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Friday, April 15, 2011

Let's lower our inflation target to 2.0% pa and get better outcomes

For no particularly good reason, the RBA has selected the highest consumer price inflation target--of 2.5% pa (or a band of 2-3% pa)--in the developed world. (The 2-3% pa range was plucked because it is where inflation landed following the 1991 recession.) All the other major nations have a lower inflation target--of 2% pa or less--with the exception of Norway, which also targets 2.5% pa. Unsurprisingly, the RBA has failed to achieve this target since it was first informally adopted in 1993 (formally in 1996), with headline inflation averaging a slightly higher 2.7% pa. If we look at the last 10 years--before or after the GST--we find, more disturbingly, that both headline and core inflation have all averaged a well-above target circa 3% pa. Glenn Stevens deserves every penny he gets paid. But the RBA has to do a better job.

It seems to me more than a coincidence that the RBA has opted for a high inflation target, and got saddled with an unusually high average inflation rate. The interesting thing is that investors appear to have cottoned on to this. Bloomberg provides an analysis of expected future inflation rates in bond markets around the world. In the first image below you can see those countries with the highest and lowest investor inflation expectations (click to see properly).

While the maturities differ, Australia ranks amongst the highest (with a 5 and 10 year inflation forecast of 3% pa, which just happens to be exactly what inflation has averaged over the last 5-10 years), alongside the UK (long-term bonds), France (short-term bonds) and Italy (short-term bonds).

As ICAP's Adam Carr noted the other day, the Bank of England seems, by dint of its own decisions, to have dropped its commitment to a 2% pa inflation target (over a forward 2-year horizon, which it has not got close to in the last 2 years), so it is no great shock to see investors lose confidence in their ability to hit it over the long-term.

As you would expect given their persistent deflationary impulse, Japan is projected to realise the lowest future inflation rates (indeed, investors anticipate negative outcomes, or outright deflation).

In a recent research discussion paper (previously reviewed here), the RBA tried to explain away these high numbers by noting that there was an inflation "risk premium" embedded within bond market expectations, which, once eliminated (this is a statistical guess that may or may not be correct), conveniently permits the RBA to conclude that "long-term inflation expectations are well anchored within the 2 to 3 per cent inflation target."

I am not so sure I agree with this claim given that bond market expectations are mostly irrelevant to the determination of consumer price inflation. What we really care about are consumer inflation expectations. As I clearly showed in the post below, these are anything but well-anchored, and have averaged a way-above-target 3.5% pa since 2000, and displayed strong upward drift over time (I have re-inserted one of the consumer charts, which you can click to enlarge, immediately below).

Turning back to investors, you can see in the third image below the change in bond market expectations for Australia's future inflation rate (the chart in question, which you may need to click to view properly, shows the break-even inflation rate on 10 year Australian government bonds)...

The bottom line: As a matter of empirical record, the RBA's inflation targeting regime, which only commenced life in 1993, has not worked well over the last 10 years. As a nation, we got awfully lucky during the GFC, as I have explained here countless times before. Australia's providence in avoiding the ex ante fate of the US and Europe, like almost all other Asian nations, had basically nothing whatsoever to do with fiscal or monetary policy settings prior to the crisis, notwithstanding some media claims to the contrary.

There are many good reasons why we skirted the worst of the GFC, and they have much to do with the comparatively slower development of our banking system and securitisation markets (which were about 5yrs behind the UK and 10-15yrs behind the US), our trading partner mix and huge exposure to Asia (ie, China, India, South Korea), our extraordinary endowments of natural resources, our strong population growth, and the considerable luck associated with having a housing cycle that was running three to four years ahead of most of our peers.

Even the RBA acknowledges--rather relucantly given the significant appeal of ex post facto historical rationalisation--that it did not materially change interest rate settings in 2002-03 in response to the speculative exuberance in domestic housing at the time (open mouth operations, it did engage in, but rate settings were generally in line with what was required at the time). This has been formally documented in the Bloxham et al RBA research discussion paper that I previously reviewed here.

If only to discipline its own actions, and Australia's actual inflation outcomes, the RBA Board should seriously consider dropping its inflation target from 2.5% pa to 2.0% pa.

Finally, if you want a refresher on why we care about inflation, read my primer here.