Later today, everyone expects the Reserve Bank board to raise its spot interest rate for the second month in a row.
Why? According to the official board minutes it is:
Some rise in interest rates is justified simply because with higher inflation, real interest rates are now negative. But the idea of returning to the old target range doesn’t hold up.
Once the current inflation spike is over, we need to rethink both target range and the whole idea of inflation targeting.
How much inflation are we aiming for now?
The Reserve Bank’s inflation target is consumer price inflation averaging 2-3% over time.
But for the better part of the past ten years, that target has been missed, on the downside, as you can see below.
But recently, consumer price inflation has risen to 5.1%, and the so-called “cropped average” measure of underlying inflation closely monitored by the bank has risen to 3.7%.
Recent inflation is partly a sign of success
While too much inflation can be a problem, it’s important to remember that the jump is partly an unintended consequence of success.
Huge government spending offset the impact of COVID and lockdowns on household outcomes and set the stage for a rapid economic recovery.
This expenditure was necessary, but inevitably went to companies that didn’t need it.
Furthermore, the success of working from home meant that many households did not lose income and did not have to spend as much on travel and clothing, and things like makeup that come with traveling to work.
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With restrictions being eased, households and businesses have been eager to spend some of their accumulated savings at a time when goods production has been disrupted, especially due to anti-COVID measures in China.
The result is classic inflation of the kind where “too much money chases too few goods”.
It is very different from the last major inflation episode in Australia, in the 1960s and 1970s, which was widely seen as a “wage-price spiral” or “cost inflation”.
This is not wage-driven inflation
Cost inflation has generally been seen as created when powerful unions demanded large wage increases, which were passed on to consumers by companies with monopoly power.
In today’s environment, while monopoly power is still an issue, unions are a shadow of their former selves, with little power to enforce excessive raises.
As a result, wages, as measured by the Bureau of Statistics’ wage price index, rose by just 2.4% in the year to March, well behind inflation of 5.1%.
This has continued a long downward trend in the wage share of national income.
Despite the apparent absence of wage push, many commentators are still working on the wage-price spiral model and argue that wages do not rise in line with inflation.
Such a policy would not only be unfair, it would also be economically disastrous – similar to the austerity policies enacted in many countries in the wake of the global financial crisis, and earlier, when Britain returned to the gold standard in the wake of World War I, helping precipitate and deepen the Great Depression.
In the current context, reductions in real wages resulting from less than full compensation for inflation would cause workers to lay off and seek new jobs, exacerbating labor shortages.
Read more: National income rises, but share going to wages shrinks
It is striking that many of the same employer representatives who say that pay increases are unaffordable also complain that it is difficult to find employees.
The correct response to the enormous growth of the money supply in the economy during the crisis is to accept a one-off increase in prices and wages, as well as wage and price-indexed incomes, such as pensions.
For the time being, prices must flow to wages
This would distribute the true cost of pandemic spending more evenly across the community than if wage earners were expected to bear the burden.
Later, we can return to using monetary policy, based on adjustments in the Reserve Bank’s cash rate, to keep inflation at acceptable levels. But what should that level be?
For the past 30 years, the RBA has aimed for an inflation rate of 2-3%, but the rationale for such a low percentage has always been weak and has since broken down.
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In the 1990s, the main argument for a low inflation target was the need to break the expectations created by decades of high inflation.
In contrast, the current inflation episode is more like the brief inflationary bursts of the 1950s, which disappeared when the driving forces behind inflation were removed.
Even during the heyday of inflation targeting, critics argued that low inflation of goods and services prices contributed to asset price instability, potentially leading to financial crises.
Many, myself included, have long favored a 4% inflation target. Now there is a new argument for it.
Over time we need a new target
A central concept in monetary policy is the neutral real interest rate: that is, the inflation-adjusted interest rate at which monetary policy is neither expansionary nor contractive.
Over the past twenty years, the neutral real interest rate would have fallen to close to zero or possibly even less, meaning if inflation is 2-3%, the neutral real interest rate should be 2-3%.
But the nail is hard to hit. Actual interest rates set by central banks tend to hover around neutral interest rates, by as much as three percentage points in both cases.
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This raises the prospect of the target cash interest rate turning negative, and interest rates usually cannot go far below zero. We’ve been seeing this “zero lower bound” for years in Australia and elsewhere.
So if we want to continue with the inflation target and get it right, it will be necessary to raise the inflation target of 2-3%.
Given the obvious political difficulties of doing so, it might be better to ditch the inflation target altogether, as myself and economists, backed by former Senator Nick Zenophon, have suggested for some time.
It’s one of many ideas likely to be submitted to the Reserve Bank’s independent review promised by treasurer Jim Chalmers during the election.
Author: John Quiggin – Professor, School of Economics, The University of Queensland