What is Monetary Policy Anyway?

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Last week you may have seen the release of a review into the Reserve Bank of Australia. The review calls for a number of changes, none of which are particularly earth-shattering or will change how monetary policy operates in Australia. But that begs a bigger question: what is monetary policy anyway?

Monetary policy, at it’s most simple definition, is the way in which interest rates are set in a country such as Australia. As we have written before, our interest rates are basically set by the RBA. They do this through what are called ‘open market operations.’ These operations are where the RBA announces that it will enter into a particular loan market, as either a buyer or seller, to achieve a particular price in that market. The market is the overnight loan market between banks (including the RBA) and the price in that market is expressed as an interest rate. By manipulating this particular interest rate, the RBA will influence the price (interest rate) in all other loan markets. At base, if the RBA raises the rate in the overnight loan market, all other interest rates will usually rise as well. And vice versa.

For a more detailed explanation, the RBA’s website contains a detailed description of monetary policy.

The RBA is wholly owned by the Commonwealth of Australia. It is often referred to as being ‘independent of Government.’ This is not actually true. The RBA is independent from politicians. But it is in fact a part of the broader Government. RBA policy is Government policy.

The RBA has a very important role in our economy. This role requires the RBA to pursue three things:

  • Stable prices (that is, low inflation);
  • Full employment; and
  • Economic prosperity (usually understood to be economic growth).

Each of these three things is supposed to have equal importance.

By manipulating the interest rate, the RBA encourages or discourages new lending. Higher interest rates discourage new lending, lower interest rates do the opposite. New lending is a major determinant of economic growth: the more lending there is, the more growth there is likely to be. Higher lending also tends to encourage greater employment. So, at times when the RBA thinks the economy needs a boost to achieve higher employment or growth, it will lower interest rates.

That said, the conventional wisdom is that inflation and unemployment tend to run in opposite directions. So, if inflation is becoming a problem, the usual response from the RBA is to increase interest rates. This usually reduces new lending. While this generally increases unemployment and lowers economic growth, it is also hoped to lower demand in the economy and, through that, lower prices.

Right now, the RBA is focused almost solely on reducing inflation. That’s why we have just gone through a period of increased interest rates (which may or may not be finished). The aim of these rises is to discourage new lending. This will almost certainly have the flow on effect of increasing unemployment, but as we say above, right now the RBA is prioritising inflation more so than its other two purposes.

One of the criticisms of monetary policy is that it is a very blunt instrument. For example, while the purpose of raising interest rates is to discourage new lending, the inevitable ‘side effect’ is that existing lending becomes much more expensive. Thus, people with existing debt, such as homebuyers, find that their spending power becomes greatly curtailed. For many borrowers, interest expenses have doubled in the past 12 months. These people are locked into their loan repayments, so the only way they can respond is to either reduce their savings or cut back on spending elsewhere.

The recent review did not look into this inherent limitation of monetary policy. This is one of the reasons that not much will change as a result of the review. You could say that, if the RBA were a hammer, this review will make it a slightly better-designed hammer. But hammers are only good for a particular type of problem – one that looks like a nail. For everything else, they tend to be too blunt to be much good.

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