Inflation rate is critical in RBA strategyAustralian
Financial Review, Op-Ed (page 63), 28 January 2003 |
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With interest rates in the US dangerously close to zero,
surely this provides pause for thought for the Reserve Bank of Australia. What happens if
the economy slows and the central bank has no further room for activist
policy? Deflation may set in. Generations of
Australians have been schooled to believe that inflation can never fall far
enough and that deflation is an affliction too exotic to contemplate
seriously. Japan has skewered
that perception. Japanese interest rates stand at 0.1 per cent, yet growth
remains anaemic. The problem is that nominal interest rates cannot be forced
below zero, yet falling prices have raised the real interest rate. In turn,
higher real interest rates have further stymied growth. There is
increasing fear that similar recessionary dynamics may hit the US. Yet,
paradoxically, the Federal Reserve's strongest ally is the fact that
inflation expectations remain high. With inflation
expectations around 2 per cent, the US already has something the Japanese
cannot get: negative real interest rates. Fed chairman Alan Greenspan has 125
basis points of room to move, but inflation effectively adds another 200
points of stimulus and he may need them all. What about
Australia? With reasonable growth and the cash rate at 4.75 per cent, the RBA
is blessed with both less need to stimulate, and more room to move than its
US counterpart. But to declare that the possibility of a liquidity trap does
not exist in Australia would be foolish. The RBA can shift
nominal interest rates down as far as zero if recession hits. But, as with
the US and Japan, the extent to which this is stimulatory depends crucially
on inflation expectations. Further, the
Howard government's fiscal irresponsibility during good times limits the
scope for further fiscal stimulus during bad times. Australia, of
course, has an inflation target of 2 to 3 per cent. The key is whether this
target is policed symmetrically. Is the RBA as
committed to cutting rates to boost inflation when it falls below 2 per cent
as it is to raising rates when it breaches the 3per cent ceiling? Current
bond market returns suggest that the RBA is erring on the hawkish side. By comparing rates
of return on nominal and inflation-indexed 10-year bonds, we can estimate the
market's inflation expectations. The two yields now differ by about 2.25 per
cent. But this cannot simply be read as the expected rate of inflation
nominal bonds incorporate a risk premium of about half a percentage point to
account for the risk that inflation will erode their purchasing power. Hence
the market expects inflation to average 1.75 per cent over the next decade. Apparently the
market does not believe the RBA is committed to its inflation target. Allowing the
perception to spread that the actual target is simply ``less than 3 per
cent" may have been a useful tactic to establish the bank's credibility
in a high inflation era. But when deflation is stalking the global economy,
insisting on a rate above 2per cent becomes just as critical. Justin Wolfers is an assistant professor of economics at
Stanford Business School. |