The Reserve Bank's devotion to its inflation target was on full display this week. Indeed, Tuesday's decision to hold rates steady offers clear insights into the way the bank operates. Despite economic growth being 'somewhat below trend' and labour market conditions having 'softened during 2011' by the Reserve Bank's own admission, they are nonetheless waiting for the next inflation print before they possibly cut rates. Rather than trust its forecasts, it seems the Reserve Bank is very focused on actually seeing the trends in the CPI data. This is an important point for understanding its behaviour.
With only one policy instrument, the bank is well aware that it can only really have one target. While the Reserve Bank Act specifies three goals, including price stability, minimising unemployment and improving 'general welfare', the RBA's signed agreement with the government mechanises this in the form an inflation target. The RBA has decided, over a run of years, that the best way to meet all three goals in the Act is to set monetary policy consistent with maintaining stable inflation. Specifically, the bank seeks to maintain inflation 'between 2-3 per cent, on average, over the cycle'. Of course this requires that it is forward-looking in its approach.
But, at the same time, the Reserve Bank is highly sceptical about anyone's ability to forecast anything, including its own ability to forecast inflation. In a speech last year, Governor Stevens pointed out just how difficult it was to accurately forecast. He cited estimates suggesting that if "the central forecast for CPI inflation at a two-year horizon was 2.5 per cent, the chances of the outcome being between 2 and 3 per cent... would be about two in five".
This is where it really gets interesting, and where understanding the Reserve Bank's aversion to trusting forecasts can better help us understand the bank's reaction function. Given the uncertainties associated with forecasting inflation, the Reserve Bank often deems that the lowest risk strategy is to wait for the next inflation print, rather than move ahead of it based on forecasts. We saw this course of action vividly on display this week.
This approach partly reflects the idea that unless you are at a turning point in the economy, then a good guide to next quarter's inflation is last quarter's inflation print. This is because inflation is typically quite persistent. In an econometrician's parlance, the model that best fits the inflation process is an autoregressive model. We find that an autoregressive process usually fits well.
Clearly there is a trade-off here. Trust your forecasts more and move ahead of the CPI data, or, wait for the data but possibly fall into the trap of not being forward-looking enough. When push comes to shove it seems the Reserve Bank mostly thinks it is better off waiting. Last August's experience with almost lifting rates just before the third-quarter CPI print in October showed that inflation was much more benign than they expected, is probably still haunting the decision makers at the bank.
This focus on the inflation measures also means that all other economic indicators are subservient to the CPI data. To understand this it helps to come back to first principles. Let's start at the beginning. In simple terms, the bank sees its job as keeping demand growing in line with the supply capacity of the economy. The problem is that there are no perfect measures of demand or supply. It is actually often the case that a lot of the measures are indeed metrics of the intersection of demand and supply – for example, GDP.
While estimates can be made of demand and supply, they are imprecise. Indeed, while other central banks publish estimates of potential output (an estimate of supply capacity), output gaps (the gap between supply and demand) and estimates of the natural rate of unemployment (an estimate of labour supply capacity), the Reserve Bank is far more circumspect. They are cognisant that these tools are all estimated with error and also tend to be time-varying. In fact, an estimate of today's supply capacity may change down the track just because you have more information, not because anything has actually changed in the economy.
While you may think you have an estimate of the current output gap, revisions to GDP series – or imprecision in any of the other inputs into the calculation, such as capital, labour and productivity estimates – can bias your estimates. In the end you need to ask whether the imprecision in these estimates makes them subservient to an approach that just involves waiting a bit longer for the next CPI print. So the Reserve Bank's view seems to be that, at any point in time, the best guide to whether the economy is growing ahead of its potential is to look at whether inflation is rising or not. That is, if demand is starting to run ahead of supply then inflation will be rising, and vice versa.
This is why the bank is so obsessed with measures of the pulse of inflation. Adding to the complexity of the measurement issues is the fact that the headline CPI is often very volatile and not a good reflection of the intersection of demand and medium term supply capacity. Rather, headline CPI can be knocked around by one-off shocks. For example, headline CPI is affected by temporary supply side shocks, like flood effects on banana prices or the effect of political unrest on oil.
The bank has, therefore, developed a suite of underlying inflation measures that abstract from these shocks. These are its preferred measures of inflation, which include the trimmed mean and weighted median. Small movements in a well measured inflation metric are deemed one of the clearest signals that demand is running ahead of supply.
At the moment, the RBA's ongoing concern seems to be that weak productivity growth means there is still upside risk to inflation. Its fear remains that the mining investment boom could still stoke inflation, as it could push demand ahead of the weaker supply side of the economy. While the central forecast is for underlying inflation to fall into the lower part of the target band – it is currently in the middle of the band – they clearly attach a non-zero probability to the idea that inflation remains stubbornly higher.
The most persistent part of the inflation measure – the non-tradeables component – has remained uncomfortably high. In fact, the appreciation of the Australian dollar over recent years is the key reason why overall underlying inflation has remained contained and it looks as though the currency has stopped appreciating. If the first quarter inflation print – due on 24 April – shows that non-tradeables inflation persists at its current elevated level, it is clearly possible that the bank will hold rates steady again.
One thing that would help in this whole process, and a point we have raised before, would be to have a monthly inflation measure. Almost all other OECD countries have a monthly CPI and so do most developing economies.
Indeed, if Australia had a monthly CPI, there is a good chance the Reserve Bank would have cut rates this week. The alternative, of course, to having a more frequent CPI could be to have less frequent RBA meetings. Given their preference for waiting for CPI prints before moving rates, perhaps they should meet less frequently.
Paul Bloxham is HSBC's chief economist for Australia and New Zealand, and a former RBA economist.