The RBA followed up on its strong guidance during May and cut the cash rate 25bps to a record low 1.25%. The statement accompanying the rate cut also indicated that the RBA is likely to cut the cash rate further over coming months. The latest rate cut (the first in three years) and any further cut – or cuts – over coming months mark what seems to us a change in RBA thinking about the role of inflation targeting in setting monetary policy. That change is that monetary policy should be used more aggressively to try and push annual inflation back inside 2-3% target band, especially when inflation is running consistently below the band as it is at present.
To be fair, the change in RBA thinking about inflation targeting is not sudden but has been evolving over the past few years as too low inflation bordering deflation has become a more prominent risk than too high inflation. The current low annual inflation rate at 1.3% y-o-y for the headline inflation rate and roughly 1.6% for the various underlying inflation measures sits well below the RBA’s 2-3% target band and is showing no signs of returning inside band in the near term. Low inflation is a symptom of an economy not growing fast enough to fully utilise capital and labour resources.
Another way of looking at it is that economic growth could be pushed to grow faster reducing unemployed resources. All going well as growth lifts and resources are more fully employed inflation would lift to a level that is still acceptable.
For more than a quarter of a century the acceptable level of inflation has been 2-3% which each successive RBA Governor has agreed with the Treasurer of the day to try and achieve. In the early years of inflation targeting in the mid-1980s inflation was still high and the inflation target was something of stretch objective occasionally requiring periods of aggressive rate hikes forcing the economy into recession as occurred infamously at the end of the 1980s leading into the 1990s.
As the RBA and other central banks fought to tame inflation through the 1980s and 1990s other factors served to reinforce strongly the forces of disinflation in most economies including Australia. Among those factors were increasing globalisation, over-investment in the new manufacturing power-house economies of Asia including China, reform of work practices and wage setting procedures including the rise in recent years of the “gig” economy.
Although not well recognised at the time many forces were promoting disinflation through the 1990s extending into the first decade of the new century and central banks were still conducting monetary policy on the basis that potentially too high inflation would be the biggest potential policy headache. That thinking started to change when central banks had to deal with the sharp downdraft in economic growth and deflation in the wake of the Global Financial Crisis. Persistently low inflation bordering deflation threatened to become permanent.
Old habits die hard. Even as central banks, including the RBA aggressively promoted easy monetary conditions, much commentary, including from the central banks themselves, revolved around the problem of restoring normality to monetary policy once the immediate economic crisis of too weak economic growth and too low inflation had passed. In other words, the back-stop position of the central banks was that at some stage economic growth would lift to potential or higher placing upward pressure on inflation.
In the case of the United States the long economic recovery since the Global Financial Crisis has seen its GDP growth rate push above potential growth at times and the unemployment rate at 3.6% is the lowest in 50 years. There has been a flicker of inflation build up only to die again and setting up a position where even the Federal Reserve is now able to consider a rate cut at some stage.
In Australia, economic recovery since the Global Financial Crisis, has been a more sporadic affair than in the United States, primed by particular sectors of the economy. Initially the mining investment boom led growth. As that collapsed the housing boom in the Eastern States took over. Then that collapsed in late 2017 helping to depress growth in household consumption spending along the way. There is a new leader of Australian economic growth, exports, but it is barely offsetting the weakness in housing and consumer spending. The story of Australian real GDP growth floundering between 0.2% to 0.4% per quarter since mid-2018 is one of downward pull from the housing correction and very soft growth in household consumption spending.
The economy is still growing enough to employ more people, but not enough to cut the unemployment rate at 5.2% or the under-employment rate still above 13%. There are only small pockets of upward pressure on wages and in general wages growth is accelerating from current 2.3% y-o-y clip glacially slowly.
The RBA has started to take the view that the threat of lower inflation is at least as great, if not greater, than the risk of higher inflation. In these circumstances the economy can be encouraged to do better and send the unemployment rate well below 5%. The RBA is still inflation targeting but is no longer waiting for hopeful circumstances to lift growth and take inflation back inside the 2-3% target band. Rather it is working to try and push inflation up and would like assistance from the Government in the form of more economic reforms and targeted increases in Government spending.
At the very least, the RBA looks set to cut the cash rate once more to 1.00% probably in August. There is a chance it could cut more than once more, but that assumes little or no response from the economy to easier policies. That looks a tall order to us.