RBA should lower its inflation target: Westpac

Keeping interest rates at a record low could lead to a ‘dangerous imbalance in the housing market’, according to Westpac chief economist Bill Evans.

The RBA’s inflation target was first referred to in August 1992 when inflation had averaged 6.4 per cent over seven years.

A leading economist has warned that the Reserve Bank’s inflation target is too high.

Holding interest rates at a record low to achieve the current target could lead to a “dangerous imbalance in the housing market”, according to Westpac chief economist Bill Evans.

The midpoint of the 2-3 per cent target for CPI inflation hasn’t been met since mid-2014 – a fact highlighted by the OECD last week when it proposed an independent review of the RBA’s monetary policy framework, saying that: “There are some areas that could be improved.”

Mr Evans said the RBA’s inflation target had been “too high for too long”.

“The rationale and efficacy of targeting a higher inflation rate than our peers are not clear,” he said.

It came as the IMF said Australia should use lending curbs to cool the property market amid a boom fuelled by record low interest rate settings by the RBA in the wake of the coronavirus pandemic.

“Macroprudential policy should be tightened to address gradually rising financial stability risks,” the IMF said in the concluding statement of the 2021 Article IV discussions.

While the surge in housing prices has been driven by owner-occupiers taking advantage of low mortgage rates and fiscal support programs, high debt-to-income mortgages are “on the rise amid elevated household debt, and investor demand has begun to increase from low levels”, the IMF said.

“Surging housing prices raise concerns about affordability and financial stability,” it added.

“Lending standards should be monitored closely, and macroprudential measures should be employed to address incipient risks.”

The IMF said the potential options include increasing interest serviceability buffers and instituting portfolio restrictions on debt-to-income and loan-to-value ratios.

RBA assistant governor Michelle Bullock said this week that regulators were “continually assessing” whether or not to address these risks via so-called “macroprudential tools”.

But RBA governor Philip Lowe said two weeks ago that interest rate hikes to cool the property market were “not on our agenda” and the best way to address concern about the level of house prices was via structural factors that influence the value of property.

Set at 2-3 per cent over the cycle, the RBA’s inflation 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 was 5.75 per cent.

The target was formalised with an agreement between the RBA governor and the treasurer in 1996.

“Since 1992 the world has changed and the flexibility of central banks has been severely curtailed as policy rates have run into their lower bounds,” Mr Evans said. “Yet we are still asking the RBA to achieve the same target.”  He noted that other central banks had lower targets – the US Federal Reserve and European Central Bank both target a “symmetric” 2 per cent, the Bank of England targets 2 per cent, and the Bank of Canada and Reserve Bank of New Zealand both target a 1-3 per cent range with a midpoint of 2 per cent. Some have recently adjusted their targets.

Mr Evans noted that the argument against lowering the RBA target seemed to be that it would lower inflationary expectations and change economic behaviour.

But measures of expectations, including market measures, are much closer to 2 per cent than 2.5 per cent, suggesting there should be “limited incremental impact on (inflation) expectations of a change to 1-3 per cent rather than maintaining 2-3 per cent”.

“Reducing that target to a 1-3 per cent range rather than the current 2-3 per cent would recognise the structural changes in our economy since 1992 when the target was first adopted and align Australia with the central banks in other developed economies,” he said.

“That decision would allow the governor the flexibility to pursue his objective of lifting inflation, wages growth and lowering the unemployment rate without risking a dangerous imbalance in the housing market in pursuit of an anachronistic objective.”

While Mr Evans believed the central bank would achieve its inflation and full employment objectives by early 2023, allowing a move away from the emergency policy settings, he warned that “the level of uncertainty is high and, if we are wrong, the prospect of four years of holding the cash rate near zero presents real risks for asset markets given highly leveraged household balance sheets”.

“To eliminate these risks the Treasurer and the RBA should adjust the inflation target in recognition of the structural changes in the Australian economy and to move into line with the policies of other central banks.”

Mr Evans noted that the treasurer could implement such a change after the next election, which must be held by May next year at the latest.