RBA’s inflation target has been too high, for too long
There has been much coverage recently of two important issues facing the nation: a review of the Reserve Bank and the housing market.
With regard to the former, The Organisation for Economic Co-operation and Development and International Monetary Fund this month separately backed a review of the RBA, highlighting its failure to achieve its inflation target for several years.
But a long and costly inquiry is unnecessary.
The RBA is an institution which is both admired internationally and a model of best practice in Australia.
Using a root and branch inquiry to explain why it has not achieved its inflation mandate when the target is out of line with the evolution of the Australian and global economies over 30 years, and with the practices of all the major overseas central banks, seems unnecessary.
Set at 2-3 per cent over the cycle, the target was first referred to in August 1992 when inflation had averaged 6.4 per cent over the previous seven years, the 10-year bond rate was around 8.5 per cent and the cash rate 5.75 per cent.
The structure of the yield curve and the level of the cash rate allowed ample flexibility to reach the target, which was formalised between the RBA Governor and the Treasurer in 1996.
But since 1992, the world has changed (technology, demographics, globalisation, lower unionisation) and the flexibility of central banks has been severely curtailed as policy rates have fallen into their lower bounds around zero (or negative in some cases).
Yet, we are still asking the RBA to achieve the same target.
Other central banks have lower targets – the US Federal Reserve and ECB both target a symmetric 2 per cent, the Bank of England targets 2 per cent, and both the Bank of Canada and Reserve Bank of New Zealand target a 1-3 per cent range.
The argument against lowering the target seems to be that it would lower inflationary expectations and change economic behaviour.
But measures of expectations are much closer to 2 per cent than 2.5 per cent, suggesting there should be limited incremental impact on expectations of a change to 1-3 per cent.
I believe markets would actually welcome a move to align Australia’s target with other central banks.
Before the current situation, where we are faced with an official forecast that the cash rate is set to remain at near zero for four years to achieve the target, arguments to lower the target were not as material as we face today.
The Treasurer could implement such a change after the next election, in line with the precedent of some previous elections where the Statement on the Conduct of Monetary Policy – which specifies the inflation target – has been renewed after consultation between the government and the Bank.
Governor Lowe would then have the flexibility to still pursue his objective of lifting inflation, wages growth and lowering the unemployment rate – without having to over stretch and risk a dangerous imbalance in the housing market by pursuing an unnecessarily ambitious target.
Ironically, Westpac expects that due to the unprecedented mix of demand and supply factors following the COVID crisis, the RBA will achieve its inflation and full employment objectives by early 2023, allowing a move away from the emergency policy settings well before the official forecast of 2024.
However, in subsequent cycles, the issues we have faced since 2014 will re-emerge, highlighting that the inflation target is still inappropriate.
Achieving the target much earlier than the RBA expects would allow the Governor to avoid the dangerous impact on asset markets of four consecutive years of a 0.1 per cent overnight cash rate.
Imagine where the housing market might go if our forecasts are wrong and the RBA’s forecast is correct, with the official cash rate being held near zero until well into 2024!
Dwelling prices have already lifted by 17.5 per cent over the last year, the strongest annual house price increase since 2002, and affordability measures for first home buyers are stretched.
As has been well flagged, APRA will likely step in and introduce some controls on new lending, such as debt to income limits and increases in the serviceability rate used in loan assessments.
Such policies will certainly impact income stretched first home buyers and upgraders, particularly in the high- priced cities.
Investors who hold multiple properties and have been taking advantage of rising valuations on existing investments to acquire more properties will be affected. But new cashed up investors who are becoming cautious about a volatile equity market will be attracted to the housing market, with fixed funding costs generally lower than rental yields, while established sophisticated investors typically have access to a wide range of income sources.
So, we may be heading for a number of years when our housing markets are subject to some forms of direct controls, which still favour investors, and may prove to be less effective than expected.
In addition, we will see the usual efficiency risks around pricing signals and the movement of funds away from the regulated sectors to the unregulated but less capitalised sectors.
The question is the value of the trade-off: half a percentage point on the inflation rate relative to the prospect of a long period of distortive controls favouring borrowers who can find ways around those controls, a surge in house prices to unsustainable levels, and the associated vulnerability of borrowers to any eventual upswing in rates.
My view is that the RBA’s inflation target is now too high.
It’s time for an adjustment to 1-3 per cent to avoid some of these distortions.
Over to you Treasurer and the RBA.
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