Reasons to Maintain the RBA s 2010 Inflation Target Camellia Pham

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1 Reasons to Maintain the RBA s 2010 Inflation Target Camellia Pham Page 1 of 8

2 Executive Summary: In Australia, since adopted, inflation targeting has resulted in stable, low inflation, contributed to the sustained growth. Problems arise as the rising oil and food price globally casts down on the attainment of inflation rate within 2-3% over the business cycle. However, from historical perspective, the target has performed well. Also, the nature of Australian inflation is more of demand pull in an economy operating near the equilibrium level of full employment, which need managing by monetary policy. Besides, changing inflation target in allowance of higher oil and food price is not advisable since it will create disbelief in RBA and further fuel inflationary expectation. Lastly, the current target is sufficiently flexible to reduce inflation not immediately but gradually. Given the objective of long run growth, a period of more moderate growth is better than raising inflation target- loose control of inflation, which later means a costly disinflation. Page 2 of 8

3 I. Introduction For the past 17 years, Australia has enjoyed continual economic growth, of which the contribution of monetary policy- so-called short run preferable economic manager- in price stabilisation was of significance. Monetary policy, administered by The Reserve Bank of Australia (RBA), involves the control of short term interest rates to stabilise price, whereby assist promoting sustained growth (Bernanke et al, 1999). Australia adopted inflation targeting since 1993 as the framework for monetary policy, which requires the maintenance of inflation level within 2-3% over the business cycle (Macfarlane, 2002). However, debates have risen as whether 2-3% is still an appropriate measurement in face of inflation due to rising global oil and food price. This report supports the maintenance of the current target because of its historical perspective, the nature of the current inflation in Australia and its commitment of credibility and flexibility in implementation. II. Body A. Inflation target has performed well historically The first argument in favour of the current inflation target is that since adopted, it has been successful in maintaining price stability (Bernanke et al, 2008). Obviously high inflation is always sought to avoid due to its harm on the economic efficiency and growth. But zero inflation is considered too restrictive and impractical because its implementation cost surpasses benefits (Bernanke et al, 1999). Hence, a low level of inflation is preferred for two reasons. Firstly, it makes allowance for the overstatement in the rising Consumer Price Index (CPI) due to quality adjustment bias (Bernanke et al, 2008). Secondly, it ensures that too low nominal interest rates (to the extent of deflation) will not be the case for the economy. Rather, low inflation reasonably raises firms output prices and encourages firms to increase Page 3 of 8

4 production and employment (Bernanke et al, 1999). The target level of 2-3 % has been considered appropriate, bringing Australia in line with international practice. Historical evidence shows that since the target was adopted, in general inflation was curtailed within bounds with more moderate swings, deviation between real interest rates and nominal interest rates becomes smaller (Gramlich, 2005); while inflationary expectation was lower and output fluctuation was smoothed (Bernanke et al, 1999). It can therefore be concluded that the commitment of attaining and sustaining an average inflation rate within the target, which has been achieved over 15 years, should preserve. B. Nature of the current inflation and net effect of rising oil and food price in Australia Because the nature of the current inflation in Australia is more of demand- pull, it is not changing the inflation target but maintaining an appropriate stance of contractionary monetary policy which will promote long run growth. Although they do substantially fuels price level, the rising oil and commodity prices this year are not the only reasons of Australian inflation. Before that, Australia had acknowledged a significant inflation signal, facing the fact that the economy s equilibrium is near full employment after 15 years of continual economic expansion. Meanwhile the growth has contributed to supreme increase in consumers confidence which in turn led to high level of autonomous debt- maxing out the credit availability (Adams, 2008). For example, the price level of consumers goods accelerated quite pronouncedly (Stevens, 2008). Also, the Government policy of redirecting wealth (due to the effect of the mining boom) through income tax cut has enhanced consumption (The Australian, 2008). Meanwhile the poor level of infrastructure investment rendered it insubstantial improvement in output capacity. In fact, demand in Australia which grew by over 5½ per cent in 2007 outstripped, by a significant margin, any plausible estimate of Page 4 of 8

5 growth in potential supply (Stevens, 2008). Consequently, the simultaneous effect of both excess demand and supply constraint is inevitably inflation. Not only that, Australia is net producer of commodity and food, of which the strong overseas demand has risen the Australian terms of trade (the ratio of export to import prices), by 15 % in 2005 only, for example (Leading Edge Education, 2006), and thus has an expansionary effect on the economy by further stimulating domestic demand. Meanwhile, though Australia is net importer of oil, the appreciation of AUD (due to strong export) has the effect of dampening the rise in oil prices (Stevens, 2008). In general, the ever rising oil and food price globally has a net expansionary effect on the Australian economy more than creates a negative supply shock (Stevens, 2008). Demand is what monetary policy can manage. Here the problem is clear: if the ongoing demand is left freely above sustainable rates, steady price (even at a higher level) will never occur. In fact, as Stevens (2008) pointed out, a continuing increase in inflation will more probably be the case. Hence, it makes sense that demand has to be controlled to stabilise inflation at any level. Raising the inflation target will bring back only a temporary solution in favour of current growth while fail to control inflation (pre condition of long run growth) and thus, not advisable. Consequently, monetary policy should be tightened to achieve an inflation rate at the target. C. Changing inflation target means risking the RBA s credibility Although the rising oil and food price does create sharp pressure in cost of living and cost of production on the private sector, it is not a sufficiently persuasive argument that inflation target should increase. Changing inflation target will not prevent the economy from falling into an unnecessary recession (Stevens, 2008). However, should it be implemented it will risk the RBA s credibility. It is believed that inflation targeting, at the theoretical level, helped Page 5 of 8

6 promote the central bank transparency, clarify communication, and establish a central bank commitment to price stability (Gramlich, 2005). If the RBA fails to keep its commitment by allowing for a higher level of inflation, uncontrollable and thus undesirable consequences can occur. Firstly the less restrain monetary policy means demand will continue to fuel prices pressure. Worse, inflationary expectation will exacerbate with workers demanding higher wages to compensate the higher cost of living and firms rasing price to protect their profits. Some firms can use inflationary expectation as an excuse for price increase (Foster, Monger, 2003). As a result of inflation inertia (Bernanke et al, 2008), inflation in the economy will continually increase, which in turn means the RBA will continually adjust to higher inflation target. The speed of inflation may cause a repetition of the 1980s inflation spike as Lloyd (2008) suggested which resulted in the too costly disinflation in 1990s (big recession). This definitely distort the rationale of inflation targeting s role of providing a stable economic environment. Thus, the argument that inflation target should be increased is misplaced. D. The current inflation target is sufficiently flexible Last but not least, the current inflation target is deemed to be sufficiently flexible to respond to the economic situation. In other words, the RBA does not rush to curb inflation back to target immediately, but takes into account the effect of rates rise on output. De facto, it is undeniable that to achieve the target also means to trade off the short run growth. Moreover, monetary policy is slow to work and is not selective in its impacts since it affects all sectors in the economy in a similar way which may not be appropriate (Foster, Monger, 2003). After 12 consecutive rate rise (prior to September 2008), the higher interest rates have caused much difficulties for the private sector whom already hurt because of more expensive petrol and food (Bernanke, 2008). For example, housing affordability has declined sharply; especially up to 300,000 home owners- households with low or fixed income- was expected to default on Page 6 of 8

7 loan and could have their home repossessed (Adams, 2008). For firms, higher interest rates and tighter credit standard adversely affect investment in the non-mining sector, especially the property construction and development. However, obviously an unnecessary recession is sought to avoid, which underlined the decision of RBA to cut rates by 0.25% this September (The Australian, 2008). What is more, in fact, emerging economies, including China and India have recently tightened monetary policy (Stevens, 2008). Their more moderate demand is expected to exert downward pressure on oil and food price. Thus, though not easy to disappear, inflation is expected to be back to 3% by 2010 and decline further after (Stevens, 2008). In other words, the current inflation targeting can continue to successfully fulfil its role of price stabilisation. III. Conclusion In summary, since adopted in 1993, the inflation targeting has worked well, contributed to the sustained growth over the past 15 years. Although the rising price of oil and food globally adversely affects cost of living and of production, it has a net expansionary effect and thus further stimulates the excessive demand in the Australian economy. The inflation target should therefore be maintained to enhance the RBA s credibility; ensuring inflation is controlled within 2-3% over the business cycle for the sake of long term economic growth. Given its flexible nature, it is interesting to see the horizon to bring inflation back within the target, as remarked by Woodford (2005). Page 7 of 8

8 REFERENCE: Adams, S. 2008, Rate rise to hurt home owners, The Epoch Times, 6-12 February, p.6. Bernanke, B., Mishkin, F., Laubach, T., Posen, A. 1999, Inflation Targeting: Lessons from the International Experience, Princeton University Press, America. Bernanke, B., Olekalns, N., Frank R Principles of macroeconomics. 2 st ed., McGraw- Hill Australia Pty Limited, Australia. Foster, G., Monger, R Economics: Australian Business Perspectives. 3 rd ed., Vocational Education & Training Publications, Western Australia. Gramlich, E Interview at the Euromoney Inflation Conference, 26 May Paris, France. [MP3 recording]. Leading Edge Education, External imbalances still at record levels despite commodity boom, Economics Update, vol.13, no. 3, April Lloyd, G. 2008, Monetary policy, The Australian, 27 February, p. 20. Macfarlane, I Speech 12th Colin Clark Memorial Lecture. 21 August 2002, Brisbane[MP3 recording]. Stevens, G Interview with the Anika Foundation Luncheon, 16 July Australian Business Economists and Macquarie Bank, Sydney. [MP3 recording]. The Australian, 2008, Reserve in no rush for series of interest rate cuts, [Online], Available: [16 September 2008]. Woodford, Michael, Central Bank Communication and Policy Effectiveness NBER Working Paper No (December). Chandler Jr., A.D. (1962). Strategy and structure: Chapters in the history of the industrial enterprise. Cambridge, MA: M.I.T. Page 8 of 8

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