The long flight against inflation
02 June 2010
This article examines the Reserve Bank of Australia’s (RBA’s) long fight against inflation and why it has quickly returned to the centre of the RBA’s policy focus.
The task of keeping inflation low and stable is becoming more difficult than it has been for 20 years. This raises the risk that inflationary expectations could also ratchet up, which – if it was allowed to occur – would make it even more difficult to dampen inflation.
In this environment, the RBA may consider the risk of raising rates so far that they flatten household spending – a more acceptable option than being more timid on tightening and allowing inflation to creep higher. In other words, the risk is clearly skewed in the direction of the RBA raising rates further and faster than the market expects.
The statement accompanying the RBA’s decision to hike interest rates in May had a little for everyone. While the commentary surrounding growth – both domestic and international – was generally favourable, they did note that interest rates were now at ‘average’ levels and that there had been a ‘significant’ tightening of monetary policy since 2009. This raises the prospect of a short pause in rates in the next couple of months as the Bank monitors how the removal of stimulus affects the economy.
That said, the statement was notable for the following comment:
“the extent of decline (of inflation) from here may not be quite as much as earlier forecast and inflation now appears likely to be in the upper half of the target zone over the coming year.”
Moreover, it is worth noting that the current dip in inflation was a result of “a noticeable slowing in private-sector labour costs during 2009, the rise in the exchange rate and the earlier period of slower growth in demand.”
The A$ has since fallen back, while labour costs and demand growth are both likely to be much stronger in the year ahead. So, imagine what inflation would be like now without all of those factors dampening price pressures over the last year.
It is also useful to place the RBA’s current challenge in a longer-term perspective. In the early 1990s, many analysts questioned the inflation-fighting credentials of the RBA. However, an Assistant Governor at the RBA expressed confidence that the RBA was winning the war against inflation. This was because since the 1980s, each peak in inflation had been lower than the previous one, and each trough in inflation was also lower than its predecessor. As long as this remained the case, then inflation would be kept to a low and stable rate.
Over the last decade, however, things have changed. Since the late 1990s, each peak in inflation has been higher than the preceding one and average inflation is also creeping up. In this kind of environment, there is a clear risk that inflationary expectations could also ratchet higher. While this is not yet the case, there has been some recent evidence of these expectations beginning to edge up.
From a policymaker’s perspective, this is an uncomfortable situation. The inflation genie hasn’t jumped out of the bottle, yet, but it is clearly threatening to do so. And at the same time, policymakers will have the issue of sacrifice ratios running through the backs of their minds.
The sacrifice ratio shows how much unemployment needs to rise (or output to fall) to achieve a reduction in inflation. A low sacrifice ratio is a double-edged sword. When an economy has a low sacrifice ratio – as Australia has had in the last decade – it means that it can achieve large reductions in the unemployment rate with only a modest rise in inflation.
The downside, however, is that if inflation jumps higher, then the cost of getting it back down to an acceptable level will be high. Again, in terms of the policy implications, it suggests that if inflation is threatening to burst higher, then policymakers should respond aggressively.
With most interest rates in the economy now getting back to ‘average’ levels, the first stage of the RBA’s monetary tightening has now been completed. Removing stimulus when the economy is growing at – or above – trend is a fairly straightforward decision. However, the next stage of monetary tightening will not only be more contentious, but also intrinsically much more difficult.
Obviously, the flow of data will play a key role in determining the timing and extent of further rate hikes. But when the policy call is a 50:50 bet, policymakers are likely to fall back on the ‘bigger picture’ to inform their decision. The analysis in this report suggests that this bigger picture will push them to hike interest rates on these 50:50 calls more often than not.