Reserve Bank's independence essential to our growth

Australia came late to stand-alone central banking. Until 1960, the government-owned Commonwealth Bank combined the nation's central banking alongside its own commercial operations. It was a global oddity, both supporting and competing against the private banks.

Half a century later, the RBA now ranks among the most reputable central banks in the world after guiding the Australian economy through the crisis. It's a historic first for the nation.

On the weekend, this newspaper chose Kevin Rudd as its Australian of the year for fighting off the global crisis. Time magazine chose US Federal Reserve chairman Ben Bernanke as its person of 2009 for cleaning up some of the mess his central bank largely caused.

RBA governor Glenn Stevens avoided a subprime housing boom and banking crisis; moved ahead of any other central bank to aggressively cut interest rates when the crisis hit; but then was the first to twig that Australia's China card would allow us to weather the worst of the storm. Stevens has since quickly lifted official interest rates three times, something the old politician-controlled RBA would never have been allowed to do.

That's evident from The Evolution of Central Banking in Australia, a 150-page monograph commissioned by Stevens from economic historian Selwyn Cornish to mark the RBA's first 50 years. It's basically the story of how the high inflation and high-unemployment stagflation of the 1970s was turned into the prolonged low-inflation economic upswing in the early 90s. That also makes it about the RBA's transformation from political subservience that extended to printing money to finance Canberra's budget deficits in the 70s to the political independence that jacked up official interest rates during the 2007 election campaign.

Significantly, the lesson of the RBA's history as told by Cornish is that the central bank has been driven by what works rather than by doctrine or ideology. The pragmatic declaration is that the RBA's monetary policy is more potent with deregulated financial markets and independence from political influence.

Cornish's accounts of the RBA's dealings with the Whitlam government are chilling.

Then governor John Phillips told new treasurer Jim Cairns in late 1974 that the board was "concerned and apprehensive about the current and prospective economic situation. Rapid inflation and high unemployment pose grave threats to our economy and our society. Moreover, both inflation and unemployment could become much worse and the potential damage could be very severe." Labor's massive government spending and budget deficits needed to be urgently reined in.

Then there are gems from Cornish's trawling of the Treasury files. Only months earlier, Cairns, the deputy prime minister, had told then treasurer Frank Crean: "I have come to the conclusion that we should move immediately to float the dollar."

Amid the madness, that didn't happen of course until 1983 under the next Labor government. In the meantime, Cornish details the subterranean battles with the Fraser government.

These disputes intensified as the late 70s resources boom picked up. According to Cornish, treasurer John Howard personally confronted the RBA board in February 1979 after it rejected the government's demand to lower the regulated ceiling on bank lending rates. Governor Harold Knight issued a threat: the RBA would not hesitate to invoke section 11 of the Reserve Bank Act, which would make public its unresolved opposition to a government directive. The RBA held sway and to this day section 11 has never been invoked.

As the boom weakened, Howard's 1982 budget speech foreshadowed using the private banks' statutory reserve deposits held at the RBA to boost the housing industry. The board "objected strongly" to this sectoral "raid" on its SRD accounts. Amid "prolonged discussions" with Howard, the RBA again threatened to invoke section 11. Again it held sway.

After the boom turned to bust, the floating currency and financial deregulation strengthened the RBA's leverage over the economy through use of its official cash rate, rather than varying SRD requirements and the like. The problem, exposed by the late 80s boom, was that it lacked a set of rules to effectively operate this price lever. This came after the RBA exploited the pain of the early 1990s recession to entrench low inflation. Thus started the era of explicitly targeting low - 2 to 3 per cent - inflation. Granting the central bank operational independence made the target more credible. That meant it was more likely to anchor low inflation expectations.

The result has been nearly two decades of low-inflation growth. "There is nothing to compare with this period in Australia's economic history", says Cornish. Hence, the early 90s marked "a historic turning point - a defining moment - in the bank's history and indeed in the history of Australian monetary policy".

Importantly, this includes "perhaps the longest sequence of monetary tightening in the bank's history", from 2002 to the eve of the global financial crisis, as Australia's China boom heated up.

The string of cash rate hikes provided "an important source of macroeconomic stability". "Indeed, for the first time since World War II, an export-led boom was experienced without an accompanying wages break-out and excessive price inflation," Cornish concludes.

The implication is clear. Today's RBA leadership - Stevens has just posted 30 years' service - suffered many defeats before finally slaying 70s inflation. It is determined to make sure prices growth doesn't become entrenched above its target zone in 2010 as the resources boom picks up steam again. That ensures Stevens will lift interest rates further, regardless of political pain.

Yet, the central banks we used to look up to - such as the US Fed and the Bank of England - have been monetising their governments' massive budget deficits in the wake of the crisis. That's a recipe for inflation.

And the Asian central banks we will look to more - particularly the People's Bank of China - are fuelling asset price bubbles by keeping their currencies undervalued and their interest rates too low in the face of weak exports.

The Asian central banks are politically controlled, a recipe for instability.

This means the global crisis may have merely postponed the real test of whether the RBA's inflation target regime can withstand a full-blooded resources boom. Stevens has set the test: the RBA's institutional autonomy rests on the pragmatic issue of whether it contributes, in the words of its founding 1959 act, to "the economic prosperity and welfare of the people of Australia".