A strange message from Australia's Reserve Bank

Mortgage rates are likely to rise again next month, after the Reserve Bank revealed it thinks inflation will exceed its target until 2010.

In a strongly worded quarterly statement on monetary policy released this morning, the bank said there was a rising risk that higher wages and higher inflation expectations would fuel inflation.

"Absent a further shift in economic risks to the downside, monetary policy is likely to need to be tightened in the period ahead,'' it said.

The warning comes less than a week after the Reserve Bank lifted its cash rate to the highest in over a decade to 7 per cent.

The bank has revised up its expectation for inflation this year from 3.25 per cent to 3.5 per cent, well above its target band of 2 to 3 per cent.

Inflation is also expected to remain "uncomfortably high'' for the entire of 2009, at 3.25 per cent.

Even in 2010, inflation is seen to remain high at 3 per cent.

"If this is not reversed reasonably quickly, the recent pick-up in inflation carries the risk of generating an upward drift in inflation expectations, which could feed back into wage- and price-setting behaviour.'' - SMH.
I find this message from the reserve bank strange.

Like many central banks (and unlike the US Federal Reserve), Australia's Reserve Bank uses inflation targeting. Essentially this means that interest rates are adjusted to ensure that inflation remains between an arbitrary amount. The European Central Bank's target is essentially between 0 - 2%, while Australia's target is between 2 and 3%.

But what this report from the SMH says is that the Reserve Bank is expecting inflation to remain above their target for another 2 years. That doesn't make sense to me. Although this media release is being interpreted by the media as an indication of further rises in interest rates (which is a fair enough interpretation), I am perplexed by this sudden allowance by the Reserve Bank of inflation above 3%.

The way all central banks fight inflation is through raising interest rates. But when the Reserve bank says "inflation is forecast to decline gradually from late this year, but would still be around 3 per cent in two years time", it is essentially saying that such levels are, well, unavoidable.

To me that's ridiculous. If the Reserve Bank chose to it could crush inflation altogether through the imposition of even higher interest rates (which, of course, would result in a recession... but that's not the point). But by saying "sorry, but high inflation levels are unavoidable" it is communicating in some strange way that it is no longer using inflation targeting. And if that is so, then what measure is the reserve bank going to use to determine the rate of interest?

This does not fill me with much confidence. We learned way back in the 1970s that the solution to stagflation (high inflation + rising unemployment) was to focus entirely upon inflation and kill it outright. This was what Federal Reserve Bank chairman Paul Volcker did way back in the early 1980s. While this bitter pill led to a massive world recession, the economic recovery was more sustainable than anything done in the previous two decades. Inflation targeting and independent central banks (free from the interference of elected officials) were the natural result. While there have been plenty of economic problems since the early 1980s, inflation has not been one of them.

Now, however, it appears as though central banks are less than happy about dealing with inflation first. The US Federal Reserve has decided that it can ignore any inflationary problems that a currency devaluation will have upon an economic system (problems that have been proven time and time again through bitter experience of non-American nations) and have decided to approach the current crisis by recklessly lowering rates.

And here in Australia, we now seem to have a Reserve Bank that now sees its "inflation target" as merely a suggested guideline rather than a number that, when crossed, will be reduced no matter what.

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