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New breed of vigilantes controls monetary policy

By Henry Thornton - posted Tuesday, 6 September 2005

There is almost universal agreement that Australian monetary policy is "set fair" with no need to change for the foreseeable future. Oil at $US70 a barrel and the havoc wreaked by Hurricane Katrina may lead the US Fed to slow its tightening.

The run of Australian economic data provides no strong or obvious reason for policy changes. Indeed, the latest slowing of monetary and financial asset growth gives some comfort about the general soft-landing hypothesis that the monetary authorities have been assuming and hoping for. Is this the death of monetary policy?

Interest rate changes are still possible, of course. A collapse of global asset prices, if the price of oil keeps rising or if bird flu mutates and turns into a human pandemic, would quickly lead to interest rate cuts around the globe, including in Australia. But such cuts would be implemented by market forces well ahead of action by central banks.


Today, we explore the view that monetary policy is nowadays largely in the hands of the market. This is not a new idea, but the main actors are different. This deserves explanation. The non-official hands that shape monetary policy were once described as those of financial market vigilantes. This was in the days when bond market participants were sceptical about the resolve of central banks to control inflation. Market interest rates frequently rose ahead of the cash rates controlled by central banks. Now, financial market participants are believers in the resolve of central bankers. But other actors impose different disciplines.

We start with some potted history of monetary policy in Australia - something similar could be constructed for other developed countries. The graph shows aspects of our monetary history over 3½ decades. The lines show growth of a broad monetary aggregate (M3) and growth of a measure of goods and price inflation (CPI inflation.)

Milton Friedman once famously said "inflation is always and everywhere a monetary phenomenon". The 1970s in Australia provided apparent support for this proposition. M3 growth surged and, after a lag, CPI rose sharply. Money growth fell and so did inflation. Money growth again rose and so did inflation. Two oil price surges did not upset the clarity of this relationship, although oil price fluctuations were part of concurrent global monetary fluctuations, as clever analysts noted with respect to Australia's experience.

During the 1970s, a form of monetary targeting was adopted in Australia, as it was elsewhere. The theory was simple. Control the growth of money and you would control inflation. Pure Friedmanism. The currency float in 1983 gave more power to monetary policy. Inflation fell - a great result - but money growth rose sharply, upsetting the Friedmanites. The disconnect was attributed to re-intermediation as a result of financial reform that brought finance back on to bank balance sheets. The monetary targets were abandoned and replaced by a checklist. This was controversial but avoided creating the recession rigid adherence to the Friedmanite monetary targets would have produced.

The Reserve Bank governor has described the checklist as ludicrous, but then it seems this was also his first response to the suggestion that Australia adopt inflation targets, the innovation of the 1990s. The severe recession of 1991-92 drove inflation to zero, creating a far lower set of inflationary expectations. The CPI inflation target was introduced by then RBA governor Bernie Fraser under the Labor government and endorsed and formalised by the incoming Liberal government in 1996. Clearly, the performance of inflation (and money growth) has been both more subdued and less volatile since. But there has been no Friedmanite correlation - inflation and money growth have fluctuated almost independently. For example, when the GST drove inflation up, M3 growth fell sharply - no causation there.

In the past few years, annual money growth has been noticeably stronger - averaging around 10 per cent - while CPI inflation has averaged around 3 per cent.


"This is a triumph for inflation targeting," the RBA-boosters proclaim. No doubt the recession helped create a far better climate for inflation control. Little doubt also that inflation targeting helped keep inflation low. But there was one global force that we believe is far more important than either of these factors.

Productivity growth in the US, China, India and elsewhere has been especially strong, an experience that Australia has shared. In Australia's case this is due to economic reform in the 1980s and 1990s, which got us into the race for global best practice in many areas. Global productivity growth has held down global goods and services inflation largely independently of monetary policy, and its imperfect reflection in monetary growth. Relatively high monetary growth has, of course, had its influence. Easy money, with goods and service inflation held down by strong global productivity growth, has spilled over into global asset inflation.

Financial market participants - the old inflation vigilantes - have enjoyed a boom time as asset prices soar. The new vigilantes are the producers of goods and services. Goods and service markets are fiercely competitive, in large part because of the rise of China (with India and many other countries following) and in part because of the global IT and communication revolutions. The many people driving these revolutions have rarely spent more than a moment worrying about monetary policy or monetary growth.

But in driving global productivity growth so hard, the new vigilantes are exercising market discipline far more certainly than the old financial market vigilantes. This is why we asked our question about the death of monetary policy. Of course, if any individual central bank (or government, for that matter) tried to buck the disciplines of the new vigilantes, the price would be high.

We hope the RBA and the federal Government understands this point with total clarity. Only time will tell. But note one particular point. The new global vigilantes are effectively demanding lower rates of income tax. It is no accident that real reform of Australia's income tax is now on the political agenda, and indeed is becoming bipartisan.

The Death of Monetary Policy

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First published in The Australian on Septmeber 6, 2005.

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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at

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