The Monetary Policy Rule in Australia: Does the RBA Target Inflation Only?

Abstract

This paper estimates a simple monetary policy reaction function for Australia. Although the reaction function is rather simple, it is shown to be able to capture the essential elements across different policy regimes. The empirical findings mostly corroborate the RBAs own claims made through Reserve Bank Report and Financial Statements. During the pre-inflation targeting period (1985-1992), the RBA targeted external factors such as the current account deficit and the Federal Funds Rate, in addition to inflation. Over time, the policy focus has, however, become directed explicitly towards price stability. During the post announcement period (1990-1999), the RBA targeted only future inflation up to one-year ahead. As the forecast horizon became longer than one year, however, the RBA targeted short-run output fluctuations in order to allow medium-run expected inflation to adjust rather slowly to the medium-run target. The results show that, in a flexible inflation targeting regime, medium-term price stability can be maintained while allowing some scope for targeting output variability.