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, May 20, 2011

What happens when a central bank consistently misses its inflation target (chart)?

Over at Club Troppo, Richard Green scoffs at me finding fault with the RBA consistently missing its formal inflation target (see also David Bassanese below for a recent summary of the Bank's performance). John Quiggin seems to be in agreement, and is encouraging other, more hawkish central banks to raise their inflation targets to match the RBA's 2-3% band.

For those labouring under any misapprehensions, I can absolutely assure you that the RBA does not believe that long-term core inflation running at 3% pa is consistent with its 2-3% mandate. The RBA's target is the middle of this band, through the cycle.

The problem when you consistently miss the target, as the RBA has for over 10 years now, is that inflation expectations start drifting up, as they did in Australia prior to the GFC (I have posted the long-term expectations charts here too many times before to do it again). The RBA well knows that it got very lucky care of the exogenous shock that was the GFC; it was the deflationary event that "we had to have", much like the RBA acknowledges it got lucky with the policy errors that exacerbated the 1991 recession with the unanticipated benefit of a structural downward shift in inflation as a result of the huge output gap (recall unemployment peaked at around 10.9%). (I have posted the germane historical quotes from RBA decision-makers at the time here or over at Business Spectator.) In the absence of the GFC, we would likely have been staring down the barrel of double digit mortgage rates.

Finally, there is the more recent case-study of the Bank of England's abysmal inflation-targeting performance, where CPI risks spiralling out of control: core just printed 150bps above the BoE's 2% target, while headline inflation has risen to around 4.5%. The chart enclosed below is an illuminating illustration of what happens when you repeatedly miss your objective over a period of time. It shows the BoE's actual inflation outcomes benchmarked against their forecasts. The BoE likes to blame their woes on the inflation imported via a stark depreciation in their currency. They neglect to mention that exchange rates are largely determined by interest rate differentials, and the BoE is sitting on amongst the lowest rates in the world...

For those new to this issue, allow me to borrow David Bassanese's words, inked earlier in the week, to explain the RBA's challenges in greater empirical detail:

"And it is probably also irking the bank that despite its aim to target the mid-point its 2 per cent to 3 per cent inflation target, both headline and underlying inflation have averaged 3 per cent in the past 10 years. In the past five years, moreover, the trimmed-mean and weighted-median measures of underlying inflation have averaged 3.2 per cent and 3.4 per cent respectively. The longer underlying inflation averages about 3 per cent, the more likely this will be factored into wage bargaining outcomes – especially as the labour market gets tighter. In turn, this risks entrenching a higher level of underlying inflation, and making achievement of 2-3 per cent inflation over the medium term increasingly difficult."