Forward guidance on cash rate was the wrong call, says Peter Costello

The Reserve Bank set borrowers up for a fall by trying to predict the future cash rate during COVID-19, the former Treasurer says.

Australia's longest-serving Treasurer spoke at Melbourne Business School this week about interest rate pain after COVID-19, Australia's exposure to China and whether the Reserve Bank should be focused on employment rates as well as inflation.

Mr Costello's thoughts on the recent succession of interest rate rises to fight inflation offered little comfort to people struggling to pay their mortgage after 12 increases in the cash rate since May 2022.

"Now we're sitting around, seeing whether inflation's going to come down. It looks like it's not rising anymore but is it actually coming down?" he asked.

Mr Costello criticised the Reserve Bank for introducing "forward guidance" into its public announcements during COVID-19, when the cash rate was just 0.1 per cent, compared to 4.1 now.

"The forward guidance that the Reserve Bank gave was that it could see the cash rate of 0.1 percent staying that way to 2024 – guidance that not only are rates low now, but they'll remain low, so get out there and borrow," he said.

Mr Costello said the subsequent pain caused by shifting from historically low to rapidly rising interest rates was a lesson for all borrowers, especially those borrowing for a home.

"I was saying when the cash rate was 1.5 per cent, this is not normal. Don't stretch yourself on a 30-year mortgage, thinking that the 1.5 per cent cash rate is normal," he said.

"When the cash rate went to 0.1 per cent, I was saying it doubly, this is not normal. This is emergency levels. It's not going to last.

"When the bank was saying it will last till 2024, I was saying the bank doesn't know. It can't possibly tell you what the rate is going to be in 2024."

Trade tensions and renewable energy

As Chair of the Future Fund that he set up as Treasurer, which now manages more than $200 billion in Federal Government investments, Mr Costello's words still carry significant weight.

In answer to an audience question from City of Melbourne Lord Mayor Sally Capp about where the Future Fund invests its money, Mr Costello warned against relying too much on China.

"Big trade wars are going on between the United States and China at the moment, which we will get caught up in, we are being caught up in. So, if you're thinking about it, China's been a great bet for a long time but just look very carefully at China."

While supportive of the Federal Government's plans to make Australia a major renewable energy exporter, Mr Costello doubted renewables could replace the earnings the country receives from its coal, gas and other resource exports any time soon.

"I'm not saying it can't be done, but I would say to you it's a long way off," he said.

"In the interim, the products that are contributing most to national income are our exports from mining or coal and gas. The prices for these commodities are extraordinarily high. These are the highest prices since the gold rush."

'The Reserve Bank should stay focused'

Mr Costello said he was particularly concerned about proposals from a recent review of the Reserve Bank that would require it to consider employment levels in addition to inflation when setting interest rates.

"They want to have a dual target of an inflation target and a full employment target. I think the dual target will take the bank's eye off what I think it can and should focus on, producing an inflation outcome," he said.

Mr Costello, who served as Treasurer under Prime Minister John Howard from 1996 to 2007, said adding full employment to the Reserve Bank's mandate would diminish its primary goal.

"I think the Reserve Bank should have a clear inflation focus," he said.

"To the extent that you introduce other objectives, you leave open a confusion both to the bank itself and to investors."

Watch the full recording of Mr Costello's presentation here:

 

Mr Costello said central banks around the world were under pressure to tackle issues they had no power to address, such as housing affordability, which the New Zealand central bank must now consider when setting interest rates.

"I'm arguing for a sole focus for the RBA. If you say, 'oh, well, you're responsible for inflation and you're responsible for employment and you're responsible for housing and you're responsible for climate change', the bank will be spinning its head," he said.

"You won't really know how to hold it accountable, and you'll be asking the bank to do a whole lot of stuff that it can't actually do."

Mr Costello said expecting central banks to take on more responsibility reflected a general failure by political parties to address important structural changes needed to reverse declining productivity growth.

"The famous saying by the US economist Paul Krugman says 'productivity isn't everything but, in the end, it's nearly everything'. Productivity is what boosts living standards, and the problem for Australia is that our productivity growth has been in decline.

"I think monetary policy has become the preferred lever of economic policy, very easy to pull. What I'll call structural reform, microeconomic reform, is much harder. And I think we've got to get back to that."

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