The Reserve Bank will meet tomorrow to decide whether or not to raise interest rates. Mortgage holders and others carrying debt are awaiting the decision nervously, yet most commentators now think a rate rise is a certainty. For their part, the RBA has made no secret of its target range of 2% to 3%, and with inflation headed towards 4%, there is little reason to keep rates steady. Or is there?

Crikey asked some of Australia’s leading economists if the RBA needs to rethink its inflation targets. Is 2% to 3% still the right target for Australia?

Michael Knox, Chief Economist and Director of Strategy at ABN AMRO Morgans. Glenn Stevens, before he was the RBA governor, gave a speech in which he said that the RBA arrived at that target range by looking at what the US Fed had done for the previous 10 years. They found they’d achieved average inflation rates of around 2.5%. When we look at the levels of inflation that actually damage economic growth, inflation has to be consistently above 4% to damage economic growth. On the other hand, if you get inflation below 1%, many people say that there is a measurement problem because the composition of inflation changes. So if 4% is too high and 1% is too low, then your upper range should be 3%, which is comfortably below 4%, and your lower range should be 2%, which is comfortably above 1%. For practical purposes, I’d say 2-3% is the right range.

Professor John Quiggin, University of Queensland. The real question is, should you have inflation only targets or should you have a separate inflation and growth target? If you have an inflation only target, 2%-3% is pretty reasonable. There’s an assumption that if you focus your monetary policy on inflation and aim to keeping it smooth over the cycle you should also stabilise growth. That’s the theory underlying it. It’s worked well for the time since the policy emerged, but the big question is not so much whether the target band should change to accommodate economic conditions as whether the whole thing has been undermined by asset market inflation and the potential crunch in asset prices, or the potential credit crunch. That’s a much more difficult question. The inflation target is a domestic policy target to do with Australia’s inflation rate, and traditionally has been implemented by looking at how the domestic economy is going. But we don’t know what if anything is coming out of these shocks in the US.

Shane Oliver, AMP Capital Investors. I think the current range probably is the right one. The logic was that if you go much below it, because the CPI understates the rate if inflation, you’re verging into deflation. But it’s reasonable to ask whether 4% inflation is a disaster. I would say it’s not. A disaster was the high double digit inflation we had in the 1970s and the high single digits we had in the 1980s, but the sort of numbers we are dealing with today hardly constitutes a disaster. I think the RBA is worried that if it’s not tough enough, Australians will think it’s going light on inflation and will therefore build into wage claims and price setting norms and so on the belief that, going forward, inflation won’t be 2%-3%, it will be 4%-5%. After a while a higher inflation rate will get entrenched. Up towards 4% is not a disaster but the RBA wants to be seen to be acting tough on it to ensure that expectations on inflation don’t steadily rise.

Associate Professor Steve Keen, University of Western Sydney. The danger in focusing on that target range is that it ignores other factors in the economy which can become far more important. Chief among those factors is the level of debt. That is overwhelmingly what the RBA is ignoring by focusing just on the inflation rate. Imagine you’ve got a patient with a whole range of indicators as to their health, and all you look at is the blood pressure. The inflation rate has been between 1%-4% for the last 15 years now, and it’s just reaching the upper end of that band. Meantime, the debt level has gone from 80% of GDP as it was 11 years ago to 160% now and is on an exponential path. If you have an indicator for a patient and it’s on an exponential path, there is only one outcome: death. Ironically, if you get into a debt crisis you want inflation because that reduces the debt burden. That’s where Japan found itself after its bubble economy burst in 1989 and they’ve been trying desperately now for 17 years to cause inflation and they have failed. We’re on the same precipice.

Peter Fray

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Peter Fray
Editor-in-chief of Crikey