Understanding Australia’s Inflation Targeting: Insights from Stephen Grenville
In a recent interview conducted by the Reserve Bank of Australia (RBA), Stephen Grenville, who served as deputy governor from 1996 to 2001, shed light on the rationale behind the RBA’s inflation target of “2-3 percent.” The discussion covers the historical context of inflation targeting in Australia, how it compares to other nations, and its impacts on asset prices, particularly property. Grenville’s candid reflections emphasize both the successes and challenges faced by the RBA over the years.
The Origins of Inflation Targeting
Grenville mentions that the concept of inflation targeting has its roots in New Zealand, which pioneered this approach in the late 1980s. He highlights that New Zealand’s monetary policy was influenced by a free-market philosophy which linked inflation directly to the supply of money. As the RBA looked for a framework, Grenville noted that although New Zealand’s target was set at 0-2 percent, Australian officials defined this as overly cautious. They concluded that a minor level of inflation was more beneficial for the economy, allowing for adjustments in relative prices and mitigating risks associated with deflation.
The RBA eventually landed on the 2-3 percent target after careful consideration. Grenville describes how officials believed that setting an ambitious target just below the drastic inflation rates of the early 1990s would be more realistic and stimulate economic growth.
Evaluating the Success of Inflation Targeting
According to Grenville, the inflation-targeting framework generally succeeded for two decades following its adoption, helping to stabilize the economy and instill public confidence in financial institutions. However, he expressed concerns regarding the post-2008 Global Financial Crisis (GFC) era. The significant economic fallout and ongoing pressures from declining inflation rates resulted in rate cuts that brought many problems of their own. He argued that even though inflation targeting had mostly worked, it had not adapted well to the pressures faced during the extended economic malaise of the 2010s.
Grenville acknowledges that while the RBA made effective use of monetary policy during the prior decades, the focus on inflation led to persistent questions about interest rates after 2008. The RBA found itself in a predicament where, despite lowering rates in response to low inflation, other economic indicators such as unemployment did not improve. He suggested that simply focusing on inflation numbers marginalized other relevant economic conditions.
The Dilemma of Asset Prices
One critical takeaway from Grenville’s interview is the dilemma faced by the RBA in addressing asset prices within the framework of inflation targeting. He argues that low interest rates may not effectively stimulate general economic activity but do inflate asset prices—such as housing—significantly. This predicament could lend a false impression of economic health, benefitting homeowners but neglecting systemic issues in the broader economy.
Grenville describes how asset prices can outpace inflation, making it challenging to manage them within existing monetary policy rules. He highlights how policy considerations around housing, stock prices, and overall economic activity must be more nuanced than the straightforward adoption of inflation targets suggests.
Broader Implications for Monetary Policy
Grenville’s reflections serve as a call to critically assess the limitations of the current inflation targeting framework. He emphasizes that a one-size-fits-all approach can create significant unresolved issues. For instance, if the economy were experiencing a lower-than-target inflation rate without deflation, it might be more beneficial to allow for some flexibility rather than rigidly adhering to the inflation target.
Given the changing economic landscape, Grenville proposes that flexibility within inflation targeting could be key. This rethinking would not only help maintain stability in asset prices but also address the urgency of broader economic growth concerns.
Future Considerations
As of June 2023, Australia’s inflation rate was beginning to decline from a post-COVID spike, yet the RBA faced the ongoing challenge of rising asset prices, particularly in the housing market. With property prices in Australia predicted to rise significantly in upcoming years, the RBA’s strategies for managing inflation and asset prices will necessitate adaptation. Grenville’s discussion provides a perspective that emphasizing both inflation and asset prices may be essential for effective economic management in the future.
Through Grenville’s insights, the complexities of inflation targeting in Australia illustrate the necessity for multifaceted approaches in monetary policy—balancing inflationary goals, asset price management, and overall economic health to foster a resilient financial future.
