ESSA

ESSA

Has inflation targeting become a sporting event?


Lachlan Walden

By

May 5th, 2013


Recent mainstream media reporting on the monthly RBA meetings may be in dire need of some reworking.


At the time of writing, available odds for this Tuesday’s RBA meeting are $1.40 for rates to remain unchanged, $2.20 for a decrease of up to 25 basis points and then a respectable $19 for a cut between 25 and 50 basis points. Any increase in the cash rate pays $34 but putting money on that would surely be the equivalent of backing a horse with a broken leg – unless it is called Black Caviar perhaps.

On a more serious note, however, how has the mainstream media been able to turn RBA meetings into basically nothing more than a sporting event? Every month is the same: the media reports the ‘winners’ and ‘losers’ from any change in the cash rate and subsequently integrates this with simplistic examples such as more job losses in the manufacturing sector or perhaps of house prices having a bad quarter. It has got to the point where some media outlets go as far as mentioning the ‘lost benefits’ or ‘avoided costs’ to those who are affected by the cash rate – virtually everyone – in a month when rates are left unchanged.

While the odds from betting agencies on RBA rate calls are generally not frequently communicated by the media as I just did, the use of ‘expert’ analysis and ‘consensus opinion’ is in some respects worse. At least betting markets have been shown for years to be relatively accurate predictions of outcomes and events.

The reported ever-increasing ‘cost of living’ – what some have called inflation since the fourteenth century – is only currently running at a modest 2.5% and has been at around this level for many years now. Even allowing for the fact that some individuals have a different, perhaps more expensive, basket of goods to which the headline CPI figure comes from, Australians actually have very little to complain about. Why is this? Because most Australians receive incomes that consistently rise at a rate greater than that of inflation. Yet the media never seems to even attempt to explain this reality.

So, if the current sporting event media reporting paradigm needs improvement, in what direction should coverage be heading? This all comes back to better explaining what the RBA does: determine Australia’s monetary policy. When the Reserve Bank Board meets on the first Tuesday of each month it is evaluating the need for a change in the cash rate based on targeting an inflation rate of 2-3 per cent, on average, over the economic cycle.

The target of 2-3 per cent serves as an ‘anchor’ for the inflationary expectations of the private sector and has a truly fundamental role in Australia’s monetary policy framework. To explain just how the ‘anchoring’ process works, the concept of aggregate demand – the total demand for final goods and services in an economy – needs to be used.

Often the RBA is unable, or at least unwilling, to respond immediately to an expansionary/contractionary gap – essentially when aggregate demand is too great/weak for an economy’s current capacity – in the economy because of the reality of delayed inflationary and aggregate demand related data. To illustrate this point, inflationary figures in Australia are only published by the ABS on a quarterly basis and even then the RBA may wait for consecutive quarters of data to be released in order to confirm a trend and/or account for any inevitable revisions made to the previous quarter’s CPI figure.

In the likely event that the RBA does not respond to an exogenous increase or decrease in aggregate demand immediately, there is a profound difference between if private-sector expectations are ‘anchored’ and if they are not.

The concept of inflationary expectations being ‘anchored’ at the RBA’s target range means that despite any indications that inflation is likely to rise (fall) appearing in the economy – such as an expansionary (contractionary) gap due to an increase (decrease) in exogenous aggregate demand – the inflationary expectation incorporated into price and wage contracts will not increase (decrease) the rate of inflation because of the private-sector knowledge that the RBA has committed to consistently take action to maintain the rate of inflation between 2-3%.

There are three main advantages for the RBA and thus ultimately the economy from this private-sector inflationary expectation. These will now be examined within the context of inflation increasing.

Firstly, the ‘anchoring’ of private-sector expectations at the RBA’s target inflation range of 2-3% results in – partially due to inflationary inertia whereby it takes a relatively long time for inflation to adjust – the RBA having more time to act before inflation actually changes. This often allows for the avoidance of an increase in inflation and the subsequent necessary temporary forced recessionary gap (the latter as a result of the disinflation process).

Secondly, if the RBA fails to respond before the inflation rate starts to eventually increase, it will do so more slowly because of the expectation that the RBA will take action to bring inflation back to 2-3%. Thus, the RBA will be more likely to be able to contain inflation to a level still relatively close to the target range. By containing the extent of the shift upwards in the inflation rate, the size of the contractionary gap can be mitigated.

Thirdly, even if the inflation rate increases significantly because of what would have to be a very slow RBA response, ceteris paribus, the ‘anchoring’ advantage will likely result in it being quicker to decrease once action is taken than if there was not private-sector inflationary expectation of the RBA’s target range. This is because the private-sector will know that the 2-3% inflation range is where the RBA is committed to keeping inflation at and consequently that the induced disinflation is not a temporary monetary policy.

While this process is inherently technical and content relating to it perhaps not accessible to the majority of the population, surely the outcomes of RBA meetings deserve more respect than superficial repetitive analysis that often features sports-like media coverage.

Just between you and me by the way, I reckon that the $2.20 payout for a cut of up to 25 basis points looks pretty good value. Betting really is a fool’s game though.

Follow me on Twitter: @lachlanwalden

The views expressed within this article are those of the author and do not represent the views of the ESSA Committee or the Society's sponsors. Use of any content from this article should clearly attribute the work to the author and not to ESSA or its sponsors.

  • Ben Wadham

    enjoyed reading your latst contribution to the economic literature: I endorse your last line! (The bookies’ adage is “there’s a mug born every miunute; thenk God that some of them live”. On a more serious note – at what point does disinflation turn into deflation?

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