specific ratios for each sector. For example there can be a ratio for owner/occupier residential loans, commercial loans, margin loans, credit cards, agriculture businesses, manufacturing and so on.