Inflation: A Schizophrenic Target!

In the US, many, like Blanchard and Krugman, have for long advocated a higher inflation target as a means of getting the economy ‘moving’.

However, if the Fed, just as the ECB, BoE or BoJ are having a hard time pushing inflation up to the 2% target, why should a higher target “solve” the problem?

Australia, on the other hand seems to be ‘flirting’ with the opposite tack: reduce the inflation target:

The RBA is likely to indicate that it remains wedded to the target, stressing that there is a high degree of flexibility for policy that goes with it.

But the target doubters argue that if low inflation is entrenched, there seems little sense in promoting a target that won’t be achieved without driving interest rates still lower and inviting financial sector stresses in the process. In other words, why risk the fallout from a domestic housing bubble by obsessing over a price target that global forces are keeping out of your reach?

Funny how central banks all over are quick to say they´re “powerless”. That´s just like a “forger” saying that he has no money to buy a new car!

What central banks miss is that inflation is low, not because of “structural” (or entrenched) reasons, but because they are conducting monetary policy to make it so!

Australia provides a good example of good monetary policy that has more recently turned bad.

The chart shows that since the IT regime was adopted, inflation has clocked 2.5% on average, for either the headline or core measures. That´s exactly the center of the 2% to 3% target band.

Australia IT Change_1

Meanwhile, monetary policy was mostly good, keeping NGDP evolving close to a level target path.

Australia IT Change_2

For the past two years, however, the RBA has been “sleeping at the helm”. NGDP has deviated systematically from the “target level”.

Australia IT Change_3

So, it´s not at all surprising that inflation, in either guise, is also trending below the target band!

Australia IT Change_4

The “solution” is not to have a higher or lower inflation target, but to “get a grip” on nominal spending (NGDP). If the RBA says it´s “powerless” to do so, bring in a “master forger” like Gideon Gono, the former head of Zimbabwe´s central bank.

Revisionist Thoughts: Was Australia just luckier than most?

This post was motivated by Scott Sumner´s musings about Australia: Australia´s Great Stagnation:

It looks like the Great Stagnation has hit even Australia.  In an earlier post I pointed out that Australian NGDP rose at a 6.5% rate from 1996:2 to 2006:2.  Then we had the Global Financial Crisis, and Australian NGDP growth slowed to . . . er . . . it stayed at 6.5% from 2006:2 to 2012:2.  No tight money and no recession in Australia.

Some important facts about Australia:

1 NGDP and Trend

Revisionist Thought_1

2 RGDP & Trend

Revisionist Thought_2

Notice that when NGDP climbs above trend, RGDP falls below trend!

Zooming in (circles explained later)

Revisionist Thought_3

Revisionist Thought_4

What explains the counterintuitive fact that RGDP falls below trend at the same time commodity prices take off?

Revisionist Thought_5

The rise in NGDP translates into a rise above target in core inflation.

Revisionist Thought_6

The 200 basis points increase in the cash rate (equivalent to the Fed´s FF rate) just goes to show that interest rates are bad definers of the stance of monetary policy. Despite the increase in the cash rate, inflation and NGDP were moving up, indicating monetary policy was “too easy”!

Revisionist Thought_7

With Australia being a commodity exporter, another way to gauge the stance of monetary policy is by comparing the move in the exchange rate to the dollar and commodity prices. Monetary policy is “just right” if a rise in commodity prices is accompanied by an appreciation of the Aussie Dollar (USD/A$) and a fall in commodity prices goes hand in hand with a depreciation of the exchange rate.

The chart below shows that in 2004-07 monetary policy was too loose, consistent with NGDP climbing above trend (and inflation increasing). Monetary policy was tightened in 2011-13, consistent with NGDP converging to trend and inflation decreasing (see circles in NGDP & Trend chart above).

Revisionist Thought_8

At present, NGDP is back on trend (actually just a “whisker” below it). What happens next? Will Australia go the way of Sweden, Israel and Poland, or will it get “smart”?

In the case of Sweden things started unraveling when the Riksbank decided to “prick” a housing “bubble”. According to the FT:

Sweden’s central bank has been lambasted by critics for trying to use interest rates to combat signs of a housing bubble. It lifted rates in 2010 and 2011 as it publicly worried about what it saw as high household debt levels.

In the case of Israel, it may not be coincidence that NGDP began a systematic deviation from trend when Ms Flug took over at the Bank of Israel. Maybe she prefers the role of Finance Minister:

Speaking at a Calcalist conference, Governor of the Bank of Israel said today, “Exceeding the 3% fiscal deficit target will expose the Israeli economy to significant risk and will be liable to harm us citizens. We must show responsibility and take into account the consequences of our decisions over time. Israel’s structural deficit, the deficit not subject to one-time shocks, is already one of the highest in the western world.”

This is what happened:

Revisionist Thought_9

In the case of Poland, it took three years, but in late 2011 Poland finally botched up and went the way of the majority of countries, letting NGDP fall way below trend. They didn´t (correctly) react to the 2007-08 oil price rise, like the US, UK, EZ, etc. and fared well, but didn´t resist when oil prices picked up again in 2010-11, when, among the initial group, only the ECB was dumb enough to react.

Revisionist Thought_10

By talking about house prices, the RBA is tempting the “fate” that hit Sweden and Israel. Scott links to an article in a subsequent post:

The Reserve Bank of Australia’s surprise decision to defer its widely anticipated April rate cut for at least another month might have been influenced by the increasingly pricey housing market, which it regards as posing a real “dilemma”.

This, unfortunately, has been going on for some time. Last September, RBA Governor Glenn Stevens was warning of bubble risk in the current low interest rate environment:

Addressing members of the Committee for Economic Development of Australia (CEDA) lunch in Adelaide, he said monetary policy aimed at encouraging business investment and generating employment amid global economic weakness was in danger of creating a housing bubble in Australia.

And the next chart compares two “bubbles”.

Revisionist Thought_11

Please, Governor Stevens, start thinking smart!

“I’m reluctant to criticize the excellent RBA, but they do need to ease policy a bit.”

That´s one line towards the end of this Scott Sumner post. It reminded me that some months ago I had entertained the idea that the RBA was “cutting it close”:

It would be a pity if this late into the game Australia “crossed the Rubicon” and let NGDP go south of trend!

Unfortunately, it has!

The “Australia story” is interesting from the point of view of Market Monetarists because it emphasizes the crucial role of monetary policy not only in avoiding crashes but also excessive fluctuations.

The focal point is that monetary policy should keep the economy evolving along an NGDP level such that nominal stability results. For some economies (US, Eurozone, Japan) that NGDP level should be the target. In the case of small open economies such as Australia, strongly dependent on commodity exports, it should adopt an Export Price Norm (EPN), which Lars Christensen characterizes as the open economy version of NGDP level targeting.

EPN simply means that the central bank should peg the exchange rate to the price of the commodity. In this case, if the exchange rate moves together with the commodity price, monetary policy is “just right”. If the exchange rate moves by less than commodity prices monetary policy will be “too easy” if commodity prices are rising and “too tight” if commodity prices are falling.

With those considerations in mind, we can chart the history of monetary policy in Australia since the early 2000s. [Historical note: During the Asia crisis of 1997/98, Australia escaped “scot-free” exactly because the EPN was in full play].

The top chart shows the A$/USD exchange rate and commodity prices. For different periods, the nature of monetary policy is characterized by comparing moves in the exchange rate with moves in commodity prices. For example, during 2004-06 monetary policy was “too easy”. While the exchange rate remained “flat”, commodity prices climbed significantly.

The bottom chart shows the corresponding movements in NGDP. For example, in 2004-06, with monetary policy being” too easy”, NGDP began to rise above trend. When monetary policy didn´t tighten (to compensate for the previous easing), NGDP remained above trend.

Australia below trend

During the international crash, when NGDP dropped far below trend in most economies, Australia was able to ease sufficiently to avoid being “penalized”.

Between the second half of 2011 and early 2013, with NGDP above trend, monetary policy tightened. With this, NGDP remained “flat” and converged to trend.

An indication that the RBA is at least conscious of the EPN is gleaned from comments by the RBA Governor in February 2003:

“The inflation outlook, as assessed at present, would afford scope to ease policy further, should that be necessary to support demand [“code” for NGDP],” Governor Glenn Stevens said in a statement today in Sydney after leaving the overnight cash-rate target at 3 percent.

“On the other hand, the exchange rate remains higher than might have been expected, given the observed decline in export prices, and the demand for credit is low, as some households and firms continue to seek lower debt levels,” he said.

Right after those comments, the exchange rate depreciates to “catch-up” with the fall in commodity prices.

Unfortunately, for most of 2014, monetary policy becomes excessively tight again. Australia got infected by with the “financial stability virus”, which previously had “put Sweden to bed”.

In its severest warning yet on house prices, the RBA said surging investor demand for property may cause the market to overheat and invite sudden price falls.

A housing-market crash might undo a lot of the central bank’s efforts supporting a still-fragile economy trying to cope with a downturn in mining investment.

Record-low interest rates were supporting the economy, but policy makers needed to be aware of the risks to future growth accompanying “a large further build-up in asset prices,” the minutes of the bank’s September 2 policy meeting said.

Hopefully, the recent large drop in the exchange rate is indicative that the RBA has learned from the mistakes, and NGDP will be “carried back to trend”.