I am usually uninterested in the month to month guessing/commentary game around RBA board meetings. It’s the financial market version of political race calling. However the decision on Tuesday to hold the current target rate highlighted some issues around the purposes and goals of inflation targeting. Those bewildered and using market gossip and entrail gazing to divine the inner thoughts of the board might well look at this 2003 speech by then Deputy Governor Glenn Stevens that I was required to read in my second year Macro class. It is entitled Inflation Targeting: A Decade of Australian Experience, and ends with a discussion on what challenges lay ahead. Put together they help explain the caution with which the RBA approaches decisions, and I think it is also a sensible way of doing things. The whole of the relevant section will be under the fold.
Three challenges are described.
The first is a reminder that there is a lower bound on the inflation target, and that inflation targeters must conduct policy with this in mind. Deflation/disinflation is also dangerous because it increases the real burden of debt or merely because it prevents downward sticky prices adjusting. To anchor expectations of low but positive inflation helps prevent this. I’ll mention here that this makes me think there is very little conflict between the inflation and employment mandates of monetary policy if one is assuming a “natural rate” definition of full employment – one has to be as cautious of supra NAIRU unemployment as sub NAIRU unemployment.
The second is a recognition of the difficulties inflation targeting faces with regard to supply shocks. Supply shocks increase inflation, but monetary policy only impacts demand through investment and consumption decisions. In the event of a supply shock a central bank should be careful to bring inflation back to the target gradually as the supply shock passes or the real economy adjusts to a structural change. Temporary above target inflation is acceptable so long as long term expectations do not adjust to it.
The third issue is interesting, and involves asset prices and long term stability. Stevens describes a hypothetical situation where a central bank recognises a boom in asset prices. They then have a choice. They can keep near term inflation at the target and running the risk that the boom is in fact a bubble that, upon bursting, will result in far below target inflation or deflation. Alternatively they can tighten policy and have lower than target inflation in the short and medium term, but reigning in asset prices and maintaining a steady trajectory. In the weasily speech required of central bankers Stevens says “There would be a fair proportion of people who might select the second alternative, given the choice.”. [fn1]
How do these relate to the current situation. Number two is easy. Inflation hawks themselves describe Australian inflation as imported, making it a cost-push , supply led problem in the context of the Australian currency zone. Added to this are the lingering effects of the Queensland floods. Monetary policy has limited capacity to address inflation from this source, especially when credit growth is already very low by historical standards. It pays to be cautious.
The implications of the thinking behind challenges 1 and 3 need combining. If I was a central bank in the current environment I would be very cautious about overshooting. With great uncertainty in the Northern Atlantic I would be wary of the risk of falling in a recession and deflationary environment (as per challenge 1) over the longer term. Subsequently I would be more prepared than usual to accept shorter term above target inflation as a trade off against the risk of longer term disin/deflation. This follows the same kind of reasoning in challenge three. Perhaps (I make no attempt to judge) the decision to hold in the face of last weeks inflation figures are vindicated in light of stock market events over the past 24 hours.
If this is the kind of reasoning the RBA is working under, I think it’s very sensible . I won’t guess whether any given monthly decision is right, but this is a fairly sensible way of going about making the decision. The implications of an inflation targeting mandate are broader than each CPI release or whether the market believes what you are going to do are what you say you are going to do. They need to be taken into consideration.
[fn1] I read this in 2005, and we were discussing it in terms of what my (American) lecturer was baldly stating was the US housing bubble. This is partially why the surprise of many in 2007 left me incredulous.
MC Stevens, rock the room.
The record of inflation targeting in Australia is a good one. But it is not enough to look only backwards. We need as well to be asking whether the system we have is capable of coping with circumstances different to, and less advantageous than, the ones we have seen to date. I’d like to organise our thoughts here around three issues.
First, deflation. An argument might be made that fighting inflation is fighting the last war. Maybe the new enemy is deflation. Certainly, more countries have experienced deflation in the past year than for many years, if not decades, and in a great many more countries inflation is very low and renewed cyclical weakness could, if it occurred, push it down further, perhaps to or below zero in some cases.
There is no time today to go into detail about how we ought to think about deflation.10 The point for today is that inflation targeting isn’t just inflation fighting. It involves inflation fighting but it also involves deflation fighting in equal measure. To my knowledge, all the countries practicing inflation targeting view their targets as symmetric: undershoots are no better than overshoots. All targets are centred on a number above zero, partly to guard against unexpected lapses into deflation. Further, credible inflation targeting that helps anchor expectations of inflation above zero helps to avoid the worst kind of deflation, which is not a temporary decline in prices but a persistent and widespread expectation of falling prices.
The second potential challenge is dealing with adverse supply-side shocks. Monetary policy works on the demand side of the economy. When the prevailing disturbances come from that side too – as they have in the conventional business cycles which we have experienced in the past – monetary policy can dampen fluctuations in demand and by doing so it will be stabilising price fluctuations. When the shocks emanate from the supply side of the economy, on the other hand, things can be more difficult. Adverse supply shocks push activity down and prices up. Should this persist for any length of time, monetary policy is faced with more awkward choices, though there is no uncertainty about what its longer-term objective ought to be: to control inflation.
For most of its history, inflation targeting has coincided with, if anything, favourable supply shocks. We have had positive surprises on productivity, and in the supply-enhancing effects of internationalisation of production. These surprises tended to push output up and prices down. This has been, we have to admit, a very benign environment in which to operate monetary policy. It may not always be this way in future.
Inflation-targeting central banks will certainly find challenges if adverse supply disturbances occur, but this is also true of any other monetary policy model we could think of. I imagine that inflation targeters, if faced with a rise in inflation above target due to supply shocks, will focus on gradually bringing inflation down again. If inflation expectations are well anchored near the target rate, as they appear to be in most countries, there is no reason to believe this will be unduly difficult, and in fact there would in such circumstances be flexibility to take some time to achieve convergence back to the target, which could help adjustment on the real side of the economy significantly.
The third issue for the future is how, if at all, to respond to major movements in asset prices. This is the most difficult problem to tackle, both conceptually and in practice. Most people agree that asset price inflation per se should not be an objective of monetary policy. Most people also agree that, to the extent that asset price movements have implications for the course of the economy over the standard forecasting horizon of a couple of years – through wealth effects, for example – those effects should be allowed for in the setting of monetary policy. This is really just saying that in searching for the optimal policy setting to achieve the inflation target over a two-year horizon, all the relevant information should be taken into account. We can all sign up to that.
But there is a lot more to asset price dynamics than that. These events typically have a lower frequency than the business cycle frequency to which our normal policy practices are attuned. They build up over a number of years. Furthermore, asset price movements and their effects are often asymmetric. When asset prices are rising, they can easily co-exist with low CPI inflation. But because this is often associated with a build up in debt, the ensuing correction in asset prices can cause acute distress to borrowers. This means both that spending behaviour is affected and that there can be a risk of systemic financial instability because distressed borrowers often mean a deterioration in the asset quality of the lenders. This, if it occurs, weakens the economy significantly and can push inflation down sharply.
In that final phase of this asset price cycle, monetary policy will need to be easy. The question, however, is whether during the earlier phase it should be tighter than normal, in order to try to lessen the probability of a bust, at the expense of having somewhat lesser short-term growth and inflation lower than the announced target. Put another way, should policy accept a mild short-term undershoot of the inflation target in order to lessen the likelihood of a much bigger undershoot in three or four years’ time?
Here there is less agreement. Some people argue that there is a strong case for this additional response, particularly on the grounds that if the costs of the bust are large it is worth paying some cost to avoid it if at all possible. Others argue that a modest response of policy to the asset price problem would be ineffective in dampening the asset price dynamics, and that an aggressive response would bring on the problems that policy-makers are setting out to avoid. In this view, policy should stick to its usual macroeconomic concerns, responding to any after-effects of the asset price cycle when they emerge.
Does inflation targeting allow scope for responding to asset price concerns, if that is thought to be sensible? I think it does, provided we are prepared to adopt a sufficiently long time horizon. Inflation targeting is often presented, for expositional purposes, as a commitment to vary the instrument so as to keep the forecast inflation rate at the target at some particular horizon – two years, for example.11 But surely policy-makers care, in principle at least, not just about the inflation rate two years from now, but the whole path of future prices. We care not only about where inflation will be two years from now, but where it might be heading at that time and how quickly.
Consider two hypothetical outlooks. In one, a given set of policy interest rates assumed for the forecast is associated with inflation in two years’ time at the target, but also with an asset price boom and increasing leverage, which means that there is an uncomfortably high probability that, beyond the two-year horizon, perhaps in year 4, there will be a crash which could impair the financial system, take the economy into recession and reduce inflation well below the target. In the alternative outlook, a higher assumed set of policy interest rates is associated with lower growth and lower than target inflation over the standard two-year horizon, but also with reduced risk of the really big fall in inflation and activity in year 4.
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Would we automatically select the first of these two possibilities purely on the basis that inflation is at target in two years’ time? There would be a fair proportion of people who might select the second alternative, given the choice.
Of course, life is not quite as simple as the hypothetical choice I have concocted here. We don’t know enough about the behaviour of asset prices, much less their linkages to the economy through the financial sector, to make such forecasts with any confidence. Nor do we know much about how the dynamics might respond to monetary policy. So we cannot easily identify the optimal response to the situation. There would, as well, be significant communication issues associated with a policy which sought to reduce the risks associated with asset price developments, but which carried the side effect of slowing the economy.
But despite the difficulties, it seems to me that thinking through the nature of risks posed by these asset price swings is helpful. Policy should not rush to respond to every asset price movement that comes along. But a case might be made, on rare occasions, to adopt a policy of ‘least regret’ so far as asset prices are concerned, if financial and macroeconomic stability were thought to be at risk. To do so would probably require an acceptance of a longer time horizon for inflation targets, and an acceptance of a bit more short-term deviation from the central point of the target. These issues remain unresolved among theorists and practitioners of monetary policy. There will be a good deal of further discussion about them in the period ahead.12