Comments following RBA Governor Phillip Lowe’s speech
Governor Lowe’s speech* can be taken as a strong defence of not only the current inflation-targeting regime, but also the current inflation target band of 2 to 3 % over the medium term.
The Governor suggests that to change the band would
1) undermine longer-term central bank credibility and
2) entrench a low inflation “mind-set”.
The key issue, however, is how long the structural factors cited by the Governor continue to push down the level of consumer prices.
As the Governor notes, “this level effect is playing out over many years, so it appears as persistently low inflation”. But there is nothing to suggest this process need end anytime soon, which in terms suggests the “temporary” period of low inflation could persist for a long time.
Indeed, if structural factors hold down inflation for the next 5 to 10 years, central banks will still lose credibility by clinging to an inflation target that they persistently fail to achieve.
And the higher a central bank’s inflation target, the less likely it will be achieved if these structural forces continue to play out. Australia has the highest central-point inflation target in the developed world.
Worse, in their vain pursuit of higher inflation, central banks risk keeping monetary conditions unduly loose for too long, and thereby risk building up financial market imbalances – particularly over-inflated house and equity prices. These risks seem to be have downplayed by the Governor, especially given signs that the Sydney property market is hotting up again.
To my mind the global economy is benefiting from positive supply shocks – such as rising labour force participation among older workers, globalisation and new technologies – which is boosting both economic and holding down inflation. Central banks continue to downplay these positive supply side effects on inflation, or at least assume they will prove more temporary than currently seems the case.
That said, I still expect the RBA to cut rates to 0.5% by early-2020 give their current framework and my expectation that the unemployment rate will edge higher over the next six months.
But the strongest case for lower interest rates is that unemployment remains too high, rather than inflation being too low – and can and should be pushed back up. But against this needs to be balanced the risk of creating bubbles in both equity and house prices.
* Inflation Targeting and Economic Welfare, 25 July 2019