Australia needs a higher - not lower - inflation target

Much has been written on the failure of the Reserve Bank to achieve its inflation target in recent years. Bill Evans and The Australian Financial Review have argued that the Australian Government should make it easier for the RBA to meet its target, by lowering the current target from 2-3% to 1-3%. Rather than bring the RBAs inflation target in line with other central banks, they should be bringing their inflation targets in-line with ours.

In the interests of debate, I think such a move would be a mistake - and leading economists agree with me.

Indeed, the debate around the inflation target is not a new one, especially after interest rates hit zero around the developed world. Olivier Blanchard (former Chief Economist at the International Monetary Fund), Lawrence Summers (former US Secretary of the Treasury), Paul Krugman (Nobel Memorial Prize in Economic Sciences) and Kenneth Rogoff (former Chief Economist at the International Monetary Fund) have all argued for higher - rather than lower - inflation targets.

Economists that advocate a higher inflation target argue that there is ample evidence that deep-seated structural forces (like shifting demographics and slower trend productivity) have dragged down the real natural interest rate — which keeps the economy at full employment without stoking inflation — has collapsed to historically low levels. 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.

In a world of low interest rates, conventional monetary policy has less room to stimulate the economy in an economic downturn, making the RBA more dependent on unconventional monetary policy measures like quantitative easing or negative interest rates to stimulate the economy back to growth. If this is the new economic landscape, then we could expect more of the same in the next recession - higher asset prices and questionable impacts on the real economy.

Economists think that there are ways to lift the real natural interest rate. Long-term investments in education, public and private capital, and infrastructure aimed at increasing the productive capacity of the Australian economy would help. Countercyclical fiscal policy would too. For too long fiscal policy was held to tight in recent years, working against the efforts of the RBA.

On the monetary policy side, the most effective way to raise the real natural interest rate would be to raise the inflation target. This would imply a higher average level of interest rates and give the RBA more policy room to move in the next recession. Of course, there are risks to this approach - the bond market would sell-off if this was announced overnight, raising the interest cost burden on the Australian Government. For this reason alone, it is unlikely that a higher inflation target will be mandated by the Treasurer but moving the target lower and increasing the RBA’s reliance on unconventional monetary policies should not be the answer to long-term global structural forces.

In many ways, the argument around the inflation target is a red herring. The greater focus of the RBA is the strength of the labour market. It is the unofficial full employment target of 4% and wages growth, rather than the inflation target, that dictates monetary policy settings today. This is why we will likely see interest rates held at their current level for some time to come.