With local inflation and interest rates seemingly entrenched at low levels, this note suggests it now perhaps an opportune time for the Reserve Bank and Federal Government to reconsider the inflation target itself – especially as it now seems a little higher than the international norm.
Lower for longer presents dangers
Last week marked two years since the Reserve Bank of Australia last cut interest rates – a record period of inaction from our central bank.
At face value, the case for continued steady low interest rates seems compelling.
The case against raising rates rests on traditional macro-economic grounds. Although the economy is growing reasonably well, and interest rates remain well below “neutral” levels, persistent low wage inflation and surplus labour market capacity means that consumer price inflation is still struggling to move firmly back into the RBA’s 2 to 3% target band. Lower rates would allow a faster absorption of surplus labour capacity and a quicker return of inflation to the target band.
That said, the case against cutting rates rests on financial stability grounds. Even lower rates today would mainly operate through stimulating even greater debt-led consumer spending and risk re-inflating sky-high property prices in Sydney and Melbourne. In turn, that would risk a bigger shake out in property markets later, and therefore a possible fall in inflation even further below the 2 to 3% target band over the medium-term.
Either way, the reality is that even the RBA acknowledges it will likely take some time for inflation to lift back to the mid-point of the target band. And the longer this process takes the greater the risk of inflation expectations entrenching at lower levels – and the longer, therefore, interest rates would need to remain at abnormally low levels. In turn, this increases the risk that the economy comes to rely on permanently lower rates, through increases in consumer and housing debt.
Time for a re-think?
Against this background, it is perhaps an opportune time for the RBA – and the Federal Government – to reconsider the inflation target itself.
This argument rests on two grounds. For starters, a lower inflation target would recognise that a range of structural factors – from population ageing, globalisation and technological innovation (e.g. Robotics) appear likely to keep average rates of global inflation generally lower in coming years than has been the historic norm. The pass through of currency depreciation into imported good prices has lessened over time, for example, as has the sensitivity of wages to labour market tightness. Technological innovation is stripping costs out of a range of goods and services on a continuous basis.
Secondly, Australia’s long-established mid-point inflation target now appears increasingly out of line with international norms. Indeed, as seen in the table below, most inflation-targeting central banks in other advanced industrial countries target a level of inflation around 2% p.a.
Australia’s higher mid-point inflation target – were it to be achieved – implies a long-run nominal depreciation of the currency simply to preserve relative pricing power against our international peers. A more stable framework for the economy to operate in would be to harmonise our mid-point inflation target with what now appears established practice among major industrial economies.
To allow sufficient flexibility – but also align our long-run mid-point inflation target with international norms – I’d favour a broader but lower inflation target band – such as Canada and New Zealand’s 1 to 3% target range.
But in exchange for this broader band, the RBA should also face greater accountability to ensure the upper and lower bounds of the target are very rarely breached, unless under very extra-ordinary circumstances. This could involve – as is the case with the Bank of England – a formal letter of explanation to the Federal Government whenever a breach of the target band takes place.
Were the RBA (and Federal Government) to lower the mid-point inflation target, it would reduce the need to consider further interest rate cuts anytime soon and allow the RBA greater scope to begin the long but necessary process of re-normalising policy rates (as is already being done in the United Kingdom, Canada and the United States).