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."

Monday, August 1, 2011

The RBA's inflation-targeting track-record (chart)

With high unemployment, low economic growth, and poor prospects dominated by deleveraging, Europe's central bank, the ECB, remains very jittery about inflation running at more than a two per cent per annum pace.

Yet with underlying inflation expanding at a 3.6% per annum rate over the last half-year (based on an average of the RBA's official measures) contextualised against extremely low (4.9%) unemployment, trend economic growth, a once-in-140-year terms of trade boom, and a solid outlook given one-third of our exports go to China and India alone (and only 3.8% to the US), Australia's central bank has not shifted interest rates since November 2010.

What gives? More pointedly, is Australia's central bank tolerant of higher inflation than its peers overseas?

To answer this question, I thought I would update some analysis I have done previously on the RBA's inflation-targeting performance. Given the impact of supply-side shocks like the floods and taxes, using the official 'headline' inflation proxies makes the RBA's track-record look especially disappointing.

A much fairer and more accurate approach is to take the quarterly average of the two underlying measures of inflation developed by the RBA itself--the so-called 'trimmed mean' and 'weighted median' (to two decimal places)--which strip out the first-round effects of these once-off events (based on the assumption that consumers ignore them).

We can then sum up this quarterly core inflation benchmark to create a rolling year-on-year series, which is displayed in the chart below.

Average core inflation since the RBA started its inflation-targeting regime in 1993 has been 2.6% pa. This is a good result, which they should be pleased with given the RBA's implied target is 2.5% pa. However, over the last 10 years core inflation in Australia has drifted up to 3.0% pa.

And, more worryingly, under Glenn Stevens, who was appointed in September 2006 (or around 5 years ago), it has drifted up even further to a quite unacceptable 3.3% per annum.

By pure coincidence, this is nearly the exact same pace that core inflation in Australia has been running at over the first half of 2011 if we exclude the controversial deposit and loan facilities expenditure class. Specifically, the trimmed mean falls for the June quarter from 0.92% to 0.85% based on analysis that we have checked with the ABS. (Click to enlarge the charts.)

To quantify the 'miss', on the RBA's own measures, core inflation has been rising at a pace that is about one-third above their 2.5% pa target since Glenn Stevens was made Governor. This brings me back to the so-called "policy of least regret".

I think people have got a little lazy in how they think about this after 20 or so years of uninterrupted economic growth. For an inflation-targeting central bank like the RBA, the "policy of least regret" is that policy that gives you the most confidence of hitting your inflation target in your 'modal', or 'base', case scenario.

The policy of least regret is not the policy that minimises community discontent with high interest rates. It is not the policy that maximises employment or economic growth over the RBA's 18 to 24 month forecast horizon, since these two variables conflict with price stability (ie, low inflation) in the short-run. Nor, for that matter, is it the policy that delivers a trend rate of employment or economic growth.

One senior RBA official has argued that past inflation outcomes are irrelevant so long as you are forecasting inflation coming back into your target band over your forecast horizon. This is also wrong for several reasons.

First, this assumes that your forecasts can be relied upon to determine future inflation outcomes, which the RBA, and Phil Lowe more precisely, have comprehensively shown is not the case (ie, the RBA has consistently underestimated inflation). In fact, the RBA was not forecasting core inflation above 3% pa until 2013, and yet we look like we are going to get it into 2011.

Second, under its agreement with Government, the RBA is obliged to keep inflation between 2-3% pa on average over the cycle, and is judged by its actual inflation outcomes, not its forecasts. It would be akin to an ASX-listed company's CEO saying, "Ignore my share price performance over the last 3 years, and just focus on what I am forecasting will happen."

Finally, the reason the RBA has an inflation 'target' is to establish a credible nominal anchor for consumers' inflation expectations. If you keep on missing your target, as the RBA has done over the last decade, and continues to do so in this new decade, then the inflation target, by definition, becomes increasingly non-credible.

Should the RBA lift rates on Tuesday? What the RBA "should" do, and what they "actually" do are two entirely independent things. I argued they "should" have raised rates in May following the first quarter inflation numbers, but noted that I did not think they would. I believe this was a serious policy error.

I also think it is a mistake to try to calibrate, or "price", interest rate policy for near-term data perfection, as the RBA seems to be falling into the trap of doing. My personal view is it is very likely they "will" raise rates in the next two months, but most economists, and the financial markets, disagree with me.