'FLAWED': JP Morgan explains why the RBA shouldn't cut its inflation target

  • With inflationary pressures in Australia weak and household debt levels at record highs, some have argued that the RBA should cut its inflation target so it can begin to normalise interest rate settings.
  • JP Morgan’s Australian economics team argues this could create more problems that it solves.
  • Should progress in lowering unemployment and lifting inflationary pressures not continue in the future, it says the RBA would likely cut interest rates, not its inflation target.

If the Reserve Bank of Australia (RBA) is having so much trouble meeting its inflation target, why doesn’t it just reduce it?

That’s been heard a lot since Australia’s June quarter consumer price inflation (CPI) report was released in late July, revealing that both headline and core inflation remained entrenched below the 2.5% midpoint of the RBA’s 2-3% target.

The idea has been particularly prevalent among analysts, commentators and economist at the hawkish end of the monetary policy spectrum, offering an “escape clause” for the RBA to begin lifting official interest rates after being held at record low levels for over two years.

If the RBA is reluctant to cut rates further in fear of households accumulating even greater debt levels, by simply lowering its inflation target, it could take pressure off the banks to reduce borrowing costs even further.

Inflation would sit around target, possibly allowing for an earlier start to policy normalisation at the central bank.

The recent debate has not gone unnoticed by Sally Auld, Chief Australia and New Zealand Economist and Interest Rate Strategist at JP Morgan, who says a number of factors have contributed to the call for a lower inflation target.

“The argument goes that the current target of 2-3%, with a mid-point of 2.5%, is now too high because a number of other major developed market central banks target 2% inflation,” she says.

“In a world where global factors are now more relevant in determining local inflation, Australia’s target of 2.5% ‘on average over time’ will therefore be significantly harder to achieve… [with] a target of 2.5% representing an ‘old economy’ inflation target that is no longer relevant in a ‘new economy’ world.

“Suggested alternatives include lowering and broadening the RBA’s inflation target to 1-3%, or lowering the target to 2%.

“Aside from striking a supposedly more achievable target over the medium term, some have argued that a lower inflation target would help to ease the current tension between financial stability concerns and a tardy return of inflation to target.”

As the debate goes, a lower inflation target could ease the burden on the RBA to cut rates further in order to boost inflationary pressures.

While, to some, this makes perfect sense, Auld is not convinced it would solve the current conundrum facing the RBA.

“We think this argument is somewhat short-sighted and ignores the role that expected inflation — that is, the inflation target — plays in determining the average level of nominal short rates in an economy, and hence the central bank’s ability to respond to cyclical downturns via conventional monetary policy,” she says, adding that a lower inflation target could actually lead to lower inflation expectations and nominal interest rates, a scenario that could limit the effectiveness of monetary policy to boost activity levels whenever the next economic downturn hits.

Less monetary policy ammunition, in other words.

Auld says there are plenty of other reasons for the RBA to not cut its inflation target.

“For starters, there is a view that changing the target once might encourage some to believe that it can be changed again, hence risking a destabilisation of inflation expectations,” she says.

“Moreover, Australia has had the same inflation target since its introduction in 1993. There is a sense that stability in the inflation target, together with the RBA’s success in achieving the target, have anchored inflation expectations and contributed to a broad understanding of the target among economic agents.

“This suggests that the potential costs of change are not necessarily small, and so a decision to change the target should not be taken lightly.”

The chart below from JP Morgan shows that despite periods of both weak and strong inflationary pressures since the RBA’s inflation target was introduced, headline CPI has averaged 2.5% over this period.

JP Morgan

Based on the anchor it has provided for financial markets, as well as recent commentary offered by the RBA, Auld says the RBA appears unlikely to act on the advice of those advocating for a cut to its inflation target.

“The RBA has been clear on the current strategy for policy — [that] risks associated with financial stability can be ameliorated with a slower return to inflation target-consistent levels for CPI,” she says.

“But some necessary conditions of accepting the trade-off between financial stability concerns and a slower return to the inflation target are that the economy continues to make progress on eradicating the negative output gap and the RBA’s credibility as an inflation targeter remains intact.”

So far, Auld says both these views remain intact, noting that Australia’s unemployment rate has fallen 0.3 percentage points, and wages growth has stabilised at low levels, since Philip Lowe became RBA Governor back in late 2016.

Although at a glacial pace, both suggest that firmer levels of economic activity are helping to reduce spare capacity in the Australian economy, an outcome that has allowed the RBA to keep policy settings unchanged for over two years despite underlying inflation remaining well below the midpoint of its 2-3% target.

It’s also helped the bank to push back against constant, and in some instances growing, calls for further cuts to official interest rates.

Looking ahead, should progress in reducing unemployment and lifting inflationary pressures slow, stall, or even reverse, Auld says that rather that simply reducing its inflation target, the RBA would likely respond by delivering additional cuts to Australia’s cash rate.

“If macroeconomic conditions were to change, and the RBA’s sense of ‘progress’ was threatened, then we think the first port of call would be conventional monetary policy — rate cuts — rather than shifting the inflation target lower,” she says.

“At a time when the central bank might be worried about slowing cyclical momentum and the risk of lower inflation, a move to lower the inflation target, and hence inflation expectations, would appear to be counter-intuitive.

Pointing to the chart below, and with the RBA’s inflation forecasts already projecting a nine-year moving average of headline CPI slipping below 2.0% for the first time in almost two decades, Auld adds that there is “not much scope for error on the downside”.

JP Morgan

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