One of the on-going myths that mainstream (New Keynesian) economists propagate is that monetary policy (adjusting of interest rates) is an effective way to manage the economic cycle. They claim that central banks can effectively manipulate total spending by adjusting the cost of borrowing to increase output and push up the inflation rate. The empirical experience does not accord with those assertions. Central bankers around the world have been demonstrating how weak monetary policy is in trying to stimulate demand. They have been massively building up their balance sheets through QE to push their inflation rates up without much success. Further, it has been claimed that a sustained period of low interest rates would be inflationary. Well, again the empirical evidence doesn’t support that
Bill Mitchell considers the following as important: central banking, inflation
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One of the on-going myths that mainstream (New Keynesian) economists propagate is that monetary policy (adjusting of interest rates) is an effective way to manage the economic cycle. They claim that central banks can effectively manipulate total spending by adjusting the cost of borrowing to increase output and push up the inflation rate. The empirical experience does not accord with those assertions. Central bankers around the world have been demonstrating how weak monetary policy is in trying to stimulate demand. They have been massively building up their balance sheets through QE to push their inflation rates up without much success. Further, it has been claimed that a sustained period of low interest rates would be inflationary. Well, again the empirical evidence doesn’t support that claim. The evidence supports the Modern Monetary Theory (MMT) preference for fiscal policy over monetary policy. Even though the Reserve Bank of Australia has not pursued a QE program (fiscal policy saved our economy from recession during the GFC), it has persisted with very low historic interest rates. And as yesterday’s latest inflation data from the Australian Bureau of Statistics – Consumer Price Index, Australia – shows, the RBA is struggling to push it inflation rate into the so-called target policy range of 2 to 3 per cent. The data shows that the All Groups CPI grew by 1.9 per cent in the 12 months to September 2018 and the so-called core analytical series – Weighted Median and Trimmed Mean – used by the RBA to assess whether interest rates should shift or not grew by less than that. The most reliable measure of inflationary expectations are flat and below the RBA’s target policy range.
The summary Consumer Price Index results for the September-quarter 2018 are as follows:
- The All Groups CPI rose by 0.4 per cent and has been steady for the last three quarters.
- The All Groups CPI rose by 1.9 per cent over the 12 months to the September-quarter 2018, compared to the annualised rise of 2.2 per cent over the 12 months to June-quarter 2018.
- The Trimmed mean series rose by 0.4 per cent in the September-quarter 2018 (steady) and by 1.8 per cent over the previous year (steady).
- The Weighted median series rose by 0.3 per cent in the September-quarter 2018 (0.4 per cent in the June-quarter 2018) and by 1.7 per cent over the previous year (steady).
While the Australian debate has not been centred on any QE myths – that is, the Reserve Bank of Australia (RBA) has not engaged in any widespread asset purchases unlike its counterparts in Europe, the UK, Japan, the US – there is still an obsession that inflation is just about to accelerate and this will force the RBA to increase interest rates.
Even though inflation has been benign now for some quarters, the market economists (banks) still think it is about to accelerate and the RBA will be hiking interest rates.
But the reality is quite the opposite.
If anything, the pressure is now on the RBA to reduce interest rates given that their preferred measures (see below) are now consistently below their targetting range (2 to 3 per cent).
What is apparent from yesterday’s inflation figures and the most recent labour market data is that there is plenty of room for further fiscal stimulus to boost growth towards its trend level and reduce unemployment and underemployment.
Trends in inflation
The headline inflation rate increased by 0.4 per cent in the September-quarter 2018 and 1.9 per cent over the 12 months to September (down from 2.2 per cent in the previous quarter).
Inflation has been fairly steady over the 2018 despite a sizeable depreciation in the exchange rate (see below).
The following graph shows the quarterly inflation rate since the March-quarter 2008. There is clearly no breakout trend emerging.
The next graph shows the annual headline inflation rate since the first-quarter 2002. The black line is a simple regression trend line depicting the general tendency. The shaded area is the RBA’s so-called targetting range (but read below for an interpretation).
The trend inflation rate is quite steeply downwards.
Once we take out the so-called ‘volatile’ items (food and fuel), the annual inflation rate is only 1.6 per cent. Well below the RBA’s target range.
Petrol prices rose by more than 5 per cent in September and that will probably impact on the December-quarter figure.
It was claimed when the Labour Force data came out for September that as the unemployment rate had fallen to 5 per cent that wage pressures would start to seep into the inflation figures.
I analysed that argument in this blog post – Australian labour market weaker – no employment growth and participation down (October 18, 2018).
The point is that the lower unemployment rate was not a sign of strength emerging. It was driven by a decline in participation arising from slack employment growth.
The mainstream commentators were completely wrong on that score when the ABS released the data.
Further underemployment remains persistently high and, combined with the poor employment growth, is creating flat wages growth conditions.
There will be no major wages push in the inflation data for the foreseeable future.
What is driving inflation in Australia?
The following bar chart compares the contributions to the quarterly change in the CPI for the September-quarter 2018 (green bars) compared to the June-quarter 2018 (blue bars).
Note that Utilities is a sub-group of Housing.
The ABS say that:
- The most significant price rises this quarter are international holiday travel and accommodation (+4.3%), domestic holiday travel and accommodation (+2.4%), tobacco (+1.8%) and automotive fuel (+1.4%).
- The most significant offsetting price falls this quarter are child care (-11.8%) and telecommunications equipment and services (-1.5%).
Under Recreation and culture, the main driver was “international holiday travel and accommodation … The rise in international holiday travel and accommodation is due to the summer peak seasons in Europe and America.”
So even though our currency depreciated steadily over the quarter, Australians still were able to take holidays abroad.
The rise in tobacco prices “is due to the effects of the 12.5% federal excise tax increase” – so a government impost.
And the increase in fuel “is due to continued increases in world oil prices flowing through to consumers.”
So even though the currency has depreciated by 12.1 per cent since February 29, 2018, the ABS report that:
… the tradables component of the All groups CPI rose 0.1% and the non-tradables component rose 0.2%.
This tells you something about the extent of exchange rate pass through effects and the likelihood in a small, open economy exporting primary commodities, that a depreciating exchange rate will be highly inflationary. In Australia’s case, that probability is low.
The next graph provides shows the contributions in points to the annual inflation rate by the various components.
In the twelve months to the end of September 2018, the major drivers of inflation were Housing (energy), Transport (petrol), and Alcohol and Tobacco Prices (government policy).
Inflation and Expected Inflation
I mentioned at the outset, the on-going inflation obsession among market players.
If you examine the market trends in speculative trades then it is clear that the traders were betting on a major shift in the RBA policy upwards after 2016 because they have been punting on a substantial rise in inflation.
They have been systematically wrong on that front.
More recently, it is clear their expectations have been falling as the RBA holds to its low interest rate regime.
Significantly, it is this misplaced fear of inflation, that, in place, drives the misplaced preference by New Keynesians for counter-stabilising monetary policy instead of fiscal policy.
If we went back to 2009 and examined all of the commentary from the so-called experts we would find an overwhelming emphasis on the so-called inflation risk arising from the fiscal stimulus. The predictions of rising inflation and interest rates dominated the policy discussions.
The fact is that there was no basis for those predictions in 2009 and nine years later no major inflation outbreak is forthcoming.
The following graph shows four measures of expected inflation expectations produced by the RBA – Inflation Expectations – G3 – from the June-quarter 2005 to the September-quarter 2018.
The four measures are:
1. Market economists’ inflation expectations – 1-year ahead.
2. Market economists’ inflation expectations – 2-year ahead – so what they think inflation will be in 2 years time.
3. Break-even 10-year inflation rate – The average annual inflation rate implied by the difference between 10-year nominal bond yield and 10-year inflation indexed bond yield. This is a measure of the market sentiment to inflation risk.
4. Union officials’ inflation expectations – 2-year ahead.
Notwithstanding the systematic errors in the forecasts, the price expectations (as measured by these series) are trending down in Australia, which will influence a host of other nominal aggregates such as wage demands and price margins.
The market economists’ one-year and two-year ahead expectations are well above the Break-even 10-year inflation rate. Even Union officials have fallen for the accelerating inflation outlook.
It is well known that the ‘market economists’ systematically get movements in the economy wrong and one wonders if their organisations actually bet money on their analysis!
The most reliable measure – the Break-even 10-year inflation rate – is now at 1.9 per cent, well below the lower bound of the RBA targetting range but spot on where the actual raw inflation rate came in at.
It has been at or below the lower bound of the RBA’s policy target range since March 2016.
The other expectations are still lagging behind the actual inflation rate, which means that forecasters progressively catch up to their previous forecast errors rather than instantaneously adjust, a further piece of evidence that refutes the mainstream economics hypothesis that decision makers use ‘rational expectations’ (that is, on average get it right).
Implications for monetary policy
What does this all mean for monetary policy?
Clearly, the market economists were punting on a rise in the interest rate and have only started to realise in the last few quarters that this is unlikely to happen any time soon (as disclosed by their inflationary expectations above).
The inflation trends highlighted in yesterday’s data release provide no basis for any expectation that the RBA will hike interest rates anytime soon.
In fact, if anything, the pressure is now on the RBA to cut rates again.
The Consumer Price Index (CPI) is designed to reflect a broad basket of goods and services (the ‘regimen’) which are representative of the cost of living. You can learn more about the CPI regimen HERE.
Please read my blog – Australian inflation trending down – lower oil prices and subdued economy – for a detailed discussion about the use of the headline rate of inflation and other analytical inflation measures.
The RBA’s formal inflation targeting rule aims to keep annual inflation rate (measured by the consumer price index) between 2 and 3 per cent over the medium term. Their so-called ‘forward-looking’ agenda is not clear – what time period etc – so it is difficult to be precise in relating the ABS data to the RBA thinking.
What we do know is that they do not rely on the ‘headline’ inflation rate. Instead, they use two measures of underlying inflation which attempt to net out the most volatile price movements.
To understand the difference between the headline rate and other non-volatile measures of inflation, you might like to read the March 2010 RBA Bulletin which contains an interesting article – Measures of Underlying Inflation. That article explains the different inflation measures the RBA considers and the logic behind them.
The concept of underlying inflation is an attempt to separate the trend (“the persistent component of inflation) from the short-term fluctuations in prices. The main source of short-term ‘noise’ comes from “fluctuations in commodity markets and agricultural conditions, policy changes, or seasonal or infrequent price resetting”.
The RBA uses several different measures of underlying inflation which are generally categorised as ‘exclusion-based measures’ and ‘trimmed-mean measures’.
So, you can exclude “a particular set of volatile items – namely fruit, vegetables and automotive fuel” to get a better picture of the “persistent inflation pressures in the economy”. The main weaknesses with this method is that there can be “large temporary movements in components of the CPI that are not excluded” and volatile components can still be trending up (as in energy prices) or down.
The alternative trimmed-mean measures are popular among central bankers.
The authors say:
The trimmed-mean rate of inflation is defined as the average rate of inflation after “trimming” away a certain percentage of the distribution of price changes at both ends of that distribution. These measures are calculated by ordering the seasonally adjusted price changes for all CPI components in any period from lowest to highest, trimming away those that lie at the two outer edges of the distribution of price changes for that period, and then calculating an average inflation rate from the remaining set of price changes.
So you get some measure of central tendency not by exclusion but by giving lower weighting to volatile elements. Two trimmed measures are used by the RBA: (a) “the 15 per cent trimmed mean (which trims away the 15 per cent of items with both the smallest and largest price changes)”; and (b) “the weighted median (which is the price change at the 50th percentile by weight of the distribution of price changes)”.
Please read my blog – Australian inflation trending down – lower oil prices and subdued economy – for a more detailed discussion.
So what has been happening with these different measures?
The following graph shows the three main inflation series published by the ABS since the March-quarter 2009 – the annual percentage change in the All items CPI (blue line); the annual changes in the weighted median (green line) and the trimmed mean (red line).
The RBAs inflation targetting band is 2 to 3 per cent (shaded area). The data is seasonally-adjusted.
The three measures are all currently below the RBA’s targetting range:
1. CPI measure of inflation – 1.9 per cent and below the RBAs target band for the last two years.
2. The RBAs preferred measures – the Trimmed Mean (1.8 per cent and stable) and the Weighted Median (1.7 per cent and stable) – are also below the lower bound of the RBAs targetting range of 2 to 3 per cent.
How to we assess these results?
First, despite the depreciating Australian dollar since February, there is clearly no pressures coming from the traded-goods sector to push the inflation rate above the target range.
Second, there is clearly a downward trend in all of the measures. The “core” measures used by the RBA have been benign for many quarters even with an on-going significant fiscal deficit and record low interest rates.
Third, the RBA will also be mindful that real GDP growth is still below trend and the labour market is still in an uncertain-to-vulnerable state, with broad labour underutilisation still above 13 per cent (or more).
In terms of their legislative obligations to maintain full employment and price stability, one would think the RBA would have to cut interest rates in the coming month given the state of the economy and the benign inflation environment.
Further, as I have noted elsewhere, wages growth is flat and at record lows.
Fourth, inflationary expectations are benign and trending downwards.
My view is that the RBA should cut rates now that all three measures have been consistently below the targetting range.
Just before the GFC hit all the macroeconomic policy talk in Australia was about getting deficits down and into surplus to ensure that inflation didn’t accelerate.
It was nonsensical talk even then, when economic growth was stronger and unemployment lower.
The doomsayers were completely wrong when they predicted the fiscal stimulus in 2008-09 would generate dangerous inflation impulses.
The trend has been down for some years now and some nations are fighting deflation rather than inflation.
Australia is now a member of the low-inflation brigade despite GDP growth continuing (albeit below trend) and the exchange rate depreciating significantly over the course of this year.
Interest rates remain low and even the bank economists are starting to revise their inflationary expectations downwards as they realise the predictions coming out of mainstream macroeconomic models are useless.
That is enough for today!
(c) Copyright 2018 William Mitchell. All Rights Reserved.