11 June 2019

RBA sticks with IT

HSBC Australia Chief Economist Paul Bloxham argues in the Australian Financial Review that the RBA’s inflation targeting regime is still on the money.

Inflation is not currently on target, but Paul Bloxham argues it’s still the right system for the Reserve Bank

With the RBA recently cutting its cash rate to a new record low, the central bank's inflation targeting (IT) regime is being increasingly criticised. Part of the challenge is explaining why it is that inflation targeting is still the right system for Australia, given that underlying inflation has now been below the target band for almost four years.

One way to explain the system is to focus on the importance of price stability. Protecting the value of the currency's purchasing power over goods and services is one of the central bank's key objectives.

In this light, the RBA Governor, Phil Lowe, often points out that the idea of the inflation targeting (IT) regime is that Australian households and businesses should not need to worry about inflation when making economic decisions. Australians' should feel assured that inflation will be '2-point something' in the medium term.

On this, the RBA has delivered. CPI inflation has averaged 2.5% over the past 26 years.

However, this explanation of the importance of inflation targeting can sometimes ring a little hollow. It echoes a bygone era when high inflation was a problem. For those that need reminding, double-digit inflation in the 1970s and 1980s distorted many household and business decisions and caused much volatility in the economy.

Low inflation the challenge

However, the current concern is not high inflation, it is low inflation. With inflation below 2% for almost four years, a key question being asked is why does Australia need inflation to average 2-3%? And should the RBA be cutting its cash rate to new record lows to meet this mandate? After all, global inflation is low, and the major central banks are struggling to meet their own 2% inflation targets.

On this, one way to think about the inflation targeting regime is that it is more than just about keeping inflation at 2-3% in the medium term. Inflation targeting is a system of demand management.

To do this the central bank uses the CPI as a measure of the intersection of demand and supply forces in the economy, to guide the way that it sets monetary policy to support sustainable growth.

If inflation is high and rising, this is a sign that the economy is overheating, with demand too strong for supply. On the other hand, low and falling inflation is a sign of insufficient demand. Because the supply side of the economy cannot be observed directly, the inflation targeting regime assumes that the best way to know when demand is running too hot is when prices are rising more quickly and vice versa.

Paul Bloxham, Chief Economist, Australia, New Zealand and Global Commodities

Of course, the central bank cannot control all (in fact, not many) of the elements that drive demand and supply in the economy. Many of the forces which drive inflation are global, particularly given that most of the manufactured goods Australia uses come from offshore. Remember also that the floating currency is part of the monetary policy regime and movements in the Australian dollar influence inflation.

A consistent framework

In short, the key is that the inflation targeting regime gives the central bank a consistent framework from which to set policy and manage the economic cycle. The RBA's current use of its unemployment rate forecasts is a case in point.

Indeed, I would argue that the RBA's current proxy target is not inflation at all, but the unemployment rate. After all, the RBA did not cut its cash rate in May, just after the very low first quarter CPI print, but instead waited for the jump in the unemployment rate the following month, to cut in June.

While the unemployment rate was falling, the central bank could credibly argue that wages growth would pick up over time and that this would eventually lift inflation back to target. Once unemployment started rising, as it has done recently, to 5.2%, this argument became untenable, and more stimulus was needed.

Looking forward

The RBA's latest set of forecasts does not even show inflation getting back to the mid-point of the target band. However, the RBA is forecasting that the unemployment rate falls to 4.75% by the end of the forecast horizon. The central bank has such a high tolerance for low inflation that it forecasts inflation to be below 2-3% for five years.

The key is not that inflation is always on target, but that policy is set in a way that it supports demand growing in line with the supply capacity in the economy over time.

So when you think about whether it matters that inflation is 1.5%, 2.5%, or 3.5%, keep in mind that it is not just the inflation number itself that is important, but the way that the inflation targeting system helps to frame the appropriate settings for policy to manage demand.

Of course, no system is perfect. But the ultimate evidence of the success of Australia's 26-year old inflation targeting regime is that the economy is currently in its 28th year of continuous GDP growth. It is hard to ask for a better result than that.

This opinion article originally appeared in the Australian Financial Review on Tuesday, 11 June