RBA's inflation expectations may be anchored despite official target: Bill Evans

RBA's inflation expectations may be anchored despite official target: Bill Evans
RBA's inflation expectations may be anchored despite official target: Bill Evans

EXPERT OBSERVATION 

Last week the Reserve Bank surprised by lowering its inflation forecasts for 2018 (both underlying and headline).

Headline was lowered from 2.25% to 1.75% and underlying was lowered from 2% to 1.75%.

If correct, that means underlying inflation will have printed below the bottom of the 2-3% target range for three calendar years in a row. Headline inflation will have printed below the bottom of the 2-3% target for five calendar years in a row.

Economists and policy makers generally focus on underlying inflation when assessing the meaning of the “signal” from any inflation print. That is appropriate because the underlying measure “trims out” any large “one off” movements that might be misinterpreted.

However, when assessing inflation over the long term the headline measure is important since it should be a more reliable driver of inflationary expectations.

After all, expectations could be reasonably expected to be influenced by what has actually happened rather than a statistical interpretation of the data.

Inflationary expectations are critical from a theoretical perspective to delivering an inflation outcome. They impact workers’ wage demands and firms’ pricing decisions.

“Inflationary expectations” are like “the natural rate of unemployment” or “the neutral policy interest rate”. They are highly attractive concepts for economists. However they are notoriously difficult to measure.

Consider the “natural rate of unemployment”. For Australia that measure is generally accepted to be 5%. As such it is expected that any unemployment rate below 5% will be associated with rising wage pressures. However evidence from other countries indicates that in this period of accelerating technological development, which is often “job substituting”, natural rates are lower.

We expect that it is highly likely that the natural unemployment rate will also be lower in Australia. But we will not know for sure until we get there. Certainly the Federal Reserve had a view that the rate was around 4.75%. But as the rate fell through 4.75%, wage pressures were missing.

We are not sure what the position of the Reserve Bank is on this issue given that the unemployment forecasts envisage the unemployment rate holding above 5% until near the end of 2020 and yet wage pressures are expected to build through the forecast period.

Policy makers forecasts and market watchers try to measure inflationary expectations. The Reserve Bank uses a range of measures – market economists’ forecasts; unions’s forecasts; inflation swaps; and the 10 year inflation indexed bond. These measures have been gradually falling and are described by the Bank as “generally consistent with the inflation target”.

However, the inflation target has been fixed for twenty years yet the expectations which used to be well above the target are now around the target. One exception is the measure which is widely used by other central banks, including the FED, the 10 year inflation indexed bond. Implied inflation expectations have steadily fallen from 3% to 2% over the last 10 years - well below the 2.5% target.

This comfort that inflationary expectations appear to be settling around the inflation target is the key reason why the Bank resists the periodic calls to lower the target.

The Bank believes that the existence of the target is a dominant driver of inflationary expectations. Consequently, if the target were to be lowered, then expectations would fall and a more disinflationary environment would evolve. This puts considerable weight on the target as a driver of expectations.

But, as discussed, the Bank has been unable to even reach the bottom of the target zone for five calendar years. Furthermore, they have made it quite clear that the next move in rates is up. Reasonably, economic agents could conclude that, even after five years, there is no urgency to reach the target.

We are unable to find a definitive measure of inflationary expectations. However after five years of underperformance of headline inflation below 2%, economic agents would be excused if they expected such conditions to persist.

With the Bank not prepared to use its interest rate “weapon”, and other policies around credit supply actually constraining activity, there must be a risk that, at least from an expectations perspective, low inflation is embedded in the system for longer than the Bank and the market is currently expecting.

In fact, Governor Lowe has often responded to demands to lower the target by claiming that others favour a higher target in order to boost inflationary expectations.

A reasonable query on the purity of the target could be made around the need to monitor financial stability when setting policy. That approach was confirmed by the Governor’s comments in a panel discussion at the Sintra Conference in June.

“To try to get it back to 2.5% very quickly, it would be mainly through people borrowing more money, and having higher asset prices — I think that’s a much bigger risk to our economy than people having surprisingly low inflation expectations.”

Reasonably, we can conclude that after five years of missing the bottom of the target zone, a more aggressive pursuit of the inflation target has been constrained by the need to address Australia’s challenges around financial stability.

The Bank is currently forecasting that despite three years of above trend growth (3.25% in 2018; 3.25% in 2019; and 3% in 2020 against a trend growth rate of 2.75%) inflation (headline and underlying) will only have lifted to 2.25% by 2020.

Perhaps that looks cautious but with inflationary expectations potentially anchored at or below 2%, it might be a tough target to achieve unless the Bank was willing to signal that it was prepared to pursue its target more aggressively.

Bill Evans is the Chief Economist for Westpac.

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Inflation Bill Evans

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