Tuesday 31 July 2018 by Stephen Koukoulas Opinion

We have an inflation problem

The RBA keeps missing the inflation target. Low inflation is a drag on economic growth, wages growth and unemployment. Stephen Koukoulas explains why interest rates need a 50 to 100 basis point cut for the RBA to start hitting the mark

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Australia continues to have an inflation problem, with the official consumer price index for the June quarter confirming annual underlying inflation at 1.9%.

This means that underlying inflation has effectively been outside the Reserve Bank’s 2 to 3% target for three years and based on recent quarterly results, seems unlikely to pop back into the target range for quite some time.

Any hope of inflation getting into the middle or top half of the target band seems fanciful with current policy settings.

Even the RBA know this despite its forecasts which are based on the increasingly unrealistic premise of accelerating wages growth and two more years of 3% or more GDP growth. Put another way, if there is any downside to the RBA view for the economy, inflation will be even lower over the next two years.

Which begs the question, why is the inflation targeting RBA so reluctant to trim interest rates to help drive economic growth? It makes little sense when higher economic growth, and lower unemployment would help to ensure a lift in wages growth and inflation.

Is low inflation a bad thing?

The short answer is usually “yes” and it is particularly so now when the low inflation result is driven by sustained sluggishness in the economy. With the unemployment rate being too high and wages growth weak, inflation will not pick up. It is important to note, the RBA acknowledge this.

And right now, these are the uncomfortable features of the Australian economy where there is clear evidence the fall in house prices is starting to impact consumption spending. As such, it remains unclear why the policy levers aren’t being pushed or pulled in a way that will reflate the economy, get growth higher and unemployment lower.

Around 25 years ago, when the fall-out from the early 1990s recession broke the inflation stick, as the Treasurer of the day, Paul Keating famously observed the RBA embraced the new regime of low inflation by announcing its target of 2 to 3%. This range, rather than a target below that, was seen to be a pragmatic acceptance that forecasting errors do occur and if inflation undershot with an even lower target, there would be a material risk of deflation.

It was also acknowledged that a commodity dependent economy like Australia would experience greater volatility in inflation more or less in line with the swings in the terms of trade, so the target had to build in some flexibility.

There has not been a recession since the inflation target has been embraced.

Given the economy has registered 27 years with no recession since the inflation target was adopted, there clearly are benefits from monetary policy being set to help sustain 2 to 3% inflation.

This is a strong endorsement of the inflation target and suggests any deviation from it will present economic risks, especially when inflation has been low for a long time and is expected, even by the RBA, to stay very low for many years.

Is the RBA wrong?

The facts suggest the RBA no longer has the 2 to 3% inflation target as it main policy focus. While there has not been a formal abandoning of the target, given there is occasional lip service given to the goal, its actions show the target has been dropped.

The dual facts of missing the target for many years and explicitly forecasting inflation to remain well away from the middle of the target for several more years is proof of this redirection of its policy aims.

Instead, the RBA has shifted its policy focus to financial stability without defining what that is and judges that its credibility from steady interest rates is more important than aiming for the mid-point of the inflation target. In other words, even though there is no evidence at all of rising financial instability, the RBA is keeping policy tighter than it needs to be to stem the growth in house prices and household debt as it sees these as a bigger threat to the economy than having high unemployment, entrenched low wages growth and low inflation.

Recent comments from RBA officials and in publications show no sign of a turn in this approach, which is why it has run with the policy slogan that ‘the next move in interest rates is more likely to be up than down’.

RBA credibility on the line

It seems a pity that the RBA is explicitly aiming to have high unemployment as a means of slowing the growth in household debt and, related to that, house prices. Financial instability is surely more a threat with a weak labour market, than trying to stem borrowing with policy austerity.

This is particularly so given the RBA’s early resistance and reluctance around five years ago to work with the regulators to impose macro-prudential policy changes to stem the surge in house prices, which would have allowed for rates to be cut further.

Even now, with the risks of protracted weak growth with chronically low inflation growing, the RBA is still set on squeezing the economy to achieve slower credit growth and lower house prices.

There are few other central banks that would be so extreme.

Would lower interest rates work?

A scenario where the RBA were to cut interest rates with a simultaneous reinforcement of macro prudential conditions on household credit would no doubt boost economic growth and inflation.

The business sector would ramp up investment on the back on improved cash flow and a lower threshold for investment returns. The Australian dollar would be biased lower helping the export sector gain traction, lifting national income and inflation.

An about face from the RBA

For the near term, there seems little prospect of the RBA moving to cut interest rates. It would require an admission that it has been wrong over the last few years.

This is not to say there is little chance of an interest rate cut. But it would require a change in some key economic indicators over and above the low inflation readings to turn the RBA thinking.

Most important would be a clear weakening in the labour market. An unemployment rate rising above 5.75% towards 6% would be a catalyst. So too would wages growth failing to pick up from current levels around 2%.

If the fall in house prices extends to the point where consumer wealth is significantly eroded and the banks detect a rise in loan arrears and negative equity as a result, the RBA would also move to cut.

In other words, the economy needs to tank for the RBA to move.

The jury is out

Inflation in Australia and around the world remains very low. So low, that most major central banks are either continuing with extreme monetary policy stimulus or are tightening cautiously for fear of choking moderate growth in the aftermath of the global banking crisis.

The RBA is partly in the club, holding off its plans to hike interest rates each time the inflation data confirm the inappropriate nature of such a policy strategy.

When will inflation move to 2.5 to 3%?

Medium term inflation pressures will continue to be driven by the degree of slack in the economy and, linked to that, labour utilisation and wages growth.

At the moment, there is a substantial output gap (witness unemployment plus underemployment) and wages growth is meandering around record lows.

To get a sustained inflation rate to the upper half of the target band, the unemployment rate needs to drop from the current 5.5% to well below 5% and consolidate around 4.5%. At  the same time, the underemployment rate needs to drop from the current 8.5% to something nearer 7% or preferably less.

Only then will underlying inflation lift as wages growth picks up in line with a meaningful lift in labour demand. 

Inflation cannot rise in the current circumstances

On my calculations, with current interest rate settings, a slowing global economy into 2019 and 2020, a wealth erosion due to falling house prices, an assumption that the Australian dollar holds around 75 cents and the terms of trade edge 10% lower over the next two years, inflation will not rise.

Something has to give for inflation to pick up and the only thing that is within policy maker’s control is official interest rates and only if interest rates are cut by 50 to 100 basis points, to 0.5 to 1.0%, will inflation hit the target.

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