Shortly after leaving the Reserve Bank I had some time to reflect the best way of conducting monetary policy. Treasury had tried ‘monetary projections’ that failed after money growth blew out with financial reform. The Reserve tried ‘the check list’, to general lack of acclaim. Finally I decided in 1990 the rate of inflation (eg the consumer price measure) was an appropriate operational target, as did Sir William Cole. It took six years and a new government to achieve this rule, and still leaves the big question about ‘asset inflation’ unresolved.
Inflation is the persistent erosion of the value of the monetary standard. In an inflationary economy it should come as no surprise that standards of private and public morality come under pressure. Inflation is theft and an economy built on inflation is one built on deception.
Inflation forces up rates of interest, saps international competitiveness, reduces incentives to save and invest and, ultimately, puts at risk a country’s financial and economic stability. Eliminating inflation requires a national consensus that the costs of inflation are much greater than generally thought. Establishing and maintaining such a consensus is a crucial step in restoring and maintaining Australia’s economic prosperity.
This was the guts of the introduction to an article written for the journal Policy in the winter of 1990. [Reference] Australia was then in the midst of the greatest recession since the Great Depression, called by Treasurer Keating ‘the recession we had to have’. With the official rate of unemployment reaching 10.4 % and true unemployment and underemployment at least twice this figure it is no surprise that Mr Keating produced a snappy one-liner to imply at least some good might come of it.
When asked by a journalist what he thought of my article, the Treasurer said something like: ‘Ah, Dr Jonson. The principle architect of the interest rate cuts that helped get us into the current mess.’ This was in one sense a backhanded compliment. Also an outright lie, and as I was unemployed (being between jobs) could even have destroyed my new career. When the journalists called to ask for a comment I said his comment was incorrect but now wish I has said his comment was ‘simple bullshit’, as advised by Libby.
I wrote to Mr Keating to protest at his lie. He phoned me to discuss why he believed what he had said, saying he had been told that I was the man soft on inflation. I told him that was ‘simple bullshit’ and he should check his source, presumably within the RBA. I told him he should apologise and at least correct his story, which he promised to do. He then spoke at length about the ‘wimps’ (his word) at the RBA who had failed to meet his request to raise interest rates early enough and strongly enough to head off the boom that had created the current recession. I agreed with this point.
In the event, John Stanforth, the CEO of Norwich Union, did not waver in his support for his new CFO. I phoned new governor Bernie Fraser (transferred from Treasury) to request that I come in the Bank to read my own board papers but he immediately said ‘No way, hose’. On repeated insistence of my request Bernie agreed that John Phillips would read the relevant papers and phone me. This happened pretty quickly and John called to say my memory was indeed correct. I had been consistently warning about the state of the economy and recommending that interest rates be raised.
Many years later I discussed this matter with the RBA’s official historian, who concurred with John Phillips’ judgment. I assume that said historian will tell the story correctly and will therefore do Mr Keating’s job for him.
The costs of inflation
To return to the arguments about the costs of inflation, they include loss of morality by governments, business and ordinary households, the group with the least ability to avoid the costs. Related economic costs were to equity within an economy, efficiency (and therefore growth) and economic stability.
Wage earners who kept their jobs (at higher wages resulting from inflation) gained hugely at the expense of those workers who lost their jobs and owners of capital. Home owners gained massively at the expense of renters. Borrowers (including governments) gained at the expense of lenders when inflation exceeded nominal rates of interest, as it did in the 1970s. I offered the judgment that all these changes to the distribution had been larger than any that resulted from the effects of deliberate policy choice.
Effects on growth were also negative. When the national measuring rod changes in an unpredictable way, sensible long-term planning is impossible. This problem applies to business and to households. Both investment and saving is reduced, savagely so when inflation gets into double digits, as it did in Australia in the 1970s. A very specific cost of inflation is how it contributes to growth of national debt by inhibiting exports and encouraging imports, especially when inflation in higher in Australia than in our trading partners, which it was in the 1970s and most of the 1980s. Currency depreciation may help, but this is likely to be a hit or miss sort of affair.
Inflation drains money from the private sector to governments due to so-called ‘progressive’ tax systems and the dreaded ‘bracket creep’. This money will be spent, mostly on programs of less value than those in the private sector.
A final cost of inflation is the way it threatens financial and economic stability. Periodic attempts to stop inflation produce disruption that periodically produced major checks to people’s plans. Consider the adverse effect on employments and people’s plans in the major recessions of 1961, 1974, 1981 and 1989. The deep depressions of the 1890s and 1930s produced great damage to financial stability as asset prices plunged, unemployment surged and economic growth crashed.
What to do about inflation.
My bottom line was not unlike that of Mr Keating, however. Failure to cure inflation would involve costs that persist, and even a bad recession will pass. That is no consolation to people who lose jobs or business owners who fare badly, of course, which is why it is better not to let inflation get out of hand. A standard issue is monetary policy moving to head off inflation ‘too little, too late’, a point that I made in several occasions during the eleven-year career as a writer at the Australian, under the nom de plume of Henry Thornton. This column also grappled with the problem of asset inflation and how it related to commodity inflation.
The other major issue I pursued in 1990 was the independence of the central bank, as part of a ‘self-binding’ arrangement in which the government sets the objective and the bankers are responsible for implementation. I joined a call by Sir William Cole, a distinguished retired public official. He asked: ‘How long has the Reserve Bank gone along with things against its better judgment – not for crude political reasons but because its own reading down of its charter?’
It is worth quoting the current Reserve Bank Act.
‘It is the duty of the Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank … are exercised in such a manner as, in the opinion of the Board, will best contribute to:
The stability of the currency of Australia;
The maintenance of full employment in Australia;
The economic prosperity and welfare of the people of Australia.’
I had already argued that the existing charter, as set out in the act of parliament, could be interpreted differently, presumably with the approval of the government. I added that it could not be denied that, in Australia, the attempt to achieve too many objectives had meant that the primary aim of monetary policy, the elimination of inflation, had not been achieved.
In 1990, Mr Keating’s recession was in the process of killing inflation. ‘Inflation’ at that time meant ‘commodity inflation’, or ‘goods and services inflation’ or ‘consumer price inflation’. Looking back, consumer price inflation has hardly varied in the nearly two decades since the ‘Recession we had to have’. For the first six years this occurred without the Reserve Bank being independent from government, or formally pursuing a mandate to keep consumer inflation under some agreed levels.
Consumer inflation is low in most countries, uncomfortably so in many, and economists appear to be confused about why.
In 1996, the Treasurer of the incoming Coalition government, Peter Costello, signed an agreement with newly appointed RBA governor Ian Macfarlane that was virtually identical to the prescriptions of Messrs Cole and Jonson. Consumer inflation was to be kept on average in the range of 2 to 3 per cent per annum. The Reserve Bank was forthwith to be independent of government in its pursuit of low inflation. As this independence was to a task mandated by government it violated no canon of democracy.
The decision to focus on consumer inflation has never been criticised from outside the government/RBA for its potential conflict with the more detailed instructions contained in the Reserve Bank Act. The appropriate logic is that government is primarily responsible for maintenance of full employment and economic prosperity and welfare of the people.
Because of the high costs of inflation, it is arguable that low and stable inflation requires tight and stable monetary policy, which some would define as low and stable monetary growth, though we have already seen that financial deregulation kills that argument stone dead. Any structural change of the sort seen in the 1980s would certainly provide the Reserve Bank with some hard questions to answer.
Why has inflation been so low?
'Inflation', so far is it just goods and services inflation, or commodity inflation or consumer inflation. Is it the ‘Accord’ between the RBA and the government that been so apparently successful? A major point is that low inflation has been a widespread global result, and not all central banks can claim such an accord. In particular, the US Fed operated under the same rules after 1996 as before it.
The first low inflation cause is the rise of China, India and the manufacturing powerhouses of South East Asia, which established ‘low inflation’ as a vital part of the thinking of the global workforce. This set up a low inflation loop that left both wages and commodity inflation growing slowly.
The second is Paul Volcker’s new rules of play in US monetary policy. After two recessions in quick succession in the early 1980s, US commodity inflation was driven down and has stayed down since. Mr Volcker is a large man with strong ideas and that made many Americans take his words to mean what they said. Together with the Asian industrial breakout this provided low inflation expectations everywhere except in some crazy banana republics.
The third is the global financial crisis of 2007-08. With banks failing, real estate prices in America plunging and American industry taking a belting, and similar things in other developed nations, business and household inflation expectations, already low, stayed low.
It is far too early to test these hypotheses in any scientifically respectable way. I believe these points will eventually come to be the agreed reason for commodity inflation to remain low from the early 1980s in the USA, and about a decade later elsewhere, as in Australia.
As part of the response to the global crisis, central banks slashed cash rates of interest and embarked on so-called ‘Quantitative easing’. The latter policy exchanged private sector bonds for cash, the theory being that this was the way to supercharge monetary policy. Together with bail-outs and fiscal expansion, this policy prevented the deep recession or even depression many feared when the western economies began to crumble.
What about asset inflation?
What about asset inflation?
This is a question that has created great confusion for central banks, except for the central banks' central bank. For many economists and researchers it has apparently a more difficult question than consumer inflation, since that was sorted by Friedman and Schwartz, but see below.
I have separately reported the alleged comment from two RBA governors that ‘We have no framework’ for this. Current governor Philip Lowe during his time in the American academic world in an article for the Bank for International Settlements (BIS) with Claudio Borio, wrote that if asset prices are rising too quickly it is appropriate to raise interest rates.
It is worth quoting the abstract in full. 'This paper argues that financial imbalances can build up in a low inflation environment and that in some circumstances it is appropriate for policy to respond to contain these imbalances. While identifying financial imbalances ex ante can be difficult, this paper presents empirical evidence that it is not impossible. In particular, sustained rapid credit growth combined with large increases in asset prices appears to increase the probability of an episode of financial instability. The paper also argues that while low and stable inflation promotes financial stability, it also increases the likelihood that excess demand pressures show up first in credit aggregates and asset prices, rather than in goods and services prices. Accordingly, in some situations, a monetary response to credit and asset markets may be appropriate to preserve both financial and monetary stability.'
[Reference: Claudio Borio and Philip Lowe, 'Asset prices, financial and monetary stability: exploring the nexus', BIS Working paper, No 114. Paper presented in 2002, this version published in 2005.]
Despite this powerful statement by two fine economists, it is interesting that Dr Lowe did not raise interest rates during Australia’s massive housing boom. Now that house prices are falling, the Reserve Bank is letting it be known that interest rates are likely to be cut, even lower than the record levels of cash rates at 1.5 %.
My own research, to be discussed later, shows that asset inflation mostly moves more or less in the same direction as commodity inflation, which perhaps provides support for Dr Lowe’s statement quoted above. For the US economy, with two colleagues I updated the work of Friedman and Schwartz. Firstly adding 52 years of data and allowing for asset inflation, represented by US share inflation. Mostly commodity inflation moves in the same direction as monetary policy, as does share inflation. But there are several ‘aberrant periods’ in which share inflation moves very differently to commodity inflation. More on this later.
[Reference: Peter Jonson, Libby Prior Jonson and Ka Mun Ho, 'Updating Friedman', Unpublished paper available on request, 2013.]
Yet monetary policy is not the only effect on either type of inflation. In particular, asset inflation is also strongly influenced by ‘Animal Spirits’. While commodity inflation is strongly influenced by monetary policy it is also influenced by labor costs and the state of the labor market. The ‘extraneous factor’ for the two types of inflation is very different so in dynamic but slowly adjusting economies both types of inflation will behave differently at times.
[Reference: Peter Jonson and Clifford Wymer, 'A macro-economic policy model of the United Kingdom 1855 - 2014 with investment, share prices and “Animal Spirits”, Paper presented at Conference of the Western Economic Association, Vancouver, 2018, and shortly to be presented at Cornell University.]
Clearly there are some interesting questions to be sorted out here, and the question is whether the Reserve Bank’s Research Department is doing the relevant research.