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The Reserve Bank seems to have lost its way on monetary policy

By Henry Thornton - posted Wednesday, 19 November 2003

"Any statistical relationship that is relied upon will cause changes of behaviour that changes the relationship." This is a loose translation of some elegant scepticism called "Goodhart's Law". My teenage son translates it as "shit happens" as it is now happening for the Reserve Bank.

To fully explain this we must go back to the early 1970s, when the Whitlam government was wreaking havoc on the Australian economy. Inflation was being imported, although the totally mistaken Federal Treasury was blaming the unions. The exchange rate was hiked, and at one stage reached almost US$ 1.50 - yes, US$ 1.50. This is not a misprint! Tariffs were cut. Wages were hiked. Australia's industry, especially its manufacturing industry, was rendered highly uncompetitive. Money supply grew far too fast - reaching an annual rate of growth of 26 per cent if memory serves.

The results were entirely predictable. Inflation surged, unemployment rose, recession bit and Whitlam was booted out by an angry electorate after a pre-emptive strike by the Governor General.


Malcolm Fraser and his Treasurer John Howard set to work to restore some semblance of stability. Stability was achieved but there was no push for reform, perhaps most basically because of the perceived failure of Whitlam's "reforms" in the economic sphere. A further factor was the shell-shocked Treasury. Beneath the waterline, however, a fierce debate raged among the econocrats. The issue? A doctrine called "monetarism." Monetarism is a loose set of free-market principles associated most obviously with the Nobel Prize winning economist Milton Friedman.

"Inflation is always and everywhere a monetary phenomenon" Friedman proclaimed. Treasury was sceptical, the Reserve Bank inclined to sympathy. Eventually Treasury accepted the doctrine, and persuaded the government to adopt a set of "conditional projections" for growth of one measure of the money supply, M3. These were not "targets", as the Young Turks of both Treasury and the Reserve Bank would have had them, but they were better than nothing. The "Old Turks" went along with this approach as it gave them a stick with which to beat the government.

There was of course a technical flaw, as Australia's currency was still semi-fixed - this was the era of the "crawling peg." Only with a fully flexible exchange rate could the money supply be properly controlled, as the technicians of Treasury and the Reserve Bank fully understood. The Old Turks of the Reserve Bank were fond of quoting Goodhart's law to remind the Young Turks that no single target would be reliable. But with a combination of skill and good luck, the monetary "projections" were achieved for the first two years.

Then came the election of the Hawke-Keating Labor government. In short order economic reform was again on the agenda. The vital change was the float of the Australian dollar, which finally gave the "monetary authorities" the technical means to control monetary growth - at least according to the simple textbook models. But financial deregulation generally cast great doubt on the previously established relationships. Estimates within the Reserve Bank's Research Department showed that M3 was likely to grow far faster than the prevailing "projection" as the banks regained market share lost during the previous era of regulated financial markets. Attempting to attain the "projection" would require an excessively tight monetary policy that would produce unnecessary damage to the economy. After debate, the projections were abandoned - this was the only sensible approach. (The only consolation for the Young Turks who had supported the "projections" and would have had them as "targets" was that it was their own analysis that led to the change of approach.)

The "projections" being abandoned, what could the journalists and outside analysts focus on? That was the question and there was no easy answer. "We always look at every economic indicator," one bright chap pointed out, "so let's codify this." So the "Check List" was devised. Everyone involved in policy advising was uncomfortable with this, but a "Check List" was deemed better than admitting that the compass was broken and the monetary authorities were flying by the shiny seats of their pants.

Hindsight is a wonderful thing. Many years later, the current governor of the Reserve Bank described the mid-80s Check List as "ludicrous." This was well after a vigorous debate had produced a new, supposedly more reliable, monetary compass. I have it on high authority that Ian Macfarlane also used the word "ludicrous" in 1989 in response to the OECD's advocacy of inflation targeting. Clearly either he was rolled and/or changed his mind!


The new compass is the rate of inflation. Australian monetary policy, now that it is being implemented by a wiser group of boffins who are technically "independent" of political government, would no longer suffer the slings and arrows of the criticism of flying by the seat of its shiny pants. "But wait," I hear you cry. "Inflation is well within the Reserve Bank's target range, and it expected to fall, not rise. So why did the Reserve raise interest rates?"

That, of course, is for the current Governor to explain. I have no problem - indeed, I believe a prudent central bank would have raised interest rates sooner than it did. Domestic demand it growing at an unsustainable rate, national saving is negative, household debt is skyrocketing, the balance of payments is far too high, unemployment is falling and wage pressures are emerging. This "Check List" of domestic factors has demanded action for several months now, arguably for longer.

Goodhart's Law has again reared its head and as a consequence Ian Macfarlane is clearly using a "Check List," rather than inflation as demanded by his formal charter. If our commontariat was on the ball, the major inconsistency in the Reserve Bank's position would have been exposed and discussed by now. In the absence of such a response, this old monetarist has had to re-enter the debate.

Over to you, Governor Macfarlane.

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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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