Central banks concede inflation targeting a losing battle

The inflation targeting framework pursued by the RBA and its global peers for the past 20 years is under threat.

Interest rates

The inflation targeting framework pursued by the Reserve Bank and most of its global peers for the past 20 years is under threat with Glenn Stevens conceding it is proving less effective in raising inflation than it was in lowering it and an emerging view that fiscal and other arms of government policy need to play a greater role.

Some, including Federal Reserve of San Francisco president John Williams and former Reserve Bank board member and leading economist Warwick McKibbin, contend the inflation targeting framework itself is in need of revision.

Stevens remains committed to the framework, and the Reserve Bank believes that at the margin, its latest cuts may be of some benefit. But he highlights the asymmetry of dealing with inflation that is too low compared with inflation that is too high.

“When you’re tightening you can always find an interest rate that’s high enough that you’ll stop them from borrowing, but when you’re cutting, you can’t assume there’s a rate low enough that will restart it all, particularly if they started with too much debt to begin with,” he told The Australian and The Wall Street Journal last week.

The governor’s brooding about the pressure capital inflow is placing on the exchange rate highlights the diminishing returns from monetary policy as short-term rates approach zero.

Stevens said the impact of the cash rate on the exchange rate was being overwhelmed by capital inflow seeking access to high yielding Australian assets.

“The cash rate obviously matters and the assumed future path of rates has some bearing on the way the exchange rate behaves. That’s certainly true. But it’s other assets than just those that clearly matter here.”

He mentioned capital inflow seeking access to commercial property and infrastructure assets which are delivering yields of around 6 per cent — far lower than Australia’s historic return but far higher than yields in the major advanced nation markets.

“Government bonds yielding two-ish, that looks pretty attractive for many investors,” he said.

“It’s not just the rate we set, even though that does matter. It’s a search for yield world and this country still looks attractive because other yields look so unattractive.”

As a measure of his frustration with the upward pressure on the Australian dollar, Stevens canvassed the need for a national debate over what kind of foreign investment we want — whether it is investment building new assets, or investment simply adding to demand for and the price of Australian assets.

The IMF has become a lot less doctrinaire about capital controls in recent years, acknowledging that they can complement macro-prudential regulation to lower the risk of uncontrolled booms and busts. However, the fund is only talking about emerging countries.

The application of any kind of capital control by Australia in the face of an appreciating exchange rate would be a radical step back from the free-floating exchange rate that has buffered Australia from repeated global shocks over the past 32 years.

Warwick McKibbin argues there are two ways to become more competitive.

“One is to let the exchange rate depreciate, and the other is to reduce input costs and become more competitive with higher productivity and lower costs.”

A lower exchange rate brings a relative improvement in competitiveness for as long as it lasts, but an improvement in productivity delivers permanent gains.

McKibbin says the central bank has done all it can, and it is time for government to step up its efforts to improve the ability of the economy to lift output with reforms in areas such as competition policy, tax, infrastructure governance and industrial relations.

The exchange rate might get uncomfortably high, but it will force the pace of reform.

Some argue, to the contrary, the problem is that the RBA has simply not been aggressive enough with its monetary policy. After every cut, it has given the impression that it has done enough, only to be forced into doing more as inflation drops.

It has made little use of forward guidance to encourage business to accept rates will be low for a long-time, other than the period between February 2014 and February 2015, when each month’s meeting concluded with the statement that “a period of stability” would be appropriate.

McKibbin says the problem with more aggressive monetary policy is that it simply pushes up asset prices.

“Monetary policy is too loose from an asset point of view. This problem comes about because monetary policy is the only instrument we have.”

“You could make a short-term argument that rates should be lower, but who’s going to clean up the mess when you’ve had the maximum impact on asset prices and it comes crashing down.”

An influential critique of inflation targeting has been mounted by Williams, the San Francisco Fed president.

It follows research he has led into the “neutral” or “natural” rate of interest — the level of interest rates that results in inflation neither rising nor falling.

His analysis of the economies of Canada, Britain, the US and the euro area shows the neutral rate of interest has been decline everywhere for the past 25 years, with the pace of the fall increasing since the global financial crisis.

In the early 1990s, the neutral rate of interest ranged from 2.5 per cent to 3.5 per cent for these economies.

By 2015, it was down to 1.5 per cent for Canada and Britain, nearly zero in the US and below zero in the euro area.

Weakening productivity, demographics and the unbalanced growth of savings in the emerging world are among the explanations.

“The key takeaway from these global trends is that interest rates are going to stay lower than we’ve come to expect in the past,” he says.

Like McKibbin, he contends the solution lies with fiscal policy, not with central banks, and particularly not with an inflation targeting formula.

“There is simply not enough room for central banks to cut interest rates in response to an economic downturn when both natural rates and inflation are very low,” he says.

“There are limits to what monetary policy can and, indeed, should do. The burden must also fall on fiscal and other policies to do their part to help create conditions conducive to economic stability.”

But where does monetary policy go in this new world?

Both McKibbin and Williams argue there is a case for central banks to target nominal GDP — essentially real GDP plus inflation.

Certainly, weak nominal growth is the central problem confronting Australia, where declining terms of trade have resulted in nominal growth falling short of real GDP.

However, the central bank has no more ability to force nominal GDP higher than it does to push up inflation.

In the interview, Stevens commented that the diminishing role of monetary policy could not be blamed on the lack of inventiveness of central banks.

“I don’t think there’s a kind of failure of imagination or willingness to act — far from it. I think what it does demonstrate is that there are certain situations or certain shocks — sets of events where monetary policy’s capacity to help is only going to take you so far.”

The era of activist policy­making by central banks may be drawing to a close.