Wednesday, September 23, 2009

The IMF wants us to do more than target inflation

Darn! We've been doing it so well

The graph below shows annual CPI inflation measured against the Reserve Bank's target of "keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle."

The International Monetary Fund has challenged Australia's Reserve Bank and other monetary authorities to do more than simply target inflation the next time around.

In an early release of some chapters from its forthcoming World Economic Outlook timed to coincide with this week's G20 leaders meeting in Pittsburgh the Fund has called on central banks to also target asset prices, tightening monetary conditions "earlier and more vigorously, even if inflation appears to be under control".

Such a move would require a rewriting of the Reserve Bank's compact with the government renewed in 2006 which requires it to aim to keep "consumer price inflation between 2 and 3 per cent on average over the cycle"...

Governor Glenn Stevens has himself raised the possibility of broadening the Bank's goals saying there could be room for taking into account wider objectives "at the margin."

It is an idea that would be on the agenda of the new financial system inquiry proposed by six leading Australian economists and under consideration by the Treasurer Wayne Swan.

IMF senior economist Alasdair Scott told a Washington news conference overnight that the Fund's examination stopped short of blaming the central banks for the global economic crisis.

"We don't see evidence that monetary policy was the smoking gun - it was not the main systematic cause. But that's not to say that monetary policy was entirely without blame."

"We would recommend that monetary policymakers consider taking a broader approach and to say that even when inflation is under control they should think of what is happening in asset price markets to see whether vulnerabilities building up."

"If they are building up they should strongly consider taking preemptive action and not think that we can just pick up the pieces after the crisis has happened," he told the press conference.

The IMF report examines 40 years of asset price busts and finds a recurring pattern of deteriorating current account balances in the run-up to house price bursts.

"A number of central banks have explicit mandates to to target CPI inflation and they have been strikingly successful in keeping inflation in check," the report says.

"But this approach has not been sufficient to prevent asset price busts; the current crisis is no exemption."

"We do not suggest that policy makers should react automatically to changes in asset prices, still less that they should try to determine an appropriate level for asset prices."

"But they should examine what is driving asset price movements and be prepared to act in response."

Published in today's SMH and Age

Now important figures in Australia disagree.

Treasury Executive Director
David Gruen in June:

Expansionary US monetary policy undoubtedly contributed to rising US asset prices, including house prices, at the time. Indeed, that is the point of the policy – rising asset prices constitute one of the ways that expansionary monetary policy works.

But I have less sympathy with the argument that monetary policy should explicitly 'lean against the wind' of a suspected inflating asset price bubble, which is implicit in the criticism of US monetary policy at that time.

In my view, to lean against the wind and do more good than harm requires a level of understanding about the likely future path of a suspected asset bubble that is simply unrealistic. Without that understanding, attempting to use monetary policy to lean against the wind is as likely to be destabilising for the wider economy as it is to be stabilising.
And Reserve Bank Assistant Governor Guy Debelle in May:

In my view, the current episode vindicates the position that monetary policy, narrowly defined as the setting of the policy interest rate, should be confined to targeting inflation. Set interest rates primarily to achieve the inflation goal as that, in itself, contributes to sizeable social gains. A departure from that runs the risk of losing the nominal anchor that the inflation target provides.

But other tools, most notably the much-touted (although not clearly defined) macro-prudential instruments, should be used to address asset price and credit imbalances. I do not think that a slightly tighter setting of interest rates would have prevented the development of the imbalances that have led to the current financial crisis. When human psychology is such that optimism about asset price rises is at the fore, then an excessively stringent setting of interest rates would be required to suppress the optimism. The Australian and Scandinavian experience in the late 1980s shows the sort of interest rate settings required to achieve such an outcome. In that example, a credit boom and bubble-like asset price dynamics took hold and only a very high setting of real interest rates ultimately curtailed that, but at the cost of a historically high level of unemployment.

I do not think it would be socially acceptable or desirable to endure the level of unemployment that would come with the high interest rates necessary to pop the bubble. It is asking too much of the single monetary policy instrument, namely, the targeted short-term interest rate to target both financial excesses and inflation.

Nor do I believe there is much to be achieved by ‘leaning against the wind’. The wind that is blowing in most episodes of credit booms is generally at least gale force. Setting interest rates a bit higher in such circumstances is likely to be close to futile when such credit dynamics take hold. Again, what would be the point of undershooting the CPI inflation target and enduring a higher than desirable level of unemployment with little to be gained. How would such actions be explained to the public?