Monetary policies and low inflation

When Philip Lowe took up the governorship of the Reserve Bank of Australia a year ago, financial markets were betting he would be cutting rates within six months. Today they are betting he’ll be raising them by May next year.

After Tuesday’s RBA board meeting, Lowe said there would be no change in rates, as he has after every meeting since his first as governor in October last year.

Westpac chief economist Bill Evans expects Lowe will be making the same ­announce­ment after the monthly RBA meetings all the way through next year and into mid-2019.

It is as if the economy were stuck in first gear, and the Reserve Bank keeping its foot to the floor is neither making it go any faster nor lifting inflation. Central banking the world over is in ferment as top officials wrestle with the risks created by a decade of ultra-low rates and with their failure to generate the modest inflation required by their formal targets.

The inflation targeting framework that has governed the world of central banking for the past two decades, and that seemed to work so well at taming runaway inflation, is now struggling to deal with price rises chronically undershooting the mandated goals.

The Reserve Bank has been pursuing a target of keeping inflation between 2 per cent and 3 per cent since the early 1990s. The underlying rate of inflation (which strips out volatile movements such as petrol price jumps) has been below 2 per cent since the beginning of last year and the RBA’s projections suggest it doesn’t ­expect a ­return to the desired 2.5 per cent until the middle of the next decade. The same is true the world over, and it is leading central bankers to question whether their explanation of the economy and their impact on it is correct.

In a speech last week, US Federal ­Reserve chairwoman Janet Yellen pondered whether there was a “risk that our framework for understanding inflation dynamics could be misspecified in some fundamental way”. A week earlier, Bank of England governor Mark Carney had claimed globalisation was responsible for weak inflation but said he was not ready to ditch his bank’s inflation target.

Citigroup chief economist Ebra­him Rahbari argues that central banks everywhere are abandoning their inflation targets but not admitting it. The US Fed is planning to lift rates, despite inflation lagging its target, while others including the Bank of Japan and the European Central Bank are cutting their inflation forecasts below target levels but are not responding by cutting interest rates.

The Bank for International Settlements, which is a kind of central bank to the world’s central banks, warns that the inflation targeting framework is fostering a dangerous build-up of risk. Head of its monetary and economic ­department Claudio Borio says central banks must “feel like they have stepped through a mirror”. Having spent their lives struggling to bring inflation down, they now toil to push it up. Where once they feared wage increases, now they urge them on.

Borio challenges the intellectual underpinnings of central banking. For the past century it has been assumed that there is a “natural” (or “neutral”) rate of ­interest that balances the needs of savers and investors. If a central bank sets its policy interest rate below this natural rate, it will ­encourage people to run down their savings and lift spending, pushing inflation higher. If the policy rate is higher than the natural rate, people will save more of their income to take advantage of the higher rates, spending less, and inflation will fall.

The theory runs that while central banks set the short-term rate of interest, long-term bond rates trend ­towards the “natural rate”. But this natural rate of interest is an economists’ hypothesis — it can’t be seen or measured, except by economists’ models. Borio calls it an “abstract, unobservable, model-dependent concept”.

He jettisons the idea of a “natural” rate of interest and says central banks have far greater sway over long-term interest rates than their theory suggests, but much less influence over inflation. He says central banks should relax about inflation rates dropping below their targets and instead ­redouble their attention on financial stability. Global debts have risen from 225 per cent of world GDP to 275 per cent since the ­financial crisis. He frets the central banks are sinking into a “debt trap” where they can’t raise rates for fear of wreaking economic havoc because debts are so high.

Borio and Lowe are close — in the early 2000s they collaborated on a paper arguing that securing financial stability should be a target for monetary policy. The ­financial crisis has made it one of the most widely cited and prescient papers in central banking.

Borio has now gone much further than Lowe, who remains a firm supporter of the inflation targeting framework. But Lowe has shifted the bank’s approach to monetary policy, writing into his agreement with the government that the inflation rate could vary from the target range in the interests of financial stability. He ­argues that the RBA in theory could do more to get ­inflation back to its target band more rapidly by cutting rates further but this would encourage a further undesirable build-up of household debt. He has declared himself patient and is relying on the banking regulator using its supervisory powers to control the growth of bank risks.

The question is whether this prudence has come too late. The RBA slashed its cash rate from 4.75 per cent to 1.5 per cent between late 2011 and late last year, triggering a house price boom that pushed up household debts by an average of almost 7 per cent a year.

This week the International Monetary Fund said household debts much above 60 per cent of GDP were a threat to growth and financial stability. The RBA’s measure of the household balance sheet shows debts have soared from 120 per cent of GDP to 137 per cent since 2011, putting them among the highest in the world.

Lowe worries that a small shock could turn into a much lar­ger downturn as households seek to repair their balance sheets. The danger is that debts are already so high that any rise in rates would crunch household spending, while rates are still low enough to make further borrowing attractive. With no path forward, the Reserve Bank is stuck where it is.

Published today in The Australian. Posted here with permission of the author.