A close inspection of RBA decisions on interest rates since 2006 raises the question, has the RBA really helped?  By Professor Neville Norman.

Each month there is a circus of guesswork about the Reserve Bank’s own guesswork on where the economy is going and where it needs to put interest rates.  Two questions need to be asked: Is this guesswork activity about the Bank worth it? And is the Bank helping to stabilise or otherwise improve the Australia economy?

The theory is that the Bank reads the economy and shifts interest rates to reduce the swings in real activity in the Australian economy. As we approach boom conditions, rates are increased to cool off business and household rate-sensitive spending; as a slump is looming, rates are cut to encourage such spending. For this theory to work, the Bank needs good knowledge of the effects of its actions, including lags, good forecasts of where we the real economy is going, and a skill in getting rates moved well in advance of real activity movements.

What if we examine the RBA’s track record on this and look back, to see what actually happened to us. Let’s take the period from early 2006 before the apparent onset of the global financial crisis to the present day.

We can take around 3% p.a. as a core (real GDP) growth rate for ‘normal times’ and chart the booms and slumps as deviations from this norm.  We brand any growth under 2% as a slump and positives over 4% point as boom, smaller positives being styled ‘normal’. The “lag zone” looks a year ahead, to make allowance for the longish lags before changes in monetary policy take effect.

Milton Friedman observed that changes in monetary policy have long and variable lag times, from six months to sometimes over two years. Australia's relatively high interest rates have made the dollar popular with currency traders.

The test for correct active short-term interest-rate management is to move rates up in a coming boom, down in a slump. Holding rates in a neutral activity requirement closer to trend growth gets an “OK” score.

Doing this we find that the RBA made 8 OK decisions for the 26 quarters considered, from March quarter 2006 just before the GFC arose; they made just 4 right actions, but importantly they made 14 incorrect actions with rate movements going in the wrong direction, making booms and slumps bigger than they would otherwise have been. By contrast a standard 4.5% cash rate throughout would have been less destabilising and saved a great deal of time and speculation.

On this analysis, the Bank should leave the area of short-term forecasting and reversible rate adjustments, the media could then stop running beauty contests of rate-speculating economists, and the government could engage in more regular fiscal sightings and actions, using the long-established research finding that impacts from fiscal changes are far faster than interest-rate impacts.

Let the Bank and others direct their undoubted research expertise to making its own investigation of its own success rates, a task which none of 114 RBA research papers since 2001 has seemingly ever directly addressed.

This opinion piece by Professor Neville Norman, appeared in the Australian Financial Review on the 6th June