RBA review dashes hopes for reform

An analysis of the Reserve Bank's performance has failed to recommend solutions to key problem areas such as employment, wage growth and inflation. Lachlan Newland reports.

WHEN THE TERMS of reference for the first independent review of the Reserve Bank of Australia (RBA) in three decades were released, economists were pleased to see it would not just look at the structure of the institution, but would ‘assess Australia’s monetary policy arrangements’ more broadly.

Now that the final report has been released, it appears hopes for reform were misplaced.

Full employment

Despite the fact that achieving “full employment” is one of the RBA’s primary objectives – alongside price stability – the panel spent very little time examining exactly what this means.

Our current definition of full employment is based on the “non-accelerating inflation rate of unemployment” (NAIRU). This is the idea that greater bargaining power for workers when unemployment is low results in wage demands that increase business costs which need to be passed on to consumers.

No meaningful reform from review of RBA

Recommendations from the review of the Reserve Bank of Australia's approach to stability seem mostly procedural and lack ideas for substantive change.

Therefore, “full employment” means a level of unemployment leaves enough supply of workers in the labour market to prevent their “price” – wages – from increasing dramatically.

The RBA’s concern is that this effect can allow workers to demand higher wages when they expect inflation to increase, turning an initial price shock – such as a war in Ukraine – into a persistent inflationary episode via the self-perpetuating factor of wages.

Although it recommended that the RBA should ‘better explain its understanding’ of full employment, the review panel provided very little guidance on how it should do that, instead citing a few articles which all concluded that the exact level of unemployment required for this is hard to define.

This is significant, given the staggering amount of research coming out – including from the RBA itself – proving the increasing irrelevance of the NAIRU.

In a speech to the Australian Industry Group in 2018, referencing data from the National Australia Bank and the Australian Bureau of Statistics which indicates labour constraints and wages have not correlated since 2013, RBA Governor Philip Lowe remarked:

“...firms are finding it more difficult to find suitable workers. Yet despite this difficulty, wages growth has not responded in the way that it once did.”

An RBA paper in 2018 found that:

‘...wage growth has remained low and little changed over the past five years while the unemployment rate has declined by around 3 percentage points.’

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There is no doubt the Coalition-stacked Reserve Bank needs a deep clean-out, hopefully, including an updated, more democratic selection process.

A Treasury paper in 2017 found that wage growth from 2012 to 2017 was lower than expected, given the unemployment rate.

It noted that:

‘The unemployment rate is usually a key cyclical factor for wage growth and so the divergence from this relationship is puzzling.’

Another Treasury paper gave evidence that labour market concentration pushed down wage growth by a little under 1 per cent from 2011 to 2015.

All of this points to, at the very least, a “fall” and “flattening” of the Phillips curve as observed by the International Monetary Fund (IMF) — that wages and inflation are less responsive to changes in employment levels.

This was being observed by economists at the RBA as far back as 2008. This effect has also been observed internationally by the IMF and the European Central Bank (ECB).

It begs the question, how weak does this relationship need to be before it disappears entirely? What are the implications of this if our entire monetary framework is based on its existence? Most importantly, why were none of these questions considered in the review?

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Competition policy

This next qualm with the review is not necessarily a failure of the panel, but of the terms of reference themselves.

The Treasurer asked the panel to consider the ‘interaction of monetary policy with fiscal and macroprudential policy’ but notably excluded competition policy.

RBA research from 2018 and 2019 found that market concentration has increased in Australia and that this has contributed to higher price mark-ups by large firms.

These papers found that:

‘...consistent with the increase in retail concentration, aggregate retail mark-ups increased over the mid-2000s, indicating decreasing competitive pressures. Estimates of retail mark-ups suggest that retail prices rose relative to marginal costs over the 2000s...’

As well as:

‘Statistical analysis suggests that higher business concentration across industries has lowered the aggregate labour share since the early 2000s.’

It is clear that the growing level of concentration in Australian markets is a determining factor in competition and price mark-ups, but the Treasurer decided this was not worth consideration.

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Although it was not asked to do so, the panel dedicated a couple of paragraphs to exploring ‘regulations to support market competition, increased use of price controls, financial regulation, or intervention in supply chains’ in response to submissions it received.

It claimed that these policies are not as ‘nimble’ or easy to withdraw as monetary policy and could have ‘undesired impacts’ on ‘competition or the efficient operation of the economy’, although it failed to provide any studies to support these claims.

This is simply incompatible with the admission in the RBA’s February 2023 Statement on Monetary Policy which, referring to price caps imposed on wholesale gas contracts in late 2022, noted that ‘wholesale electricity and gas prices declined’.

In its submission to the Government in relation to the price caps, the Australian Competition and Consumer Commission (ACCC) advised:

‘...a temporary price cap is an appropriate response to the current operation of the market and domestic prices being driven by international factors that do not reflect the underlying cost of production.’

The ACCC also noted last year that ‘competition is posing little constraint on [gas] producers' pricing decisions’.

It found that:

‘...LNG exporters and associates had influence over almost 90 per cent of the proven and probable (2P) reserves in the east coast in 2021...’

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As well as:

‘LNG exporters have been net withdrawers of gas from the domestic market since 2021… which has worsened the gas shortfall.’

If the panel thinks that the RBA and the Treasury should ensure that their ‘long-term frameworks are aligned’ because of their ‘significant interactions’ regarding price stability, the ACCC should also be a part of this process.

At the very least it should be included in the research program the panel recommended which specifically was told to investigate supply issues, a subject the ACCC researches extensively.

Because supply shocks in energy-related industries have knock-on effects in other industries due to transport and manufacturing costs, there is even a case to include the Australian Energy Market Operator (AEMO) and the Australian Energy Regulator (AER) in this research.

All the evidence suggests that our dogmatic approach to managing inflation lacks the nuance required to address its root causes which may be varied and microeconomic in origin. Instead, it is based solely on the principle of addressing a “wage-price spiral” which has become increasingly less relevant given the change in power dynamics between labour and firms.

If we’re going to effectively manage inflation in a future of fuel and resource uncertainty caused by climate change, we need to be honest about its causes – both the how and the who – and plan ahead.