Macquarie's Brian Redican has produced an excellent little note on the RBA's experience in 2007-08. And he makes some rarely highlighted points (emphasis added):
"[R]ather than viewing 2007-08 as a failure, the RBA might actually argue that it represents a successful containment of inflationary pressures.
To understand why, first note that we didn't find out that inflation had risen above 3% until the end of January 2008 when the 2007Q4 inflation data were released. While inflation subsequently hit 4.5% later in 2008, the RBA says that policy is always directed at moving inflation towards 2½% over the policy horizon, which is generally thought to be around 2 years. Well, by March 2010, inflation had fallen back to 3%, and has now declined to 2½%. So on that basis, the RBA has done exactly what it always said it would do.
So, yes, average inflation over the last few years has been a bit higher than the RBA would have liked. But again, as the RBA Governor argues:
"…the correct policy is to always aim at the target, regardless of where you are today, and regardless of what has happened in the past. Bygones are, and should be, bygones."
Assistant Governor Guy Debelle has been even more explicit about this:
"…the intent is that over the course of the business cycle, the bulk of the distribution of year-ended inflation outcomes should lie between 2 and 3 per cent, not that the annualised average inflation rate from the start of the business cycle to the end should necessarily lie between 2 and 3."
Thus, anyone gauging the success of the RBA’s inflation targeting policy by referring to average inflation is not using the same measuring stick as the RBA itself.
It’s worth noting, however, that over the past 5, 4 and 3 years headline inflation has averaged 3%, 2.7% and 3%, substantially less than underlying inflation. The RBA’s target is framed in terms of the headline inflation rate. And so the fact that there has been a material difference between the underlying and headline measures over an extended period of time does raise questions. Namely, should we be placing so much attention on the statistical measures of inflation, particularly when the difference between 0.6% or 0.8% quarterly inflation can apparently be the difference between no rationale to change policy and a clear-cut case for tightening?
In discussing how the RBA uses underlying inflation, the RBA Governor has said:
"…we employ analytical devices to help us detect what the ongoing trend in inflation is likely to be, and this is where the underlying measures are useful. They are not, themselves, the target variable. But a policy that targets future CPI inflation, using underlying inflation as an analytical tool and/or as a predictor of the headline CPI, would probably look very similar to one that was targeting underlying inflation per se. So, in this sense, if one is trying to assess what economists would call the Bank’s ‘reaction function’ using particular price series, underlying measures would probably be more helpful than the headline rate."
But all this is predicated on the assumption that following these measures of underlying inflation will take you to the same destination as the headline inflation data. Over the last 5 years, they haven’t. And unfortunately this has added to the impression that the RBA has missed its target. Maybe this prolonged period of overstatement means that over the next 3 to 5 years underlying inflation will be consistently below the headline rate, but we suspect not. As we’ve argued in the past, a mechanical reliance on the statistical measures of inflation is flawed."
