Inflation targeting in era of low inflation: Australia edition

Philip Lowe, Governor of RBA in this speech looks at two qs: Why is inflation low in world economy and Australia? Is inflation targeting appropriate for this low inflation era?

First why is inflation low?

There is no single answer. But there are three factors that, together, help explain what has happened. These are: the credibility of the current monetary frameworks; the continuing existence of spare capacity in parts of the global economy; and structural factors related to technology and globalisation.

I will say a few words about each of these.

First, the credibility of the monetary frameworks. One of the responses to the high inflation rates of the 1970s and 1980s was to put in place monetary frameworks with a strong focus on inflation control. In some countries, this took the form of rewriting the law to require the central bank to focus on just one thing: inflation. Many countries also adopted an inflation target, with monetary policy decisions being explained primarily in terms of inflation.

This increased focus on inflation has helped cement low inflation norms in our economies. Many people understand that if inflation were to pick up too much, the central bank would respond to make sure the pick-up was only temporary. This means that workers and firms can make their decisions on the basis that the rate of overall inflation will not be too different from the target rate. This has made the system less inflation prone than it once was.

The second explanation for low inflation is the continuing existence of spare capacity in parts of the global economy.

The existence of spare capacity was an important factor explaining low inflation in the aftermath of the global financial crisis. And today, it remains a factor in some countries, including here in Australia. But, on the surface, it is a less convincing explanation for low inflation in countries where unemployment rates are now at multi-decade lows. Based on conventional measures of capacity utilisation, these economies are operating close to their sustainable limits. One explanation for continuing low inflation in this environment is that the current rate of aggregate demand growth is simply not fast enough to put meaningful pressure on capacity. If so, stronger demand growth would be expected to see inflation pick up. Another possibility is that the unemployment rate, by itself, no longer provides a good guide to spare capacity, partly due to the flexibility of labour supply. I will come back to this idea in the discussion of inflation outcomes in Australia.

The third explanation is that globalisation and advances in technology have changed pricing dynamics. There are two main channels through which this appears to be happening. The first is by lowering the cost of production of many goods. And the second is by making markets more contestable and increasing competition. The main effect of these changes should be on the levelof prices, rather than on the ongoing rate of inflation. But this level effect is playing out over many years, so it appears as persistently low inflation.

It is widely accepted that the entry into the global trading system of hundreds of millions of people with access to modern technology put downward pressure on the prices of manufactured goods. Reflecting this, goods prices in the advanced economies have barely increased over the past couple of decades (Graph 4). But the effects of globalisation and technology extend beyond this and into almost every corner of the economy, including the services sector.

Second question:

This brings me back to the question: is inflation targeting still appropriate?

The short answer is yes, but it is important to be clear what this means in practice.

Inflation targeting can mean different things to different people. It comes in different shapes and sizes. Some versions require a central bank to focus on inflation alone and set monetary policy so that the forecast rate of inflation is equal to the target. But inflation targeting does not need to be rigid like this.

In my view, an inflation targeting regime should consist of the following four elements.

    1. The inflation target should establish a clear and credible medium-term nominal anchor for the economy.

      A high degree of uncertainty about future inflation hurts both investment and jobs. The economy works best if there is a degree of predictability. Most people can cope with some variation in the inflation rate from year to year. But dealing with uncertainty about what inflation is likely to average over the medium term is more difficult. Inflation targeting plays an important role in reducing that uncertainty by providing a strong nominal anchor.

    2. The inflation target should be nested within the broader objective of welfare maximisation.

      It is worth remembering that inflation control is not the ultimate objective. Rather, it is a means to an end. And that end is the welfare of the society that we serve. I sometimes feel that as some central banks sought to establish their credentials as inflation fighters they over-emphasised the importance of short-run inflation outcomes. And this has been difficult to walk back from. Some central banks have been concerned that if they gave weight to other considerations, the community might doubt their commitment to inflation control. So, it became all about inflation.

      But central banks have a broader task than just controlling inflation in a narrow range. They play an important role in preserving macroeconomic stability and thus the steady creation of jobs. Also, their decisions affect borrowing and asset prices and thus financial stability too. Central banks have to determine how to balance these considerations when making monetary policy decisions. This means it makes sense for inflation targeting to be embedded within the broader objective of maximising the welfare of society.

    3. The inflation target should have a degree of flexibility.

      This is not to say that the target itself should be flexible; this would diminish its usefulness in providing a medium-term anchor. Rather, some variation in inflation from year to year is acceptable and indeed unavoidable. How much variation is too much is difficult to know, but the variation should not be so large that it generates doubt about the commitment of the central bank to achieving the target over time.

    4. The inflation target needs to be accompanied by a high level of accountability and transparency.

      If the inflation target is operated flexibly and is nested within the broader objective of welfare maximisation, the central bank has a degree of discretion. It is important that when exercising this discretion, the central bank is transparent. Problems can arise if the community doesn’t understand the central bank’s actions, or if they see it as acting unpredictably or inconsistently with its mandate. This means you should expect us to explain what we are doing, why we are doing it and how we are balancing the various trade-offs.

So these are the four elements that I see as important to an effective inflation-targeting regime.

We have all four elements in Australia. Our commitment to deliver an average inflation rate over time of 2 point something provides a strong nominal anchor. We have always viewed the inflation target in the wider context, reflecting the broad mandate for the RBA set out in the Reserve Bank Act 1959. That Act was passed 60 years ago and has stood the test of time. The RBA was also one of the earliest advocates of flexible inflation targeting – this is evident in our use of the words, ‘on average, over time’ when describing our target. We also place a heavy emphasis on explaining our decisions and their rationale to the community.

Our overall assessment is that Australia’s monetary policy framework has served the country well over the past three decades. The flexibility that has always been part of our regime has helped underpin a strong and stable economy and has helped Australia deal with some very large economic shocks. We are not inflation nutters. Rather, we are seeking to deliver low and stable inflation in a way that maximises the welfare of our society.

Hmm..

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