The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Friday, October 15, 2010

Will 2010 be 2006-07 redux?

Paul Bloxham has thrown a spanner in the works regarding the market's understanding of the manner in which the RBA sets monetary policy. In his latest op-ed, he appears to contend that the RBA's monetary policy decisions today, which the RBA's analysis suggests influence inflation with up to a two year lag, will be determined not be their forecasts of future inflation, but by past outcomes.

As has been documented by many in recent months, this creates a problem of comprehension, and seems to conflict with the RBA's formally-agreed policy objectives (and, more worryingly, runs the risk of undermining its all-important inflation-fighting credibility). This is because current inflation outcomes, like the third quarter print that we will see on the 27th of October before the RBA's November board meeting, measure past changes in prices.

Yet the RBA is mandated to 'target' a future inflation rate of 2-3% pa through the life of an economic cycle (it is increasingly observed that it has failed, on average, to get both the headline and core inflation rates under its 3% upper bound over the last four years). While past inflation is clearly one very important input into an inflation forecast, it can, like much historical economic data, often prove to be a poor guide to what will happen over the next 1-2 years.

In recognition of this, much of the RBA's public communication is focussed on its 'central (future) case' for growth, employment and prices. The RBA also publishes quarterly quantitative forecasts for both economic growth and inflation over the next 2.5 years, which are meant to shed some light on the likely trajectory of rates.

But Bloxham argues that the RBA places little weight on its own forecasts of future inflation. He even posits, rather surprisingly, that the market's assumed logic that the RBA should be pre-emptively setting rates to focus on future rather than past inflation is 'unsound' in the presence of low past inflation. Here it is worthwhile quoting him in full:

"[O]thers seemed to argue that the Reserve Bank would lift rates in order to get them up before a potentially "inconveniently" low result for the September quarter consumer price index was published on October 27. I would argue that this reasoning is unsound. If the CPI prints lower than expected, the Reserve Bank is likely to take it as a signal that the inflationary impulse in the economy is more benign than expected and that it has more time before needing to move rates. It will also probably revise down its near-term inflation forecasts.

Still others suggested that if the Reserve Bank did not increase rates it was not being pre-emptive, because its own forecasts showed that growth and inflation would be strong next year. These commentators seemed to show more faith in the Reserve's forecasts than the bank does itself."

There are other reasons why this backward looking logic seems out of place. The RBA leadership--eg, Stevens and Lowe--have successfully advocated an adjustment to the orthodox inflation targeting framework to allow the RBA the 'flexibility' to use rates to respond to strong asset price appreciation in the event that the RBA believes that this will, in the future, pose system stability risks to the real economy. This is, therefore, predicated on the RBA's ability to divine that future, including the impact of current rate changes on future asset prices (eg, that using rates to respond to asset prices will not have deleterious consequences, as some have argued is a risk). Bloxham himself has co-authored a 'research discussion paper' with the RBA on this subject, and formally acknowledged the policy change in his very first note for HSBC.

The only basis upon which you would permit a central bank to use rates to influence asset prices would be, as the RBA has acknowledged, if you had confidence that they could disentangle sustainable and unsustainable rates of asset price and credit growth, and had a firm conviction about the risks that this might pose in the future.

Perhaps most ironically, some inside the RBA have used precisely this logic--ie, we have to forecast inflation, so why can't we use similar analytical tools to understand asset prices--to justify this change to the conduct of policy.

There are two final issues here. The first is that the RBA made exactly this mistake of setting monetary policy in response to past inflation before with undesirable consequences. The chart below shows what happened. In brief, the RBA left the cash rate unchanged between late 2006 and August 2007 because it was focussing principally on the benign inflation recorded at the time rather than the building price pressures. By the time the RBA eventually lifted the cash rate from 6.25% to 6.50% in August 2007, core inflation in Australia was already rising at a 3.6% annualised rate.

The final issue is the thesis that the RBA has been operating with a negative output-gap, which its own analysis implies reduces inflationary pressure, for much of the so-called 'inflation targeting period' since 1993. It is arguable that the first time the RBA faced a major positive output gap, in 2006-08, it got behind the inflation curve and was clearly struggling to manage prices. This is one reason why core (headline) inflation under Glenn Stevens has averaged 3.45% (3.0%), which is not near the mid-point of the RBA's 2-3% pa target. It also raises questions as to whether the much-lauded inflation targeting regime has been as successful as many claim.

In closing, I will leave you with the last published RBA analysis of the output gap that I can find from a 2002 research discussion paper.