Australian Monetary Policy in the Last Quarter of the Twentieth Century

It is an honour to be invited here tonight to

deliver the Shann Lecture. As is customary

when giving a memorial lecture, I have

re-acquainted myself with the writings of the

man whose memory we are honouring. It is

noteworthy that for most of his working life

he held a Chair at this University in History

and Economics, as opposed to Economic

History. This allowed him to range over a broad

area, both as a scholar and as a polemicist.

His scholarly reputation rests mainly on his

economic histories, and I am pleased to record

that he also wrote a fine piece on monetary

policy in 1933 called ‘National Control of

Banking’.1 His best known work, ‘The Boom

of 1890 – and Now’, was not much more than

a pamphlet, but was extremely important in

establishing his reputation among the wider

public. Written in 1927, it was an account of

a period about 40 years earlier – a period that

was recent enough to matter, but too long ago

to have figured in people’s working lives. I see

a lot of value in this type of work, and have

even tried my hand at a similar piece myself.

Tonight, I would like to move to a more

recent era and to a narrower topic, by

examining the development of monetary

policy over the last quarter of the twentieth

century. In doing so, I intend to cover not only

the institutional changes, but, where relevant,

the intellectual cross-currents and the political

influences that were at work. It may seem

strange to give a prominent role to political

influences, because the end point we have now

reached in our monetary policy framework in

Australia is not dissimilar to that of a number

of countries that have had very different

political developments. But even though the

end points are similar, the sequence of events

in the Australian development has been

unique, and political influences have played a

role in that sequence.

Around the world, the mid-70s was a very

unhappy period for macroeconomics – to find

a worse period in terms of economic

mismanagement, we would have to go back

to the 1930s. In the 1930s a severe deflation

was let loose on the world economy, while in

the 1970s it was a severe inflation. To make

matters worse, even though the inflation of

the 1970s was initially tolerated because it was

1. Published in Shann (1933).

thought to be helpful in pushing

unemployment down to very low levels, it

ended up having the perverse effect of yielding

a higher level of unemployment. The word

stagflation was coined to describe this period.

The experience of the Australian economy

in the mid-70s reflected these unfortunate

worldwide developments to the full. The

underlying rate of inflation reached 20 per cent

by early 1975 and was in double digits again in

the early 1980s. Unemployment rose from

1.4 per cent at the start of the decade to

6.5 per cent by 1978. While the unemployment

rate rose further in later decades, it was the

1970s that transformed Australia from a low to

a high unemployment economy.

All macroeconomic policies came in for

severe and justifiable criticism at this time,

monetary policy being no exception. A similar

phase of self-examination occurred in all

OECD countries, and there was intense

debate about monetary policy in the economic

literature. In this lecture, I would like to

examine how this debate evolved in Australia

and how it led to changes in our monetary

institutions, our guiding economic principles,

and the responsibility for decision-making. I

intend to concentrate on these three main areas:

• First, changes to the institutional

structures which formed the

underpinnings of the money supply

process – regulations on banks, methods

of government debt financing and the

exchange rate regime. Changes to these

features amounted to fixing up the

underlying ‘engineering’ of the monetary system.

• Second, changes to the guiding economic

principles which determined whether

monetary policy was on the right course.

• Third, changes to the ‘governance’ of the

monetary policy decision-making process.

From the above description it may still not

be completely clear exactly what the difference

is between these three main areas of change.

Perhaps it will be a little clearer if I employ a

metaphor. If we were to picture monetary

policy as a ship, the first of these changes was

to stop it leaking, the second was to equip it

with a more reliable navigation system and

the third was to work out who should be at the helm.

I do not wish to spend a lot of time

describing how the monetary ship was made

seaworthy because there are already some very

good accounts available.2

At our starting point in the mid-70s, most

observers agreed that loose monetary policy

had been a major factor behind the rise in

inflation, and that it needed to be tightened.

Unfortunately, there were significant

structural deficiencies in the system which

meant that no one could be confident that a

tightening could be achieved with any reliability.

The first deficiency was that the system

relied heavily on direct controls on banks,

including interest rate ceilings imposed on

banks’ deposit and lending rates. This meant

that, even if monetary policy was successful

in limiting the expansion of bank deposits and

lending (and it was by no means clear that it

would be), the tightening of conditions would

not extend to the non-bank financial

intermediaries. It was this group – merchant

banks, building societies and finance

companies (formerly called hire purchase

companies) – which were usually the fastest

growing providers of finance.

The solution to this problem was to remove

the interest rate ceilings and allow banks to

compete on equal terms with other providers

of finance.3 This meant that if banks were

2. Grenville (1991).

3. This may seem obvious now, but it was not the first response to the problem. The first response was to set in train a process whereby interest rate ceilings would be extended to cover all non-bank financial institutions. An Act of Parliament was passed – the Financial Corporations Act of 1974 – to do this, but Part 4 of the Act was not proclaimed and therefore the powers to extend controls never came into effect.

short of liquidity they could raise interest rates

and compete for funds with other

intermediaries who, in turn, would probably

have to match them. In this way the tightening

of conditions would be spread across the

whole financial sector. Interest rate ceilings

on deposits were removed in December 1980

and on smaller business loans in April 1985.

With the removal of the ceiling on loans for

owner-occupied housing in April 1986, the

last of the interest rate ceilings was gone.

The second deficiency in the system was

that there was no mechanism in place to

ensure that the budget deficit was financed

entirely by borrowing from the public. Any

shortfall in borrowing from the public was

automatically met by the Government

borrowing from the Reserve Bank, a method

of financing which is colloquially known as

‘printing money’ or ‘monetising the deficit’.

In order to stop these unintentional monetary

injections into the system, the Government

needed to move from its existing system,

where it set interest rates on government

bonds and issued only the amount of bonds

that the market wanted to buy (the ‘Tap

System’), to a new system where it sold the

amount needed to finance the deficit at

whatever interest rate the market demanded

(the ‘Tender System’). This move occurred

in 1979 for Treasury notes and in 1982 for government bonds.4

Finally, the fixed, quasi-fixed or occasionally

changed exchange rate regimes that Australia

had used over the post-war period introduced

another element of unintended monetary

injections or withdrawals into the system.

Under all these systems, the Reserve Bank had

to clear the foreign exchange market at the

end of each day. If there were more buyers of

Australian dollars than sellers, this effectively

represented an injection into the Australian

money supply. This meant that if monetary

policy was tightened in Australia with a view

to slowing the growth of the money supply,

its effects could be offset through the foreign

exchanges. This is because the tightening of

monetary policy would raise Australian

interest rates relative to other countries, and

attract money into Australian dollars. In the

first instance, this could be offset by

Reserve Bank open market operations, but in

the long run it could be self-defeating. This

problem was overcome with the floating of

the Australian dollar in December 1983.

These three changes were effectively

completed by the mid-1980s. Even though

one of them – the float of the currency – was

a massive change to Australia’s economic

structure,5 the three changes were seen by

economists as largely technical in nature, and

there was little dissent in the economic

community. Also, there was no political

polarisation with one party supporting and the

other par ty resisting the change. The

Campbell Committee, which reported in

September 1981, had been an important

influence in establishing a consensus for

change. This Committee had been set up by

a Coalition Government, but most of its

recommendations were implemented by a Labor Government.

The move to greater exchange rate

flexibility, which, as explained above, had

begun well before the float, meant that

monetary policy needed a new guiding

principle (or a new navigation system, to quote

the metaphor used earlier in this Lecture).

Instead of having an external guide (the fixed

exchange rate), a satisfactory internal guide

had to be found. This process, beginning in

the mid-1970s, took Australian monetary

4. This change permitted another important improvement – the separation of debt management from monetary

policy. See Phillips (1985) and Reserve Bank (1993).

5. Even here the break was not as dramatic as it seems, because Australians had already got used to daily bilateral

exchange rate movements under two of the pre-float exchange rate regimes. Under both the ‘fix to the trade

weighted basket’ (1974 to 1976) and ‘adjustable peg to the trade weighted basket’ (1976 to 1983), the exchange

rate of the Australian dollar against the US dollar could change every day, even though the Reserve Bank cleared

the foreign exchange market at the end of each day.

policy from a system based on pure discretion,

to monetary targeting, and ultimately to the

present system of inflation targeting. The

changes were not always smooth and there

were some important gaps along the way

which have never been satisfactorily explained.

I would like to retrace some of this ground

tonight. In doing so, I hope to skip lightly over

the periods that have been covered fully before

and concentrate on those that have been neglected.

From 1945 to 1971 the Australian dollar

was pegged against the US dollar, and this

effectively formed the centrepiece of

Australian monetary policy. If our economic

conditions got too far out of line with those

in the United States it would imperil the

exchange rate, and so fiscal and monetary

policy would have to change in order to

prevent it. It is a simple system, and one that

still finds favour in a number of quarters

around the world. The best known current

example of this system is the Exchange Rate

Mechanism of the European Monetary

System, which is scheduled soon to go a step

further into monetary union with a single

currency (the Euro) and a single central bank

– the European Central Bank.

Our link with the US dollar was broken in

1971, and thereafter the discipline exerted by

a fixed exchange rate dissipated; once the link

was broken the first time, it was no longer

‘sacred’ and could be broken again. Although

we retained a pegged exchange rate system in

one form or another until 1983, parity

adjustments became increasingly frequent. We

were effectively on our own with no clearly

enunciated guiding principle behind our

monetary policy until monetary targeting was

introduced in 1976. This period of four-anda-

half years could therefore be regarded as one

where unconstrained discretion was the

underlying basis of monetary policy.6 Since

it was also the per iod when inflation

accelerated most quickly and reached its

highest level, it confirmed the general

suspicion among monetary economists that

something more than pure discretion was

needed. Some guiding principle, or rule, that

limited the capacity for discretion in monetary

policy was essential to keep it from falling

under the influence of expediency or

succumbing to populist pressures for an

excessively expansionary stance.

By January 1976 that guiding principle was

found when Australia fell into line with a large

number of other industrialised countries by

introducing a monetary target. This move,

which coincided with the election of the Fraser

Government, had strong support from the

Reserve Bank and the Treasury. Within the

Bank, the Research Department had been

heavily influenced by academic monetarism,

as evidenced by much of their research output

in that period and the choice of visiting

overseas scholars.7 At the top of the Bank,

the Governor and Deputy Governor were

supportive of the new regime, but retained a

degree of scepticism and a recognition of the

need for some flexibility.8

The Australian system of monetary

targeting was based around an annual target

for M3, which was not unusual by world

standards. What was unusual was that it was

set by the Treasurer on the joint advice of

Treasury and the Bank. Another unusual

feature was that the Bank always preferred to

use the term ‘conditional projection’ rather

than target. Its success, as measured by how

often it was met, or by the size of over-runs,

was not very different to experience

elsewhere.9 This degree of success was

6. The term discretion is used by economists to describe the conduct of monetary policy where the authorities adjust

policy by reference to a range of indicators, none of which has any special standing. A criticism of discretion is that

the public does not know what the monetary policy framework is, and therefore has trouble telling whether the

authorities are acting in accord with principles or expedience. As a system, it is the opposite of a rule (such as a

fixed exchange rate or monetary targeting).

7. Professors Laidler, Parkin and Poole all spent time at the Reserve Bank during this period.

8. See Sanders (1979, 1982).

9. Argy, Brennan and Stevens (1990).

somewhat surprising considering that for most

of the period over which it operated the

underlying monetary ‘ship’ contained all the

leaks and distortions referred to in the

previous section.

The era of monetary targeting lasted for

nearly nine years (from April 1976 to

January 1985), which roughly coincided with

the period which Goodhart describes as ‘the

high watermark of international

monetarism’.10 I do not propose to examine

its strengths and weaknesses at any length

because I have done so elsewhere, as have

others.11 Suffice to say that it did bring some

order to Australian monetary policy and was

a big improvement on its predecessor.

Nevertheless, it had only limited success in

its central task of reducing inflation, and as

time went on its inherent weaknesses began

to show. The logic of monetary targeting

presupposes a stable statistical relationship –

the demand for money – which implies that

inflation is ultimately linked to the rate of

growth of the money supply. This relationship,

as in other countries, was never very precise

over short periods, but that could be tolerated

if it retained its long-run stability qualities. In

time, particularly as a result of financial

deregulation, the long-run relationship started

to become unstable. At some point, M3

targeting had to be abandoned.

In the event, monetary targeting was

discontinued in January 1985. The immediate

reason for it was the extent of overshooting

that was occurring during 1984, which

seemed to indicate the effects of financial

deregulation rather than a major rise in

incipient inflation. Also of importance was the

fact that Treasurer Keating had made no secret

of his lack of enthusiasm for this approach to

monetary policy.12 Even so, the decision to

discontinue targeting was seen by some as

precipitate, and many in financial markets

were unprepared for the change. The Bank

was criticised for not having produced a

convincing body of work containing the

evidence for the change in policy regime.

Some of this criticism was justified, but to

prove the breakdown in a long-run

relationship always takes a long time.13

To allay the fears of those in financial

markets who thought that the end of monetary

targeting meant a return to unconstrained

discretion, the Bank looked for an alternative

framework which it could use as the basis for

its monetary policy. As a result, the so-called

‘checklist’ was born. Its birth was announced

in May 1985 by one of my predecessors, and

its most detailed exposition was given in his

1987 Shann Lecture.14 In the event, it proved

to have a short life and there was little further

mention of it after that time. The checklist

contained a number of economic variables

that were to be taken into account in setting

monetary policy. Up to a point, it was useful

in conveying the sensible idea that monetary

policy needed to look at a wide range of

indicators, not just one. Its problem was that

it did not have a sufficiently well-thought-out

economic rationale or any cr iteria for

determining which indicators were more

important. In particular, it failed to distinguish

between the instrument of monetary policy,

intermediate targets and ultimate targets (an

essential framework that is to be discussed in

the next section). They were all in there, along

with at least one variable that did not fit into

any of these categories.

The checklist was introduced in haste –

barely four months after the end of monetary

targeting. It had not undergone close

economic analysis within the Bank, and had

not been exposed to prior public scrutiny

through research papers. In defence, it has to

be said that the circumstances of the time were

very turbulent; in 1985, the currency was

10. Goodhart (1989).

11. Grenville (1997), Edey (1997).

12. As explained earlier, it was the Treasurer who set the annual monetary target, which he announced in his budget.

13. Decisive evidence was produced in a series of research papers beginning in 1987.

14. Johnston (1985, 1987).

plunging, bond yields were rising and there

was a loss of confidence in Australian

macroeconomic policy and serious doubts

about the sustainability of our external

position. There was a feeling something had

to be done. Nevertheless, an important lesson

was learnt from the episode – no central bank

should commit itself to a new monetary policy

regime until it has researched the subject

thoroughly and established its credibility with

reference to the economic literature and

overseas practice.

With the short-lived ‘checklist’ period over,

the Bank entered 1988 with no articulated

framework for monetary policy, but a

determination not to introduce a new one in

haste. At first, there was little pressure from

the markets, the press or the economic

community to deliver a new framework

because by 1988 the currency woes of 1985

and 1986 seemed well behind us. But that

mood soon changed as critics began to focus

on the fact that Australian inflation had not

returned to relatively low rates as it had in

most OECD countries. It is this period of

intense criticism – roughly from 1989 to 1993

– that I would like to cover in some detail. I

trust I can do this safely now because we are

far enough past this period for it to have lost

its political sensitivity, but close enough to still

remember the details.

The main charge of the critics was that

Australia was still an inflation-prone economy,

and that its central bank was never going to

be able to improve the situation while-ever it

relied on unconstrained discretion as the basis

of its monetary policy.15 The critics also

attacked the Reserve Bank for a lack of

independence. Other high inflation countries

such as the United Kingdom (which was

opting for membership of the European

Monetary System) and New Zealand and

Canada (which were opting for inflation

targeting) were doing something about

‘stiffening up’ their monetary policy

frameworks, but Australia appeared to be

doing nothing. To make matters worse, in the

eyes of the critics, the newly appointed

Governor – Bernie Fraser – was known to be

a close associate of Treasurer Keating, and

they therefore assumed his appointment

would result in a reduction in the Bank’s

independence, already perceived as being too

little. This was another subject where they also

had some suggestions, but I will save the

discussion of central bank independence until

the next section. For most of the critics, there

was no alternative but radical reform of the

legislation to create a new type of central bank

subject to some form of binding monetary

rule.

Many of the critics were also influenced by

academic thinking which held that

discretionary monetary policy would

inevitably fail. Discretion was held to be

destabilising, and to have an inevitable

inflationary bias which could only be

corrected by the imposition of a rule on the

central bank. These conclusions, deriving

mainly from the writings of Friedman and

other members of the monetarist school,

received empirical support from the events of

the 1970s and 1980s.16 This debate is usually

called the ‘rules versus discretion’ debate, and

those supporting a rule generally got the better

of the argument. They were reinforced by the

newer sophisticated writings of the rational

expectations school, and in particular by its

introduction of the concept of ‘time

inconsistency’, which purported to show that

15. Many of the criticisms took place in the political arena and in the columns of newspapers, but the more substantive

ones mainly appeared in economic or political journals. A reasonably comprehensive sample of the substantive

ones would include, in chronological order, Hartley and Porter (1988), Jonson (1989), White (1989), Cole (1990),

Dowd (1990), Jonson (1990), McTaggart and Rogers (1990), Morgan (1990), Stone (1990), Hartley and

Porter (1991), Sieper and Wells (1991), Evans and Dowd (1992), Hanke, Porter and Schuler (1992), Moore (1992),

Stone (1992), Makin (1993), Evans (1994) and Weber (1994). The titles of some of the conferences organised on

the subject around this time convey the flavour: e.g. ‘Do we need a Reserve Bank?’ (CIS 1989); ‘Can monetary

policy be made to work?’ (IPA 1992).

16. Friedman (1968), Brunner (1980) and Poole (1980) are good examples of this literature.

there was a technical reason why only a rule

could contain inflation.17

While there was a degree of agreement

among the Australian critics about what was

wrong with Australian monetary policy, there

was less agreement about what rule should

replace the existing system. The critics

proposed a wide range of alternative models,

including a currency board, monetary base

targeting, a return to targeting broader

monetary aggregates, various forms of

commodity standards, and a combination of

inflation targeting and central bank

independence.18

Within the Reserve Bank there was some

sympathy for an important part of the critics’

case; it was conceded that monetary policy

based entirely on discretion was intellectually

and practically unsatisfactory, and it had been

associated with high inflation in country after

country. We also agreed that something better

was needed, but most of the concrete

proposals could be dismissed as impractical.

There were no practical working models of

strict monetary base control or commodity

standards, and monetary targeting and fixed

exchange rates had already been rejected as

unsatisfactory for Australia.

The difficulty arose with respect to the

inflation targeting proposals. There was

recognition within the Bank that this was the

most promising approach, but political

circumstances contr ived to make our

participation in the debate marginal at best.

This was because from about late 1989

onwards the most vocal proponent of the view

was John Hewson, first as shadow Treasurer,

then as the Leader of the Opposition. This

had the effect of forcing the Government into

defending its record on monetary policy and

hence the existing institutions and approach.

It was a great disappointment for the Bank

that this debate was politicised19 before the

economics profession had time to explore it

fully in an objective non-partisan way. But it

would be unfair to criticise either of the two

political protagonists for this – there is nothing

wrong with them being quicker off the mark

than the economics profession.

The Bank had long agreed with its critics

that Australia’s high inflation rate was an

obs tacle to sus tained economic

development and that monetary policy

would have to play the major role in

remedying the situation. During 1988 and

1989, the Bank’s research efforts were

taking it towards a model that had a lot of

similarities to those which underlay the

New Zealand or Canadian style inflation

targeting.20 Our research had taken us

down a path that led to the same general

framework as those models, (and of the

model of inflation targeting we eventually

adopted in 1993). It is summed up in the

schematic framework in Table 1.

In August 1989, which was just before the

subject had become politically charged, I was

able to summar ise our views to an

17. See Kydland and Prescott (1977), and Barro and Gordon (1983).

18. Hartley and Porter (1991) proposed either a monetary base control regime or a currency board. Hanke, Porter

and Schuler (1992) favoured a currency board. McTaggart and Rogers (1990), Sieper and Wells (1991) and

Makin (1993) supported monetary base targeting, while Weber (1994) supported targeting M1. Commodity

standards were proposed by White (1989), Dowd (1990) and Evans (1994).

19. I have reviewed the files in our Press Office for this period, and am still surprised at the huge amount of material

they contain. Although only the most important pieces have been kept, the Hewson versus Keating controversy

over the Reserve Bank is detailed in literally hundreds of press cuttings, excerpts from Hansard, competing press

releases and media interviews. The files confirm that Dr Hewson initially criticised the Bank in late 1989 for being

too close to the Government and called for greater independence and more emphasis on medium-term

anti-inflationary policy. This general critique was made more concrete in mid 1991 when he proposed legislative

changes to ensure independence and the single objective of inflation, plus the introduction of an inflation target of

0 to 2 per cent. It was this proposal that became part of the ‘Fightback’ package in late 1991 which formed the

basis of the Opposition’s 1993 electoral platform.

20. Some of this was presented in a conference held by the Reserve Bank in June 1989; see Macfarlane and

Stevens (1989) and Edey (1989). See also Grenville (1989).

international audience of central bankers as

follows: the cash rate is the instrument of

monetary policy,21 there is no intermediate

objective,22 and the ultimate objective has to

be a nominal variable such as the rate of

inflation or nominal GDP23 (the asterisked

elements in Table 1).

While we accepted some of the arguments

of our critics, and we shared a common

framework with the most practical of the

alternative models put forward, there were

still some major differences. First, and most

importantly, we believed that we could

achieve what our critics wanted – a return

to a low inflation environment – without

radical overhaul or a complete rewriting of

the Reserve Bank Act. In a sense, we

believed that reform from within was

possible and that this would gradually

return Australia to being a low inflation

country. Secondly, we believed that the

early overseas formulations of the inflation

targeting/central bank independence model

were too rigid in several ways:

• There was a tendency to suggest that the

single objective of low inflation meant that

central banks should pay no attention at

all to other economic variables. We felt that

there are a number of circumstances

where, even if pr imacy is given to

maintaining low inflation, the effects on

output and employment had to be taken

into account and had to influence

monetary policy actions. The best central

banks overseas, moreover, clearly behaved

in this fashion.

• There was a tendency for proponents to

understate the output and employment

costs of the initial reduction in inflation.

This was because they relied on the

conclusion from the rational expectations

school that credible disinflations would be

relatively costless.

• We were worried that if central banks were

to be judged only by inflation results, there

would be a tendency to over-achieve, i.e.

they would be very reluctant to allow

inflation to rise, even if only slightly and

for short periods, but would readily accept

circumstances that pushed the economy

in the deflationary direction.

• Because New Zealand and Canada had

chosen 0–2 per cent as their target, that

had become the numerical norm in

Overnight interest rate* None* Inflation*

or or or

Money base Money supply Nominal GDP*

or or

Exchange rate (Real GDP)

or

(Employment)

or

(Balance of payments)

21. ‘For all intents and purposes, the cash rate is our instrument’ (Macfarlane 1989).

22. ‘No-one can dispute the need for an instrument, or for the ultimate aim of monetary policy to be made clear. The

one part of the trilogy that is not self-evident is the need for an intermediate objective. It is the part we have come

to doubt, and ultimately to discard’ (ibid.).

23. ‘We have no desire to dispute the widely held proposition that the ultimate objective of monetary policy should be

a nominal variable such as the rate of inflation or the rate of growth of nominal income. A system which operates

directly from instrument to ultimate objective still has to contend with the fact that there is a long interval between

the movement in the instrument and the resulting change in the ultimate objective. For this reason, actual inflation

is not a good guide for monetary policy; leading indicators of inflation are much more useful’ (ibid.).

discussions of inflation targeting. We

regarded this as probably too low, and

certainly too narrow a range.24 No country

had achieved this sor t of inflation

performance over any significant time

interval in the past 50 years. We did not

like the concept of a ‘hard edged band’,

particularly the early formulations which

suggested some decisive action occurring

whenever the band was breached.25

During the early 1990s, par ticularly

between the 1990 and 1993 elections, the

Bank had to keep a pretty low profile in the

debate because of the political constraint

alluded to earlier. Governor Fraser made a

number of speeches which defended the Bank

and its monetary policy. In some of these he

also questioned the more extreme versions of

inflation as the single objective, and disputed

the view that central bank independence

meant that there should be an adversarial

relationship between the central bank and the

Government.

During this period, the lack of a monetary

policy framework that could command

widespread support had its costs. It meant that

each of the monetary policy easings of 1990

and 1991 were met by the charge that they

were only done for political reasons (lowering

interest rates was presumed to make the

Government more popular). There was clearly

great distrust of monetary policy, the

Government and the Reserve Bank – or, in

modern parlance, a lack of credibility.

It is interesting that virtually all of the

serious criticism of the Bank in this period

was coming from the perspective that it was

too soft on inflation.26 Hence the proposals

for reform were all aimed, in one way or

another, at eliminating the supposed

inflationist tendencies. Yet, while all the debate

was going on, inflation was actually falling to

its lowest level for a generation. In some

senses, it was this that ultimately proved

decisive in confirming that it was possible to

return to a low inflation environment without

radical change to the Reserve Bank or its Act.

It was this economic development that

ultimately ended the debate in our favour.

Having said that, I do not want to suggest

that we foresaw the whole development and

were always confident of the result. We, like

our counterparts in other countries, were

surprised by how far and how quickly inflation

came down at the beginning of the 1990s. We

also did not forecast the depth of the 1990/91

recession. But once inflation had come down,

we felt that there was a high likelihood that it

would stay low during the subsequent phase

of economic growth. We also felt that an

inflation target would help to bring about that

result.

As I have already suggested, much of the

intellectual groundwork for the development

of our inflation target had been laid well before

its introduction. The crucial step required to

turn this into reality was the adoption of a

published numerical target. For reasons

already alluded to, it was some time before

this step was taken. Not only was the issue

highly politicised, but there was a strong

presumption (by both the cr itics and

proponents of inflation targeting) that an

inflation target had to be ‘0–2’, which the Bank

felt would have been too restrictive. Although

we had a general aim of getting inflation down,

we did not follow the New Zealand or

Canadian sequence of announcing, in

advance, a planned reduction to a particular

range over a specific time period. As it turned

24. We think our views were vindicated when Canada shifted its end-point target to 1–3 per cent in 1994 and

New Zealand to 0–3 per cent in 1997. On the other hand, Canada and New Zealand could respond by pointing

out that they are now well within their ‘old band’, and did not need the change.

25. For example, the automatic dismissal of the Governor, or a system where the Governor’s salary was inversely

related to the rate of inflation. While these have never become a part of any country’s system, they were widely

believed to be an important part of inflation targeting in much of the early Australian discussion.

26. There were some exceptions – Phipps and Sheen (1995), Bell (1997), Langmore and Quiggin (1994) – but they

came after the 1989–1993 period. Also, they did not propose any restructuring of the Reserve Bank; they merely

argued that it should have run easier policy.

out, that sequence was reversed in our case –

inflation was reduced, and a commitment to

keep it low as then put in place.

The process of establishing that

commitment in the public arena was itself a

gradual one. Governor Fraser in 1993 referred

in two speeches to the objective of keeping

inflation around 2 to 3 per cent.27 The initial

flavour of these remarks was that inflation had

reached a trough in the early-1990s recession,

and that the Bank wished to ensure that it did

not rise appreciably during the recovery. This

commitment was expressed increasingly

firmly with time.

In developing our inflation target, the Bank

was encouraged by the examples of other

countries such as the United Kingdom and

Sweden, which adopted inflation targets in

1992 and 1993. These showed that alternative,

less rigid inflation targeting models could gain

acceptance. Both countries specified targets

higher than the original ‘0–2’ model.28 Our

own choice of a 2–3 per cent figure was based

partly on pragmatic considerations.29 Inflation

had declined to a trough of 2 per cent, and

the main priority was to stop it rising too much

from there. There was also a respectable body

of academic opinion to suggest that it was

optimal to aim for something in the low

positive range rather than too close to zero.30

The other unusual aspect of inflation

targeting in Australia was that it was

introduced by the central bank. In other

countries such as New Zealand, Canada and

the United Kingdom, it was from the outset a

joint undertaking by both government and

central bank, with the former setting the target

and expecting the latter to achieve it. Usually,

the agreement was formalised in a public

document. The evolutionary nature of this

process of change in Australia was no doubt

unsatisfactory to some of the Bank’s critics.

They would have preferred a more decisive

regime shift, and there were some who felt

that the absence of such a shift meant that we

did not have a ‘proper’ inflation target.

But gradually, the Government began to

recognise that the inflation target was helpful

to good economic policy. They had not argued

against it after it was introduced, but it was

difficult for them to embrace it

enthusiastically, given its chequered political

history. Even so, by 1995 and 1996,

Treasurer Willis was publicly giving the

Government’s endorsement to the Reserve

Bank’s target. In June 1995, in Accord Mark

VIII, the ACTU agreed to aim for wage

increases that were compatible with an

inflation outcome of 2 to 3 per cent. Thus,

Australia was gradually arriving at a very

satisfactory position whereby most of the

monetary policy regime was now receiving

bilateral support – a huge improvement on

the situation in the early 1990s.

This is the third and last of the areas of

monetary policy that needed to be clarified

and improved. Returning to the nautical

analogy introduced in the first section – this

area concerns the question of who should be

at the helm now that the vessel has been made

seaworthy and equipped with a reliable

navigation system? Most listeners will

recognise that this boils down to the

much-discussed subject of central bank

independence, to which I promised to return.

Although there has been a worldwide

movement towards greater central bank

independence over the past decade, I propose

only to talk about the aspects that have been

unique to Australia. One of the peculiarities

27. Fraser (1993a, 1993b).

28. In the United Kingdom, the initial target was 1–4 per cent, but to be in the lower half of the range by the end of the

parliamentary term. Sweden’s target range was 1–3 per cent.

29. See Stevens and Debelle (1995) for a discussion of the considerations involved in specification of the target.

30. Summers (1991) and Fischer (1994) outline reasons why a low positive inflation rate may be optimal. Summers

suggests an optimal range of 2–3 per cent, while Fischer’s preferred range is 1–3 per cent. Alan Greenspan had

talked about the need to ensure that inflation was ‘low enough not to materially affect business decisions’.

of the Australian debate on this subject is that

the Reserve Bank, by virtue of its Act in 1959,

was always given a high degree of general

independence as an institution.31 The fact that

it had been unable to exercise this

independence in monetary policy for much

of the post-war period was due to a practical

impediment – it did not possess the

instruments of monetary policy. In the heavily

regulated financial world which characterised

most of the post-war period, virtually all the

instruments – in the form of interest rate

controls on government debt and on bank

lending and borrowing rates – were vested in

the Treasurer. It was not until deregulation

was largely completed in the mid-1980s that

the Reserve Bank was in a position to exercise

the monetary policy powers contained in its

Act. Only when it became possible to use open

market operations to ‘set’ the overnight cash

rate, was the Reserve Bank in a position to

adjust monetary policy in the same manner

as (say) the Federal Reserve Board in the

United States or the Bundesbank in Germany.

This development occurred at about the

same time as the intellectual case for central

bank independence was gaining momentum

in major economies around the world.32 But,

just as in the case of inflation targeting, the

issue of central bank independence in

Australia also got caught up in the political

crossfire between the same two parties. It is

perfectly reasonable that it should become a

political issue, because it is about the optimal

delegation of decision-making authority, a

decision which r ightly rests with the

Government. While the Bank throughout the

1990s had independence, the political

stand-off delayed its official recognition for a

per iod longer than the delay of the

Government’s recognition of the inflation

target. The final recognition was not achieved

until after a change of government had

occurred. In August 1996, the present

Government’s recognition of the Reserve

Bank’s independence and support for the

inflation target.

There is still a lingering misconception in

Australia that parties of the political right

support central bank independence and that

those of the left oppose it. This is a peculiarly

Australian perspective based on our

experience in the early 1990s; it is not true at

present, was not at an earlier date33 and has

not been the case in other countries. The two

best known examples of countries adopting

central bank independence are New Zealand,

where the legislation was introduced by the

Lange Labour Government, and in France,

where it was introduced by the Socialist

Administration of President Mitterand. In the

United Kingdom, the Conservative

Government resisted granting independence

to the Bank of England to the end, but the

incoming Blair Labour Government

introduced it as one of its first Acts. In all of

these three cases, unlike Australia, new

legislation was required because the existing

Acts did not provide for independence.

I have covered a full quarter of a century in

this account, and have attempted to fill in

some of the political, as well as the intellectual,

background. It has been an eventful quarter

of a century for monetary policy, but one

where a lot of progress has been made. Some

of this improvement has been easy because

31. Phillips (1992) and Macfarlane (1996).

32. A much earlier expression of the case for central bank independence can be found in Professor Shann’s

piece on monetary policy, where he wrote … ‘My main theme is that central banking can give a community

and, indeed, a world economy stable money …, if the politicians will give it fair scope and if men of

technical skill and professional morale are given charge of the job with a judicial security of tenure’. Note

that this was written in the middle of the Depression and that the stable money to which he referred meant

principally the avoidance of deflation (Shann 1933).

33. Under the Fraser Coalition Government (1975 to 1983), monetary policy decisions were taken by the Monetary

Policy Committee (MPC) of Cabinet – the opposite of central bank independence.

the star ting point was so bad – the

mid-seventies to late-seventies saw inflation

peak at 20 per cent, while unemployment was

rising and economic growth was going

through its most sluggish phase in the

post-war per iod. Today’s economic

environment is extremely benign in

comparison to those days, even though, like

then, we have the threat of an external shock

hanging over us.

When my account starts, not only were

monetary institutions inadequate, but

monetary policy was not held to be very

important. Fiscal policy was given precedence,

and monetary policy played a subsidiary role.

In those circumstances, it is not surprising that

the monetary framework was not well

developed, and that little public attention was

focused on it. By the time monetarism arrived

on the Australian scene, this all changed.

Monetary policy became regarded as

extremely important and much attention was

focused on it. As we have seen, this attention

eventually increased so that by the late 1980s–

early 1990s, monetary policy had become an

intensely political subject. Not only was the

conduct perceived as political, but the design

of its institutions had become important

enough to form a major part of the electoral

platform of one of the major political parties.

Finally, we have entered a phase where a

measure of peace has returned. The day-today

conduct of monetary policy is still closely

scrutinised by the markets and the media, but

attitudes to the underlying institutions and

framework have reached a measure of

bipartisan support. With the reduction in

controversy, monetary policy has gained a

degree of credibility that seemed out of the

question a decade ago.

Of course, it is not only the bipartisan

acceptance of the framework that has

contributed to the increase in credibility. The

larger reason is that Australia has returned to

the ranks of low inflation countries, so the

underlying grievance of the majority of the

Reserve Bank’s critics has been removed.

Economic historians who look back over the

past quarter of a century may well be surprised

by the huge role played by inflation in shaping

our attitudes to monetary policy. They should

not be surprised. Just as the deflation of the

thirties was the dominant macroeconomic

event of the first half of this century, the rise

of inflation in the seventies was the dominant

event of the second half of the century. So

much of recent monetary policy thought has

simply been a response to that event, just as

Keynes provided the response to the earlier

event. What will be the next challenge?

Already, monetary thought is recognising that

there are more things to central banking than

a single-minded pre-occupation with inflation.

The recent events in Asia have taught us that

the avoidance of financial crises is as

important. In Japan, we are confronting the

spectre of deflation, which we all thought had

been left behind after the war. It would be

fascinating to know what the defining event

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