Mervyn King joined the Bank of England as its chief economist in 1991 and ran the bank for the decade which had the collapse of Lehman brothers in 2008 as its mid-point.
During his time at the bank, global finance, the economy, and central banking fundamentally changed. Not for the better, King contends in his book “The End of Alchemy: Money, Banking and the Future of the Global Economy”.
It’s a wide-ranging treatise on how banking, and as a consequence economics and the global economy, must change to both improve growth prospects and reduce risks.
It’s littered with brilliant ideas. One that stands out in the current debate about inflation and RBA rates in Australia is a piece of advice on how the Reserve Bank, and it’s governor Glenn Stevens, can continue to conduct themselves in what appears to be the shifting paradigm of inflation expectations.
To recap, the recent change in the inflation outlook from the RBA in its May Statement on Monetary Policy caught economists and forecasters by surprise. That change was then followed by a number of calls that the RBA will now need to lower rates to 1%, perhaps lower.
The changed outlooks for interest rates also forced the Australian dollar to a 12-week low of 0.7173 in the past few trading days.
Yet former governor Ian Macfarlane and current board member John Edwards have come out against these market forecasts. The pair separately have suggested that the market’s extrapolation of the RBA’s new inflation forecasts into 1% or sub-1% interest rates is premature. Both men reiterated the 2-3% inflation band the RBA manages to is over the medium term.
Here’s Edwards speaking to the Wall Street Journal Friday:
It has never been the view that the target had to be achieved each and every quarter, or for that matter each and every couple of quarters, or year for that matter.
Former governor Bernie Fraser cut rates in 1996 when inflation was above the band and the RBA has consistently let inflation run above or below the band without a mechanical reaction function to moves by raising or lowering interest rates.
Yet the very fact that the RBA so aggressively downgraded its forecasts recently tells us something has changed.
Likewise, the release of the latest Melbourne Institute survey of Australian consumer inflationary expectations for May appeared to validate the RBA’s new outlook. The MI survey showed consumer inflation expectations dropped 0.4% to 3.2%. Still on the high side, but clearly falling.
At the same time, Australian wages growth is at all-time lows of just 2.1%, ABS data revealed last week.
So Australia is at risk of inflation slipping and holding below the RBA’s 2-3% target band.
Which brings us back to Mervyn King and some advice he might offer Glenn Stevens before his remarks tomorrow.
In his book King wrote, “central banks have a role to play in changing the heuristic [the mental short cut] used by households and businesses when they see a serious disequilibrium building up”.
Arguably the RBA’s move to slash its inflation forecast but keep economic growth expectations at a relatively healthy clip was the first part of this discussion.
In doing so, it signalled it was comfortable running the Australian economy a little quicker, in terms of the growth/interest rate trade-off, via lower rates without fear of inflation’s reignition and thus the need to raise rates.
The forecasts of rates falling to 1% and no expectation of rates rising before 2018 sends a strong signal to households, investors and business about the cost of their borrowing and investment in the year ahead.
More importantly though, King suggests that Stevens should explain the very point John Edwards and Ian Macfarlane made about the RBA’s use of its target band. The one that seems to have so confused the market in the past few weeks.
What is required [when the central bank sees the disequilibrium build] is a clear an convincing explanation of why it may be desirable to allow inflation to run above or below target for a period in order to restore a sustainable path for the economy. It would be a big mistake to jettison inflation targeting altogether. It is a valuable heuristic for central banks, provided there is room to deviate when circumstance demand.
Central banking in the era of both heightened uncertainty, but transparency has never been more difficult.
But King offers a neat rule of thumb with which Stevens and the RBA can convey their thoughts and help Australia avoid slipping into the global low inflation trap over the longer run.
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