Australia: Selected Issues

Abstract

Australia: Selected Issues

Inflation Targeting in Australia: Performance, Challenges and Strategy Going Forward1

The Australian model of flexible inflation targeting has been a success, as evidenced by average inflation consistent with the target, and a substantial moderation in inflation and output volatility.

Belatedly, monetary policy in Australia has also faced some of the challenges that other central banks have faced after the global financial crisis, albeit not to the same extent.

  • A slower-than-expected recovery, economic slack, and inflation declining below target in a difficult global economic environment.

  • An increased probability of hitting the effective lower bound (ELB) on nominal policy rates, given declines in the real equilibrium interest rate (EIR) and some possibly large downside risks (e.g. China, European banks, geo-political uncertainty, etc.).

  • Risk of more persistent deviations of inflation below target (“low inflation trap”) and prolonged slack.

Staff estimates of the real EIR in Australia suggest that it has declined from around two percent in mid-2008 to around 1 percent over the past two years. The policy rate has been below the equilibrium throughout most of the post-GFC recovery, indicating that monetary policy has been in a ‘loose’ stance.

In the current situation, the prudent policy strategy would be a “low for longer” monetary policy stance while preparing for coordinated monetary and fiscal policy easing if downside risks were to materialize.

  • Around the current baseline outlook, a ‘prudent risk-management strategy’ would be to respond more strongly to negative inflation and output surprises than to positive ones.

  • To lower risks of ‘dark corners’, an effective policy response would call for both expansionary monetary and fiscal policies in the event that large negative shocks were to materialize (e.g., lower global growth and commodity prices).

Enhancing policy transparency

  • A more forecast-oriented communication policy which could include more explicit discussion of how the RBA intends to use its policy instruments over time to bring inflation back to target, with the importance of such policies in minimizing the risk of drifting inflation expectations likely to increase, the closer policy rates come to the ELB.

A. Introduction

1. Australia was one of the early adopters of inflation targeting (1993). The IT regime in Australia is widely considered a success, as evidenced by average inflation consistent with the target, and a substantial moderation in inflation and output volatility.

2. Belatedly, the Reserve Bank of Australia (RBA) has faced some of the policy challenges that are similar to those other central banks have faced after the Global Financial Crisis (GFC).

  • A lower real ‘equilibrium interest rate’ (EIR), which, everything else equal, implies that the probability of hitting the effective lower bound (ELB) on nominal policy rates has increased. At the same time, monetary policy could possibly be tighter than desired if rates are set based on earlier, higher estimates of the EIR.

  • An unusually long period of economic slack and inflation below target, and with important external downside risks, including a China hard landing and stagnation in advanced economy trading partners.

  • A difficult international environment. Market participants have been expecting that major central banks will peg their policy rates for a longer time or, in the case of the United States, raise them more gradually. With Australia’s relatively higher policy rate and bond yields, exchange rates have responded to rate differentials in these circumstances, with possible appreciation pressures interfering with the ‘shock absorber’ role of flexible exchange rates.

3. The paper analyzes three monetary policy issues in light of these challenges.

  • How expansionary has the RBA’s monetary policy stance been, given the decline in the EIR?

  • What should monetary policy do under current conditions? Easier for longer? A larger reaction to contractionary shocks to avoid dark corners? Coordination with fiscal policy?

  • What are implications for the conduct of monetary policy? Greater transparency to improve the efficacy of monetary policy?

4. The structure of the paper is as follows. Section B provides an overview of Australia’s IT framework since the early 1990s and current policy challenges. Section C looks at how much the EIR has declined in Australia and its impact on policy. Section D provides an overview of the Inflation Forecast Targeting (IFT) framework, with a focus on how IFT works as policy rates approach the ELB. Section E presents a ‘prudent risk-management strategy’ to deal with issues related to anemic global growth and low levels of the real EIR and commodity prices. Section F concludes by offering main policy recommendations.

B. Current Monetary Policy Framework and Challenges

Australia’s Monetary Policy Framework

5. Australia informally moved to an Inflation Targeting (IT) regime in 1993, seeking to achieve an inflation rate of 2–3 percent, on average, over the cycle. The inflation objective was subsequently formalized in 1996 in the first Statement on the Conduct of Monetary Policy by the Governor of the RBA and the Treasurer of the time. More recently, the core understandings of the Act were reiterated stating that an appropriate goal is to keep consumer price inflation between 2 and 3 percent, on average, over time (RBA, 2016).

6. Australia has been among the most successful IT countries. Headline inflation has been low with inflation broadly stable around the range since about 2003 as episodes of inflation outside the band have generally been short-lived. In addition, macroeconomic volatility as measured by inflation and output volatility has moderated, including after the global financial crisis of 2008 (Figure 1).

Figure 1.
Figure 1.

Australia: Inflation and Macroeconomic Volatility

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Sources: Haver Analytics; and IMF staff calculations.

7. From the beginning of the IT regime in the 1990s, the RBA has pursued what is now referred to as ‘flexible IT’, a framework where the central bank also seeks to stabilize output around potential. In fact, the Reserve Bank Act sets out that the RBA pursue policies that contribute to stability of the currency as well as full employment and the economic prosperity and welfare of the people of Australia.

8. The tradition of ‘flexible IT’ in Australia is best illustrated by looking at past episodes of monetary easing (Figure 2). The cash rate—the monetary policy instrument—was lowered when subsequent declines in inflation or increases in unemployment were expected. The episode beginning in 1996Q3 (blue line) stands out; despite unemployment being broadly stable it was inflation which had been falling considerably for several quarters (as driven by global commodity price disinflation in the wake of the Asian Financial Crisis) that triggered a sustained policy easing. The 2008 episode (red line) is also notable in the decisive easing carried out over a three-quarter period, driven predominantly by concerns about higher unemployment. In other episodes, the easing was more gradual.

Figure 2.
Figure 2.

Australia: Episodes of Monetary Policy Easing

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Sources: Haver Analytics; and IMF staff calculations.

Monetary Policy in the Wake of the Global Financial Crisis

9. With decisive macroeconomic policy responses, Australia only experienced a short, moderate growth slowdown during the global financial crisis. Growth had already recovered strongly in early 2009 as commodity prices rebounded mid-year. The mining investment boom was still accelerating at the time, with inflation within the target range by the end of 2009. Against this backdrop, the RBA started tightening in the last quarter of 2009 (Figure 3).

Figure 3.
Figure 3.

Monetary Policy After the Global Financial Crisis

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Sources: Reserve Bank of Australia; Haver Analytics; and IMF staff calculations.

10. In the third quarter of 2011, Australia’s terms of trade peaked and started falling thereafter, prompting a strong reaction by the RBA. The policy rate was lowered but less so than during the global financial crisis as the increase in unemployment that followed the commodity price bust was small compared to previous economic downturns. The inflation decline was shortlived. In early 2013, the easing cycle ended. In its Statements on Monetary Policy, the RBA noted that it expected robust growth going forward (Figure 3-upper right panel) and that it projected inflation to remain in the target range.

11. But during 2014, Australia experienced its own version of a delayed, weaker recovery. Unemployment, while still lower than in earlier downturns, remained above 6 percent, and inflation declined during the year. Initially, most of the disinflation was due to renewed declines in global commodity prices. Over time, however, non-tradables inflation also weakened.

12. The RBA adopted a wait-and-see attitude and only lowered rates in early 2015. In its Statements, the RBA indicated throughout 2014 that it projected inflation to remain in the target range. At the same time, it also signaled that it expected a further lift in growth from depreciation and further support to domestic demand from low interest rates. In February 2015, however, the RBA lowered the policy rate, noting that growth had remained below trend for longer than expected and that the expected pick up had not materialized, and followed up with another cut in May.

13. While growth picked up in the second half of 2015, inflation weakened further. After a sizeable inflation surprise on the downside in 2016Q1, the RBA lowered the policy rate in May 2016, shortly after the data had been released and then again in August 2016.

14. Headline inflation has been below the lower bound of the inflation target range before, but such deviations were typically shorter lived (Figure 4). The current episode has been longer lasting than all but one previous episode—the deviation lasted longer during the Asian Financial Crisis—and it is the first time that both non-tradables and underlying inflation are below target. These facts highlight the new challenges that the current episodes pose for monetary policy in Australia.

Figure 4.
Figure 4.

Australia: Inflation Developments after the Global Financial Crisis

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Sources: Haver Analytics; and IMF staff calculations.

Current Challenges and Monetary Strategy Going Forward

15. Monetary policy in Australia faces three sets of challenges going forward—challenges that are similar to those that central banks in other advanced economies have faced. The first set relates to a different, more difficult economic environment, notably inflation undershooting the target, declining inflation expectations, persistent labor market slack, and strong external disinflationary forces and, more broadly, a less supportive international growth environment than during the 1990s and 2000s. The second set relates to the lower EIR. Finally, the third set of challenges relates to the monetary policy time horizon and policy communication.

16. These challenges raise the question of what they imply for the optimal monetary policy strategy going forward. As detailed below, the paper argues that a ‘prudent risk-management strategy’ in the current situation would aim to avoid ‘dark corners’, where the economy could get stuck in a low inflation and low growth trap. Put differently, a “low for longer” strategy would be best suited to minimize those risks. If there were to be a sizable downside shock, leading to persistent economic slack and inflation expectations ratcheting downwards, monetary policy might be less effective in responding adequately to adverse shocks, given its proximity to the ELB. Once low inflation becomes entrenched, it could be very difficult to correct, leading to economic costs that can be considerable (such as those incurred, for example, in Japan and the euro area).

17. Such strategy should entail using conventional policy instruments more effectively, and even taking unconventional measures if the situation dictates. Strengthening central bank communication could be an important contribution towards enhancing policy effectiveness. Preparatory steps in unconventional measures, such as large-scale asset purchases, funding for credit, or negative interest rates, would also help equip policymakers with the tools to deal with shocks that could drive the economy off course.

C. The Equilibrium Interest Rate (EIR) in Australia: How Much Lower Is It?

18. Defining the EIR. The EIR is a benchmark for assessing the extent to which current monetary policy settings are either contractionary or expansionary. It is defined as the policy rate consistent with inflation being at the target and output at its potential level (full employment). In a standard macroeconomic model, an IT central bank would vary the policy rate from this equilibrium level to return inflation to the target and to manage the short-term output-inflation trade-off. The EIR is unobservable and must be estimated. Given substantial model uncertainty, a good deal of judgment is also needed.2

19. Factors influencing the EIR. For open economies with high capital mobility, such as Australia, the domestic rate will be strongly driven by global interest rates, that is, the EIRs in other major economies. But the two rates may differ due to country-specific factors, notably a country risk premium. In the Australian case, the country risk premium is likely to depend in part on its net foreign liabilities and related perceptions of repayment risks.

20. Downward trend in global and regional (real) EIRs. Inflation-adjusted bond yields have seen a trend decline worldwide since the early 1980s (Rachel and Smith, 2015). A renewed drop after the onset of the global financial crisis, accompanied by low inflation and weak output growth has led to substantial downward revisions of the real EIR. The declining trends are noted in the estimated real values in selected Asian countries, and in much of the developed world, using the Lubik-Matthes (2015) methodology (Figure 5). With respect to the U.S. neutral rate, given its global importance, Summers (2015) has cited a wide variance in estimates ranging between -3 and 1.75 percent. Obstfeld and others (2016) attribute the differences in estimates to differences in the definition of shocks. Higher estimates of the EIR, at or above 1 percent, consider the serial growth disappointments to reflect a series of transitory shocks. Lower estimates, near or below zero, classify the disappointments to reflect a permanent shock to medium-term growth. Looking back, the repeated downgrades of forecasts, the persistence of below-target inflation, and the declines in actual real rates all suggest that policy makers and markets have been underestimating the headwinds to growth and recovery.

Figure 5.
Figure 5.

Estimated Real Natural Rates of Interest

(Percent)

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Sources: Haver Analytics database; and IMF staff calculations.

21. Estimating the EIR in Australia. In recent years, while the level of the cash rate has remained low by historical standards, the persistence of a negative output gap has been protracted. Combined with low inflation, this suggests that equilibrium rates may have fallen, and the same level of the cash rate may not provide as much stimulus as it did historically. In Box 1, we report estimates of the EIR in Australia using a number of approaches. All of them point to a decline in the real EIR to around 1 percent.

22. Implications of low EIR for monetary policy. With a real EIR of around 1 percent, RBA faces relatively greater risks of reaching the ELB of about 1 percent than it would if the EIR were higher.3 Hence, it could face a situation where there is little room for a monetary policy response to negative shocks with the conventional cash rate tool and it will be important to explore the scope for unconventional measures. Concerns about risks to financial stability from low interest rates can be addressed through banking supervision and prudential policies, with a view to curbing excessive leverage by financial intermediaries, firms, and households.

Estimates of the Australian Equilibrium Interest Rate

Given the uncertainty in estimating the EIR, a mix of empirically, semi-structurally, and statistically-driven approaches are deployed. All three methods point to large drops in the real EIR in Australia to levels near 1 percent. This implies that monetary stimulus in the economy would be less than widely thought.

  • Methodologies # 1 and # 2 are empirically-driven and are subject to large statistical uncertainty. The first one uses the Laubach and Williams (2013 and 2015) (L-W) method which has some underpinnings in theoretical models of the economy; and the second by Lubik and Matthes (2015) (L-M) follows an even less structural approach, known as the time-varying parameter vector autoregressive (TVP-VAR) approach.1 For a fuller description of these approaches see the referenced papers. The empirical approaches do not impose interest rate linkages and are only influenced by Australian variables to draw out long term relationships, including trends in real GDP, which in turn depend on productivity growth and population.

  • Methodology # 3 follows an indicative approach to estimate the EIR. It is based on a simple Hodrick-Prescott (HP) univariate filtering approach to estimate trends in real interest rates. HP-filtered trends in real 10-year, 90-day and floating (standard) mortgage interest rates are estimated.

The L-W and L-M based estimates both point to a secular decline in the nominal natural rate. Expressed in real terms, this rate has fallen from an average of about 3 percent in the early 1990s to 0.8 percent in the second quarter of 2016, while at no point do the values turn negative. Commenting further on the estimated paths, since the early 2000s, the rates exhibited notable drops during the economic slowdown periods (2000Q4 and 2008Q4). In addition, the natural rate has been above the cash rate through most of the post-GFC recovery which indicate that monetary policy has been in a ‘loose’ stance (i.e., a period of monetary stimulus), except for a brief period of time around 2011. Given the high uncertainty surrounding this measure, considering the lower bound of the 90 percent confidence region for example, would point to a prevalent ‘tight’ policy (i.e. a period of monetary contraction). Furthermore, projecting to end of 2021, with output gap near zero and inflation close to 2.5 percent, an appropriate monetary policy setting at that time should be close to neutral (where the cash and the equilibrium rates ought to converge). An appropriate projection for the nominal natural cash rate is close to 3.0 percent (as per the latest WEO projections).

A02ufig1

Equilibrium Nominal Interest Rates and Cash Rate

(Percent)

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Sources: L-M natural rate is based on Staff Estimates using a (TVP-VAR) model. The solid blue line marks the median posterior estimator and the dashed blue lines indicate the upper and lower bounds of the 90 percent confidence region.L-W natural rate uses updated estimates from the FRBSF.

Indicative HP-based estimates (with stiffness parameter λ=1,600) show downward-trending real interest rates. For instance, the steady fall in the real 10-year interest rate (from over 3 percent in 2000 to just 1 percent in 2016Q2) suggests that markets expect rates will be lower for some time to come as this rate (an indication of expected returns over a longer period) largely looks through cyclical (weak or strong) periods.

In the model below, the global interest rate linkages are imposed unlike in the first two methodologies. We also think that the neutral rate in Australia is significantly driven by neutral rates in other major economies, and to the extent that these have declined, as per estimates of other authors, the neutral rate in Australia should have declined as well.

A02ufig2

Real Interest Rates 1/

(Percent)

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Sources: Haver Analytics database; and IMF staff calculations.1/ Trend real interest rates calculated using Hodrick Prescott filter.
1TVP-VAR estimates for three variables, the real GDP growth, inflation and a measure of real rate are calculated. The conditional long horizon forecast (over 5 years) of the observed real rate is used as a measure of neutral rate.

23. Are low interest rates here to stay? A debate is ongoing as to how far the neutral rates have declined since the crisis, how persistent or permanent they are, and what do they actually mean for monetary policy in terms of more frequent and longer episodes of constrained policy at the ELB (Reifschneider and Williams, 2000). One view is that the unusual decline and the long period over which they persisted have represented unusually long-lasting effects of the recession but eventually they will return to more normal levels (Bean and others, 2015 and Hamilton and others, 2015). Others, including Summers (2016) and Brainard (2016), perceive a continuing decline in the rates with no basis for supposing they will increase. For a description of the likely contributors to a persistent low neutral rate, see Brainard (2015) and Goodfriend (2016).

D. Inflation-Forecast Targeting Under Current Conditions: Some Conceptual Issues

24. Inflation-Forecast Targeting (IFT) is based on the principle that, given a long-term objective for the rate of inflation, the central bank’s own forecast of inflation is an ideal intermediate target. The inflation forecast is an ideal intermediate target as it would embody all the relevant information available to the central bank, including knowledge of the policymakers’ preferences with respect to the trade-off between deviations of inflation from target and output from potential, and the central bank’s view of the monetary policy transmission mechanism (Svensson, 1997).

25. A key aspect of IFT is that the policy interest rate should respond in a predictable way to shocks. It should be set so as to minimize deviations of actual inflation from its objective, while taking account of the implications on output. This policy feedback, via the short-term interest rate, ensures that the nominal anchor holds—the future expected path of the policy interest rate is adjusted when unanticipated disturbances hit the economy, in order to bring inflation back to the target gradually over a period of time that limits the disruptions to output. Many central banks incorporate this principle into their forecasting models and thus produce an endogenous path for the interest rate. This strategy differs from other IT approaches (relying on exogenous forecast interest rate paths, or paths derived from market forward rates) which lack the feedback from the expected future inflation rate and output gap to the policy instrument (which is represented by the red-dashed feedback arrows in Figure 6).

Figure 6.
Figure 6.

A Monetary Transmission Mechanism

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

26. Expectations of future policy rate movements over the short-to-medium term play a crucial role in the transmission mechanism under IFT. The overnight cash rate directly controlled by the central bank has a key role in influencing the cost of borrowing for businesses and households given the predominance of variable rate, rather than fixed rate, debt. Consequently, expectations about the path of this rate have an important role of play in shaping household and business decisions. Obviously, there are other important channels besides the direct lending channel through which monetary policy can affect real activities, such as wealth, balance sheet and cash flow channels. Those channels are not explicitly modeled in our illustrative simulations below, which are based on a core model of the Australian economy (Section E).

27. The exchange rate acts as a ‘shock absorber’ for the economy under IFT. This is of particular importance for commodity exporters such as Australia. In the case of a negative terms-of-trade shock, the exchange rate would depreciate, which facilitates resource allocation by stimulating exports and compressing imports. Historically, Australia’s terms of trade have been volatile, as is reflected in the RBA-Index of Commodity Prices, ICP (Figure 7-Panel 1). The terms of trade rose by 85 percent from the average of the early 2000s and reached an all-time high in late 2011. It fell 36 percent from its peak but is expected to be nearing a floor soon, albeit at a level that is 25 percent above its pre-boom level (see Kulish and Rees, 2015). The exchange rate against the U.S. dollar has been allowed to vary over a wide range, absorbing large shocks to the terms of trade (Figure 7-Panel 2). Despite the shock absorber role played by the exchange rate, the recent terms-of-trade slump has exerted a large negative shock to real domestic income (Figure 7-Panel 3).

Figure 7.
Figure 7.

Terms of Trade, Exchange Rate, and the Real Income

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

28. When the economy is at or close to the ELB where the nominal interest rate cannot further decline, a transmission mechanism, albeit somewhat weakened, could still apply, through inflation expectations. Consider a negative demand shock. In response to a contractionary shock, during normal times an IFT central bank would be expected to lower the policy rate path sufficiently to steer inflation back to target. At the ELB, under a credible regime, financial market participants would expect that inflation would go back to the target over the medium term. This would cause the expected future path of real interest rates to decline. Under a risk-adjusted uncovered interest parity condition, given unchanged long-term real exchange rate and (expected paths for) foreign real interest rates, a real depreciation would occur which in turn would help support demand, through both exports and domestic expenditure switching (from foreign to domestic goods). In summary, inflation expectations would act as a shock absorber under an active and credible monetary policy regime even when the economy is constrained by the ELB. To manage expectations, which might be difficult in practice, the central bank would publish a forecast which shows that the interest rate would be kept low for long enough to allow inflation to rise, or even to overshoot the long-term target before it returns to the target from above. To ensure the overshooting path for inflation is credible, it may have to be backed by fiscal or other policies that would stimulate the economy, including unconventional monetary policy. For further details, see Obstfeld and others (2016) and Appendix I. To ensure that the path for inflation and the output gap is credible, the central bank might have to use other instruments (quantitative easing, funding for credit, or others.) or even be backed up by fiscal measures.

E. Optimal Monetary Policy under Current Conditions: Illustrative Simulations of a ‘Prudent Risk-Management Strategy’

29. Under current circumstances, an effective monetary policy should counteract the possible risk of persistent disinflation building up and prolonged weakness in demand settling in. Under the current baseline, a ‘prudent risk-management strategy’ should result in a more aggressive cut in interest rates in the future compared to a standard monetary policy reaction function to eliminate the economic slack faster, while also taking into consideration financial stability risks when deciding on the speed with which to bring inflation back to target. To lower risks of ‘dark corners’, prudent policies call for both monetary and fiscal stimuli, in the event that further contractionary shocks (lower global growth, equilibrium world real interest rates and commodity prices) were to materialize.

30. The paper uses an open-economy New Keynesian model to derive the optimal monetary policy strategy under current conditions. It illustrates the strategy under both a ‘baseline’ and an alternative ‘downside scenario’. The model we use bears similarities to those used at many central banks for forecasting and policy analysis. It has a standard core structure, with equations for the output gap, core inflation, the policy interest rate, and the exchange rate. Expectations are forward-looking, consistent with the projections of the model itself, but the behavioral equations also embody significant lags and rigidities. In addition, the model has equations for headline, food and energy inflation, the commodity terms of trade, trade and financial linkages with the rest of the world, and bond yields of various maturities. It exhibits some nonlinearities, primarily as a result of the ELB constraint and its implications for the monetary policy. The model is calibrated with reference to both historical data and existing theoretical literature to ensure that it plausibly replicates historical data and generates sensible projections. Appendix II contains the model equations and parameter values. As a caveat, it should be noted that in practice, real-time forecasts also involve a substantial deal of judgment and data analysis, given the well-known problems with simple model-driven projections in the short term. That said, the model simulations under given forecasts and preferences, can demonstrate the key features of an optimal monetary policy strategy.

Three Different Policy Strategies under the Baseline Scenario

31. The baseline scenario is based on benign assumptions of a gradual recovery of the economy going forward, with initial conditions reflecting the Australian’s economy conditions as of 2016Q3. The output gap starts at -1.3 percent (excess supply), the year-on-year headline inflation rate at 1.3 percent, and the cash rate at 1.5 percent (assumed to be declining to 1.3 percent by end-2017 as priced by the market).

32. A monetary policy strategy responding to the near-term inflation outlook and current slack would result in a slow recovery. The blue line in Figure 8 is the results for a standard monetary policy reaction function, specifically, an inflation-forecast-based (IFB) reaction function, where the interest rate is set sequentially as a function of the expected year-on-year inflation rate one year into the future and the contemporaneous output gap. Under this scenario, the policy rate is first lowered modestly and then increased gradually over time. This results in a depreciation of the Australian dollar that helps support the economy and a gradual closing of the output gap. Under this scenario, inflation stays below the RBA’s 2-3 percent inflation target range for several years.

Figure 8.
Figure 8.

Baseline Conditional Projections (Alternative Monetary and Fiscal Assumptions)

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Source: Authors’ simulations.

33. The optimal monetary policy strategy is to respond with a “low for longer” policy, leading to a faster return of inflation to target and output to potential. Here, the optimal policy response is a path of policy rates throughout the projection horizon that is derived by minimizing a loss function which places equal weights on output gap and inflation deviations, rather than a path produced based on an interest rate reaction function, (see Appendix II for more detail). Such a forward-looking policy strategy would put a premium on avoiding ‘dark corners’, in which the economy gets stuck in a bad equilibrium and becomes resistant to conventional policy instruments. In other words, the optimal policy response is equivalent to a “prudent risk management strategy” that sets policies so as to avert possible prolonged periods of excessive economic slack. Under this case, the policy rate would be cut significantly over a few quarters, falling to 0.75 percent before it increases gradually.4 As a result, the output gap closes much faster and inflation returns inside the 2-3 percent target range shortly over the next few quarters. Furthermore, with interest rates lower for longer, the Australian dollar depreciates by an additional 6 percent.

34. A combined monetary-fiscal policy response would provide for an even faster return to internal balance while leaving monetary policy space.5 In this vein, we consider augmenting the ‘prudent risk-management strategy’ with fiscal support. Under this scenario, which is designed to close the output gap even faster, monetary policy faces a lower burden. Policy rates do not decline as much, and as a result, there is less of a depreciation in the Australian dollar. This leaves the RBA with more space to respond to potential contractionary shocks in the future.6

Downside Scenario: China’s Economic Growth Surprises on the Downside

35. A disappointing external environment may require a ‘low for longer’ strategy for monetary policy. Figure 9 considers alternative simulations where China’s economic growth surprises on the downside. This has significant spillover effects on the rest of the world and a sizable impact on commodity prices. This downside scenario implies an opening up of the effective foreign output gap relevant for the Australian economy (defined as export-weighted output gaps for Australia’s main trading partners). Specifically, the effective foreign output gap is 2.3 percentage points lower and metal prices are 5.3 percent lower at the trough compared to the baseline. Under the black line, in anticipation of the negative shocks, the policy rate declines to the ELB (assumed to be 0.75 percent) and stays there for 2 years. This results in a further depreciation in the Australian dollar that helps support the economy. However, a sizable negative output gap remains for the Australian economy as it is largely dominated by the magnitude of the negative shock. Headline inflation slightly overshoots the 2.5 percent mid-point of the RBA’s 2-3 percent inflation target range.

Figure 9.
Figure 9.

Downside China Scenario

Citation: IMF Staff Country Reports 2017, 043; 10.5089/9781475575842.002.A002

Source: Authors’ simulations.

36. A coordinated monetary-fiscal policy would provide a much-needed shot in the arm for the Australian economy if the downside shocks were to materialize. Under the red line, a direct fiscal stimulus is used to help deal with the negative external shocks hitting the Australian economy. The direct effects of the fiscal stimulus are equal to 0.25 percent of GDP for 2017-18. Monetary policy provides the ‘supporting role’ to a much-welcomed fiscal expansion by cutting the policy rate aggressively to its lower bound faster than under the previous case. This helps raise inflation and generate a modest overshoot of inflation above the upper bound of the 2-3 percent target range over the medium term. This planned overshoot of inflation raises inflation expectations and reduces the real interest rates, which combined with more depreciated exchange rate helps close the output gap much faster. A faster recovery of the economy under this more accommodative strategy allows monetary policy to normalize earlier than under the previous case.

F. Conclusions

37. The analysis in this paper shows how the RBA could use a ‘prudent risk-management strategy’ to leverage its conventional policy instruments to avoid “dark corners.” By extending the commitment to keep interest rates ‘low for long’ enough, inflation should eventually start to increase. Inflation expectations would also rise, implying that the real interest rates would decline, and the exchange rate would depreciate. In addition, the analysis also highlights that fiscal policy easing might be critical to support monetary policy; the latter could be largely aided by fiscal support which has a direct effect on demand and reduces the length of time over which the policy rate stays at the lower bound.

38. Policy credibility and the task of anchoring inflation expectations could benefit from a more forecast-oriented communications of the RBA. A reorientation could include more explicit discussion of how the RBA intends to use its policy instruments over time to bring inflation back to target, emphasizing the ‘conditionality’ of the path and the fact that it is a ‘forecast’ and not a ‘commitment’. The experience in New Zealand (since 1997), Norway (since 2005), Sweden and the Czech Republic (since 2008) suggests that the financial market participants learn fairly quickly about the ‘conditional forecast’ nature of the path. The importance of such forward guidance on policies would likely increase as the policy rates come closer to the ELB. Such communication would lower risks of drifting inflation expectations at the ELB.

Appendix I. Exchange Rate and Asset Prices as Shock Absorbers or Amplifiers

The risk-adjusted uncovered interest parity (UIP) condition

This condition, under perfect foresight, may be written as

it(itf+χt)=st+1st,

where it is domestic interest rate, itf is foreign interest rate, χt is domestic risk premium, st is nominal price of foreign exchange. That is, the future change in the exchange rate compensates for any interest differential, such that the return adjusted for change in the exchange rate and the risk premium is the same in either currency.

One period ahead we have

it+1(it+1f+χt+1)=st+2st+1.

Going forward we have

it+2(it+2f+χt+2)=st+3st+2,

such that this holds for any time t:

it+k(it+kf+χt+k)=st+k+1st+k.

Summing up all the equations, from time t to t + k, yields

it+it+2+it+k(itf+χt)(it+kf+χt+k)=(st+1st)+(st+2st+1)++(st+k+1st+k),

or equivalently,

Σj=0kit+jΣj=0k(it+jf+χt+j)=st+k+1st.

Rearranging, we get

Σj=0kit+j=st+k+1st+Σj=0k(it+jf+χt+j).

The same equation holds in real terms,

Σj=0krt+j=zt+k+1zt+Σj=0k(rt+jf+χt+j),

where rt is real interest rate, and zt is real exchange rate defined as

zt=st+ptfpt.

Real exchange rate as shock absorber

Under normal times with active policy, a negative demand shock reduces inflation in the short term, but does not affect the long-term real exchange rate (zt+k+1). An IFT central bank is expected in normal times to reduce the policy rate sufficiently to steer inflation back to target. This expectation would, through the UIP condition, lead to an immediate depreciation of the currency: the spot price of foreign exchange has to rise (=depreciates) to the point that the expected decrease (=appreciation) from then on compensates for the lower domestic interest rate.

Under a credible regime of aggressive policy responses, the expected medium-term inflation rate would also increase. The decline in real interest rates would be greater than that in nominal rates. At the ZLB, the current nominal interest rate cannot go any lower, but under the aggressive regime people would expect the future nominal interest to be zero for longer, and because of the anticipated increase in inflation, real interest rates would decline. Thus in both normal times, and during the ZLB, we have (Σj=0krt+j). Given that the long-term real exchange rate (zt+k+1) and expected paths for foreign real interest rates Σj=0k(rt+jf+μt+j) do not change, this would result in a real depreciation (↑ zt),

Σj=0krt+j=zt+k+1zt+Σj=0k(rt+jf+μt+j).

This helps support demand, through both exports and domestic expenditure switching (from foreign goods to domestic goods).

Real exchange rate as shock amplifier

At the ZLB, the exchange rate can act as a shock amplifier. If policy is passive, and not credible, following a negative demand shock, people would expect the inflation rate in the future to be lower. Current and future short-term real interest rates could increase (Σj=0krt+j), resulting in a real appreciation (↓zt):

Σj=0krt+j=zt+k+1zt+Σj=0k(rt+jf+μt+j).

This would reduce net exports and further deepen the recession.

Asset prices as shock absorber or amplifier

A similar argument holds for asset prices as for the exchange rate. A credible aggressive policy response would cause increases in asset prices (through the positive impact on profits of currency depreciation, and the effect of lower real discount rate on asset valuations). A non-credible, passive response would do the reverse. Thus depending on the policy regime, asset prices too may act as a buffer or an amplifier for the impact of shocks.

Appendix II. A New-Keynesian Model for Australia

A.II.1. IS Equation

The output gap (y^t) is defined as the difference between the log-level of output (yt) and potential output (y¯t). The IS equation relates Australia’s output gap (y^t) to past and expected future output gaps, the deviations of the lagged one-year real interest rate (r4t) and the real effective exchange rate (reert) from their equilibrium values, and the rest-of-the-world output gap. The metal price gap also affects the output gap in a significant way.1

yt=y¯t+y^tyt^=β1y^t1+β2y^t+1+β3(r4t1r¯4t1)+β4(reert1r¯eert1)+β5y^Worldt+β6rptMetal+ϵty^(0.5)(0.1)(0.1)(0.01)(0.1)(0.01)

where, the four-quarter average equilibrium real interest rate (r4t)is defined as

r4t=(rt+rt+1+rt+2+rt+3)/4

A.II.2. Phillips Curve

In the Phillips curve, the core inflation rate (πtC) depends on inflation expectations (EπtC) and past year-on-year core inflation (π4t1C), with coefficients on both terms adding up to one. The lagged term reflects the intrinsic inflation inertia, resulting from contracts, costs of changing list prices, etc. Inflation expectations are pinned down by the model-consistent solution of the year-on-year inflation one year ahead (π4t+4C). Core inflation depends on lagged output gap in a non-linear way. Core inflation also depends on the rate of real effective exchange rate depreciation, as well as the deviation of the real effective exchange rate from its equilibrium value, as a real depreciation raises the domestic cost of imported intermediate inputs and final goods, creating upward pressure on prices. Finally, we allow some small pass-through from oil and food price inflation to core inflation. This is captured by adding the two terms on the real price of oil and food adjusted for real exchange rate effects.

πtc=λ1Eπtc+(1λ1)π4t1c+λ2y^t1+λ3Δreert1+λ4Δreert+λ5(rpoilt+z^t)+λ6(rptFood+z^t)+λ7ϵt1πc(0.75)(0.2)(0.025)(0.025)(0.005)(0.005)(0.7)Eπtc=π4t+4c

A.II.3. Policy Interest Rate: Reaction Function Options

Linear IFB rule

The equation is a fairly standard policy rule. The policy rate takes into account the contemporaneous output gap, as well as the model’s forecast of inflation three quarters into the future. An IFB rule ignores shocks to the system that are expected to reverse within the three-quarter policy horizon. More generally, it allows the central bank to take account of all relevant information available to it on future developments over the four-quarter forecast horizon:

it=γ1(0.7)it1+(1γ1)[r¯t+π4t+4c+γ2(1.2)(π4t+4Hπ*)+γ2(0.4)y^t]+ɛtiπ4t+4=(πt+4+πt+3+πt+2modelforecast of inflation (depends on all inputs intoforecast including monetary policy reactions)+πt+1partly monitored)/4

The nominal interest rate (it) is a function of its own lagged value which has the effect of smoothing the interest rate to reflect the fact that, in practice, central banks do not typically change the policy rate in large increments. The policy rate responds to the equilibrium nominal interest rate, as measured by the sum of the equilibrium real interest rate (r¯t) and projected year-on-year core inflation (π4t+4C). The cyclical response of the interest rate is driven by the forecast deviation of projected inflation from its target value (π *), and by the output gap (y): these gap variables determine the policy response to deviations from the two targets of a dual mandate or flexible inflation targeting central bank. The projected year-on-year inflation rate is based on the model forecast of inflation (πt+1, πt+2, πt+3, πt+4). This formulation has the appropriate property that the real policy interest rate rises in response to an increase in inflation—with a short lag because of the smoothing feature in the adjustment of the nominal rate

Loss minimizing strategy—risk management

This strategy chooses the interest rate path to minimize the discounted current and future losses from inflation deviations from the target, output gaps, and changes in the policy rate. The loss function incorporates the principal objectives of the central bank–expressing an aversion to deviations of output and inflation from desired values that grows ever larger as these deviations increase. It provides more efficient management of the short-term output-inflation tradeoff and is very useful for designing policies to guard against dark corners.2

Losst=i=0βi(0.98)[ω1(1.0)(π4t+iHπ*)2+ω2(1.0)y^t+i2+ω3(0.5)(it+iit+i1)2]

The quadratic formulation implies that large errors or deviations are more important in the thinking of central banks than small errors or deviations. The term with the squared change of the policy interest rate prevents very sharp movements in the policy interest rate, which would otherwise occur in the model on a regular basis in response to shocks. Central banks in practice do not typically change interest rates in large steps, and there are sound theoretical reasons for this. By taking account of both current and expected future values of output and inflation, this formulation has the central bank incorporate into its decisions any information currently available that may affect its objectives over the next few quarters. It is worthwhile to note that large deviations are disproportionately more important than small deviations due to rising marginal cost of inflationtargeting errors, output gaps, and interest rate volatility. This is reasonable since policymakers should not even try to avoid small errors (i.e., fine tune), because policy actions are subject to imprecision and uncertainty. The central bank would, however, very much like to avoid recessions, or destabilized inflation expectations and would want to keep the economy far from ‘dark corners’ where recovery from shocks becomes much more difficult, because of nonlinearities. At the moment, a contractionary shock combined with the ZLB would be the main concern (at least in a lot of advanced economies).

ELB

Under both cases, the interest rate is subject to a lower bound constraint (ifloor), which is assumed to be 75 basis points in the historical simulation, consistent with Lowe (2012).

itifloor(0.75)

A.II.4. Real Interest Rates and Real Exchange Rates

The real interest rate (rt) is defined as the nominal interest rate minus the expected core inflation

(πt+1C).rt=itπt+1C

The bilateral real exchange rate between Australia and the United States (zt) is defined in terms of Australian core CPI (ptC), and in such a way that an increase means a depreciation in the Australian dollar. The real exchange rate is broken down into an equilibrium trend (z¯t) and deviation from that trend (z^t). The equilibrium real exchange rate trend is assumed to be determined by the equilibrium terms of trade (z¯ttot).

zt=st+ptUSptCzt=z¯t+z^t
z¯t=z¯ttot

The real effective exchange rate that enters the output gap equation is the trade-weighted bilateral real exchange rates of Australia versus seven regions in the world (U.S., euro area, Japan, China, emerging Asia, Latin America, and the rest of the world). The breakdown of the regions is consistent with the IMF’s Global Projection Model (GPM).

reert=ω¯Trade,USz^tUS+ω¯Trade,EUz^tEU+ω¯Trade,JAz^tJA+ω¯Trade,CHz^tCH+ω¯Trade,EAz^tEA+ω¯Trade,LAz^tLA(0.120)(0.149)(0.077)(0.233)(0.281)(0.017)+ω¯Trade,RCz^tRC(0.123)

Risk-adjusted UIP condition

The risk-adjusted uncovered interest parity condition links the bilateral exchange rate between Australia and the United States. with the interest rates in the two economies (it and itUS).

ititUS=4(Est+1st)+σtctry+σttot+ɛtsEst+1=φst+1(0.6)+(1φ){[st1+2[Δz¯t(π*,USπ*)/4]}

This allows the expected exchange rate (Est+1) to be a linear combination of the model-consistent solution (st+1), and backward-looking expectations (st–1) adjusted for the trend exchange rate depreciation (2[Δz¯t(π*,USπ*)/4]). The factor ¼ after the inflation differential (π*,USπ*) de-annualizes the inflation rates which are expressed in annual terms, while the factor 2 is necessary as we take the nominal exchange rate in the past period (st–1), and extrapolates two periods into the future using the steady-state growth rate in the nominal exchange rate. Conversely, in the condition that links Australian and U.S. interest rates, the factor 4 before the expected depreciation (Est+1st) annualizes the expected quarterly depreciation rate, to make it consistent with the interest rate quoted on the annual basis. A time-varying variable (σtctry) is included to account for shocks to country-risk premium. Terms-of-trade shifts (σttot) are also an important factor that determines the nominal exchange rate.

A.II.5. Relative Prices

Headline inflation is affected by the dynamics of relative price movements (core CPI (ptC) relative to headline CPI (ptH). In the long term the overall (headline) inflation is assumed to be equal to the underlying (core) inflation, though it can diverge over prolonged periods of time, when there is a trend in the relative prices of non-core items (mortgage interest rates, unprocessed food, energy). The dynamics of relative prices (rpt) are modeled as the sum of the relative price trend (rp¯t) and the relative price gap (rpt). The relative price gap depends on the real price of oil and food in the international markets adjusted for exchange rate effects, while the relative price trend growth is assumed to be an autoregressive process with mean zero. The parameters in the relative price gap equation are calibrated based on various information, such as the weights of energy and food in the CPI basket, and the degree and time profile of the pass-through of energy and food inflation to headline inflation.

rpt=ptcptHrpt=rp¯t+rptrpt=ρrprpt1c1rp(rptoil+z^t)c2rp(rptFood+z^t)+ϵtrp(0.5)(0.01)(0.01)Δrpt¯=ρΔrp¯Δrp¯t1+ϵtΔrp¯(0.7)

A.II.6. Term Structure of Interest Rates

The model allows for long-term bond yields to shed light on the equilibrium real interest rates. Let itGov,k be the nominal government bond yield with a maturity of k quarters, where k could be 4, 8, 20 or 40. The bond yield is equal to the average expected short-term interest rates k quarters into the future plus a term (σtTerm,k) that captures both government bond premium (same for bonds with all maturity) and term premium (a premium which increases with the maturity). A shock at the end of the equation (ɛtGov,k) reflects the measurement error.

itGov,4=i4t+σtTerm,4+ɛtGov,4itGov,8=(i4t+i4t+4)/2+σtTerm,8+ɛtGov,8itGov,20=(i4t+i4t+4+i4t+8+i4t+12+i4t+16)/5+σtTerm,20+ɛtGov,20itGov,40=i=09i4t+4i/10+σtTerm,40+ɛtGov,40i4t=(it+it+1+it+2+it+3)/4

A.II.7 Unemployment Rate

The unemployment rate (ut) is characterized by a “gap version” of Okun’s law. The equation implies that a one percentage point increase in the unemployment gap (u^t) is associated with approximately two percentage points of negative output gap. The NAIRU (u¯t) is assumed to follow a stochastic process that has both shocks to the level and to the growth rate.

ut=u¯t+u^tu^t=ρu^u^t1(0.25)c1u^y^t(0.5)+ɛtu^u¯t=u¯t1+Δu¯t+ɛtu¯du¯t=ρdu¯(0.9)du¯t1+ɛtdu¯

A.II.8. Potential Output

The potential growth rate (Δy¯t) is assumed to converge to its steady state level (Δy¯ss) in the longer term. However, it can deviate from the steady-state level for prolonged periods of time.

Δy¯t=ρy¯(0.9)Δy¯t1+(1ρy¯)Δy¯ss(2.47)+ɛtΔy¯

A.II.9. The Rest of the World

The Australian economy is linked to the rest of the world through both the trade linkage and the financial linkage. The rest-of-the-world output gap relevant for the Australian economy is defined as a weighted average of output gaps in the seven regions (U.S., euro area, Japan, China, emerging Asia, Latin America, and the rest of the world), using export shares as weights.

y^tWorld=ϖExp,US(0.047)y^tUS+ϖExp,US(0.030)y^tEU+ϖExp,JA(0.200)y^tJA+ϖExp,CH(0.375)y^tCH+ϖExp,EA(0.270)y^tEA+ϖExp,LA(0.008)y^tLA+ϖExp,RC(0.070)y^tRC

The equilibrium real interest rate in Australia is modeled in relation to that in the United States.

r¯tr¯tUS=4(z¯t+1xtotz¯txtot)+σtctryΔz¯t=cz¯Δz¯ttot(0.5)+Δz¯txtot
Δz¯t+1xtot=ρΔz¯xtot(0.95)Δz¯txtot+(1ρΔz¯txtot)Δz¯xtot,ss(2)+ɛtΔz¯xtot

A.II.10. Commodity Terms of Trade

The real price of oil (rptOil) is defined as the global oil prices (ptOil) relative to the U.S. CPI (ptUS). In the equilibrium, the real price of oil is assumed to grow at a rate of zero, although the actual growth rate can deviate from zero for significant long periods of time. The real price of oil gap (rptoil),, defined as the difference between the real price of oil and its equilibrium trend value, is modeled as an autoregressive process with a shock.

rptoil=ptoilptUSrptoil=rp¯toil+rptoilΔrp¯toil=ρΔrp¯toilΔrp¯t1oil+ϵtΔrp¯oil(0.95)rptoil=ρrpoilrpt1oil+ϵtrpoil(0.7)

We follow similar modeling strategy for the real price of food.

rptFood=ptFoodptUSrptFood=rp¯tFood+rptFoodΔrp¯tFood=ρΔrp¯FoodΔrp¯t1Food+ϵtΔrp¯Food(0.95)rptFood=ρrpFoodrpt1Food+ϵtrpFood(0.7)

The terms-of-trade gap (tott) for Australia is determined by the real price of metal gap (rptMetal). The weight in front of the term represent the share of this commodity in Australia’s total GDP.

tott=c1totrptMetal(0.01)

The real exchange rate depreciation consistent with changes in the terms of trade (Δzttot) is related to the movements in the real price of metal (ΔrptMetal). The same condition holds for this variable at its respective equilibrium value.

Δzttot=c0Δz¯tot(0.6)ΔrptMetalΔz¯ttot=c0Δz¯tot(0.6)Δrp¯tMetal

The terms-of-trade premium that goes into the UIP condition (σttot) is modeled as the “surprise” component in the real exchange rate movement consistent with the terms of trade.

σttot=4(zttotEt1zttot)

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1

Prepared by Thomas Helbling, and Philippe Karam (both APD), Ondra Kamenik, Douglas Laxton, Hou Wang, and Jiaxiong Yao (all RES).

2

Such uncertainty is not a new phenomenon. Central banks continually monitor the economy for possible changes. Signs that the EIR may be changing are initially incorporated into the Bank’s risk assessment when setting policy. If the economy shows clear signs of a change in the equilibrium rate, the Bank will formally change its estimate in its modeling frameworks. See for example., the Czech National Bank’s Inflation Report (2013), Box 2 “New steady state settings in the g3 model”, CNB’s third generation forecasting model, and RBNZ’s Structural Model for Policy Analysis and Forecasting—Kamber and others (2015).

3

Lowe (2012) alludes to ‘1% plus or minus a bit’ as a threshold representing ELB, where the incremental benefit of further cuts is ‘quite small’ and ‘other options of unconventional monetary policy become more viable’.

4

Based on Lowe (2012), a below 1 percent cash rate can be regarded as the ELB in Australia.

5

In light of factors challenging monetary policy effectiveness, complementary fiscal (for e.g., well-calibrated infrastructure spending fiscal stimulus) and structural policies (geared at enticing the private sector to increase own spending) are argued to be complementary, efficient and better-targeted policies to tackle distortions in output, growth and employment at their source. See Lowe (2016) and Gaspar and others (2016).

6

For the purpose of this paper, these fiscal measures are left unspecified. More detailed analysis pertaining to a desirable fiscal policy package identifying instruments with potentially high multiplier effects is dealt with in the accompanying paper entitled “Australia’s Fiscal Framework: Issues and Options for Reform,” in particular, Box 2.

1

On calibration, parameter values for three different groups of coefficients affecting the steady state, the dynamics, and the stochastic processes are provided in parentheses below each equation.

2

For a technical explanation of the minimization of the loss function see Clinton and others (2015), Annex 5.

Australia: Selected Issues
Author: International Monetary Fund. Asia and Pacific Dept