We’re missing the point on inflation

Stabilising

On housing, there are some early signs the market is stabilising. While that is somewhat speculative, a prospective rate cut – and a potential move from the Australian Prudential Regulation Authority to lower the mandated 7 per cent interest-rate floor for mortgage affordability calculations – would aid stabilisation (and not before time).

The broader economy has handled a 10 per cent fall in house prices relatively well, but further significant falls would in all likelihood be substantially more disruptive. For borrowers, falling house prices, along with other factors including low income growth, have contributed to a rise in delinquencies and the number of mortgages with negative equity.

However, Australia is now presenting low-inflation outcomes similar to many other countries. Headline inflation has surprised on the downside for much of the past two years, while core inflation has failed to increase despite slightly stronger wage growth.

Some have used this state of affairs to argue for a downward revision in the RBA’s inflation target. While that may or may not be wise, in many ways it’s not the point.

Monetary policy is increasingly constrained by low interest rates and weak global inflation partly driven by technology. Meanwhile, high household debt suggests sharp moves in asset prices and debt – in either direction – is undesirable. 

The stimulatory potential of lower interest rates has also been blunted by a substantial prudential tightening and the much smaller current account deficit.

The more-important issue is that Australia’s ability to achieve any inflation target is now in question. This mindset shift is an important foundation of the future evolution of the policy framework.

Approach

The environment calls for a different approach to macro-economic management - including patience. Australia needs to be more tolerant of deviations from the inflation target, as policy balances a broader range of constraints. Policy no longer has the ability to easily generate a rise in inflation. This shift in approach is necessary regardless of the precise target number.

The target should also be approached asymmetrically, emphasising the greater costs of undershooting. When debt levels are high and interest rates and inflation are low, downside inflation surprises are much more difficult to correct than upside surprises.

Consider if the RBA doesn’t cut rates soon and growth does turn downward. It’s not difficult to envisage a scenario in which higher unemployment begins to force more homeowners to sell properties, which weakens prices further. A downward spiral could develop. Monetary policy has limited ammunition to correct such a decline once it starts.

Yet, to date, policymakers have worried more about upside surprises. Consider: since 2017 the RBA’s warnings to borrowers the next rate move would be up or APRA’s 2014 introduction of the 7.0 per cent interest floor for mortgage affordability assessments “to ensure the interest rate buffer used is adequate when … operating in a low interest rate environment”.

This is one reason why lowering the inflation target would be counterproductive. It would lower inflation expectations – already close to record lows in the ANZ Consumer Sentiment Survey – potentially exacerbating the current problem.

Third, the various arms of policy require better co-ordination. Historically, monetary policy targeted cyclical stabilisation, prudential policy financial sector oversight and fiscal policy structural issues. That neat division is no longer appropriate.

Current circumstances, where downside inflation surprises and a worrying shift down in inflation expectations are constraining the RBA’s ability to reduce real interest rates, support this view.

This means a shift is needed in the way we think of RBA independence – which should have been carefully safeguarded – because monetary policy no longer has the firepower to be left alone to manage cyclical stabilisation.

Worrying about the inflation target number risks missing the point that monetary policy is more constrained and achieving any inflation target is now difficult.

Monetary policy needs to be operated with more patience than has historically been the case, the costs of undershooting the target are much greater than exceeding it, and economic policy needs to be better coordinated. A change in approach is required.

Richard Yetsenga is Chief Economist at ANZ