Reserve Bank defends inflation target

Reserve Bank Governor speech

• Reserve Bank Governor speech: Governor Lowe delivered a speech titled “Inflation targeting and Economic Welfare.”

Speeches from the Reserve Bank Governor can provide guidance on interest rate settings.

What did he say and what does it all mean?

• Ahead of the speech, there was much conjecture on whether the Reserve Bank Governor would either come out in strong defence of the 2-3 per cent inflation target or alternatively flag changes in its operation. Governor Lowe has opted for the former. We believe that was never in doubt given the weight of comments from Reserve Bank officials over time. But it is important that any uncertainties have been cleared up.
• The Reserve Bank Governor has reviewed the evidence on alternate monetary policy approaches as well as the track record of Australia’s 2-3 per cent inflation target. And his conclusion is that our current approach is still the best approach.
• Dr Lowe did note that the Board considered rate cuts between late 2016 and late 2018. But it worried that lower rates could have led to faster growth in external debt. And still, over this period unemployment was falling. Was it wrong? It made a judgment call, but with the record economic expansion still firmly intact, the RBA Board deserves to be supported.
• Those looking for another quick follow-up rate cut should think again. The Reserve Bank Governor now wants to sit back and see how the situation evolves. But clearly additional rate stimulus is possible if required.
• The RBA Governor has highlighted three factors contributing to low inflation: globalisation & technology; spare capacity in parts of the global economy; and the success of inflation targeting regimes in achieving their objectives.
• Simply, ‘Triple L’ – low inflation, low unemployment and low interest rates – is not just an Australian event, it is very much a global event. People can buy goods and services whenever they want and wherever they are.

Inflation targeting

• The Reserve Bank Governor believes an inflation targeting regime needs four elements:

1. 1. The inflation target should establish a clear and credible medium-term nominal anchor for the economy.
   2. The inflation target should be nested within the broader objective of welfare maximisation.
   3. The inflation target should have a degree of flexibility.
   4. The inflation target needs to be accompanied by a high level of accountability and transparency.

• The RBA Governor believes we have all the four elements in Australia. The Governor also reflects over the past 30 years with an inflation target and notes that inflation has averaged 2.4 per cent – close to the midpoint of the 2-3 per cent target.

Key quotes from the speech

• Inflation target: “Our overall assessment is that Australia’s monetary policy framework has served the country well over the past three decades.”
• Inflation target: “In my view, the evidence does not support the idea that a change to our inflation target would deliver better economic outcomes than achieved by our current flexible inflation target.”
• Flexible labour supply: “Suppose the participation rate had still risen materially, but by ¾ per cent, rather than 1½ per cent. All else constant, this would have meant the unemployment rate today would have been well below 5 per cent.”
• Flexible labour supply: “This flexibility of labour supply is a positive development and has meant that strong employment growth has not tested the economy’s supply capacity. More demand for workers has been met with more labour supply. This has contributed to the subdued wage outcomes over recent times, which in turn has contributed to the low inflation outcomes.”
• Interest rate outlook: “It remains to be seen if future growth in demand will be sufficient to put pressure on the economy’s supply capacity and lift inflation in a reasonable timeframe. It is certainly possible that this is the outcome. But if demand growth is not sufficient, the Board is prepared to provide additional support by easing monetary policy further. However, as I have discussed on other occasions, other arms of public policy could also play a role in this scenario.”
• Interest rate outlook: “Whether or not further monetary easing is needed, it is reasonable to expect an extended period of low interest rates. On current projections, it will be some time before inflation is comfortably back within the target range. The Board is strongly committed to making sure we get there and continuing to deliver an average rate of inflation of between 2 and 3 per cent. It is highly unlikely that we will be contemplating higher interest rates until we are confident that inflation will return to around the midpoint of the target range.”

What are the implications for interest rates and investors?

•  From late 2016 to late 2018 the Reserve Bank Board contemplated cutting rates: “the Board discussed the case for seeking a faster and more assured return of inflation to around the midpoint of the target range.” In the end the Board “judged that seeking to achieve a faster return of inflation to the midpoint of the target range would have been accompanied by more rapid growth in debt, at a time when household balance sheets were already very extended.” Also at the same time unemployment was falling, reducing the case for monetary easing.
• In hindsight the Reserve Bank may be criticised for not cutting rates. But the judgement call it made was hardly shattering for the economy. The economy has recorded slightly slower growth but the expansion remains intact.
• The Reserve Bank will likely take a few months to see how the economy is responding to the two rate cuts as well as other events or developments that have occurred in recent months. These events include tax cuts, the minimum wage decision, record-breaking sharemarkets here and abroad and the stabilisation of home prices in key capital cities.