Analysis: As Market Prices Hikes, RBA Lowe Might Be Eyeing Nirvana

• Published on
• 31 Jan 2022, 12:54 PM

(This analysis was first published on Friday, January 28 at 12:44 PM as an email to premium subscribers)

By Sophia Rodrigues

(Sydney, January 28, 2022)—As Reserve Bank Governor Philip Lowe debates whether to retire the word “patient” three months after introducing it into his forward guidance, one word that could come to his rescue is “average.”

The RBA has had a flexible inflation target since the early 1990s and its mandate is to achieve an “average” rate of inflation, over time, of between 2% and 3%.

There is an acceptable degree of variation in inflation from year to year and the RBA uses this flexibility while keeping its focus on the medium term.

After using the flexibility in the mandate when tolerating inflation below target for several years, the question for Governor Lowe is whether he can use the same flexibility on the way up.

If Lowe is convinced retaining the flexibility on inflation would help the economy reach higher level of employment that would in turn lead to higher income levels, he will use the flexibility.

In other words, Lowe might use the inflation flexibility to aim for his central bank “nirvana.”

What this really means is that while the RBA will open the door for interest rate hike in 2022, any rate increase is likely towards the end of the year, rather than the first half.

NIRVANA HAS SHIFTED

It is interesting that in February 2020, Lowe described nirvana as 2.5% inflation, unemployment at 4% or 4.5%, and wages increasing 3.5%.

Last month, Lowe said his nirvana was 2.5% average inflation, full employment, labor productivity of 1.5% and wages growth at 4%.

The two key differences are the reference to average inflation, and higher wages growth of 4%.

When Lowe talks about central bank nirvana what he really means is the state of monetary policy that makes a “material contribution to the welfare of the society” it serves.

But doing that isn’t easy and not always possible. As Lowe once acknowledged, there is an element of judgement and discretion in this approach, and more judgement than in an approach to monetary policy that mechanically sets interest rates based on inflation forecast.

TIME FOR JUDGEMENT AND DISCRETION

There is no doubt higher than expected underlying inflation in Q4 will bring cash rate hike on the table but rather than opt for a mechanical hike, Lowe is likely to make a judgement on when to hike.

The judgement would be whether raising rate to tame inflation in the next few months, or allowing inflation to remain elevated for a few more quarters and give the best chance for wages growth to rise, would best contribute to the welfare of Australian people.

It’s worth recalling Lowe’s words, “That's not to say inflation control is unimportant – because it clearly is important. Rather, we need to remember that it is a means to an end, and that end is welfare maximisation.”

To understand the RBA’s thinking after the Q4 inflation data, it is also important to understand how much of the upside move came as a complete surprise to the RBA and how much was already factored into its past thinking as upside risks.

If the difference isn’t too wide, it’s unlikely the RBA’s thinking would shift so much that from a central scenario of no hike in 2022, it would signal a rate hike in the next few months.

This means Governor Lowe could easily send some variant of the “patience” message on Tuesday in the monetary policy decision statement, and on Wednesday he could use his speech to explain to the people of Australia what his decision means for jobs and incomes.

Even prior to Q4 inflation data, communication was going to be Lowe’s biggest challenge but now the challenge has got bigger.

--Contact: Sophia@centralbankintel.com