Opinion: RBA Lowe May Have Chance Of Hitting Inflation Target This Year

• Published on
• 09 Jan 2020, 02:28 PM

By Sophia Rodrigues

For the first time since taking over as the governor of the Reserve Bank of Australia in September 2016, there’s a possibility Philip Lowe might see inflation accelerating towards the mid-point of the 2% to 3% target band this year.

If this happens, it would be a significant achievement for Lowe who has not only struggled to deliver the inflation mandate but also has a forecast showing he’s unlikely to achieve it at least until December 2021.

However, there’s a catch to this.

The rise in inflation that we might see this year would be the effect of drought and bushfires, and one that in the first instance, would be “bad” for consumers.

It would also be the kind of inflation that would see the RBA lowering the cash rate to insulate households from rising prices, and ensuring household spending continues to grow.

(Note my analysis published January 8, 2020 discussing the likelihood of 25bps cash rate cut in February)

In the long run, however, it is likely the “bad” inflation would eventually become “good” inflation – the kind of inflation the RBA has been hoping to achieve. When this happens, the cash rate would likely rise faster than currently expected.

BAD VS GOOD INFLATION

So what is “bad” inflation, and what is “good” inflation.

I am not an economist, and I note there are various definitions of good and bad inflation.

In a very loose sense, the rise in food prices due to drought and bushfires would be bad inflation because it will directly hit the consumer pocket at a time when they are already struggling from weak income growth.

Bushfires are also expected to result in rise in insurance premiums and rent.

Then there is the prospect of higher fuel prices due to rise in oil prices.

The result would be a rise in headline inflation.

Good inflation, on the other hand, would be one which would be mainly as a result of rise in wage growth which essentially means rise in demand. This is the kind of inflation that the RBA has not only been hoping for but always believed would be how it would eventually achieve the target.

But higher inflation via wage growth could take years to happen.

In the meantime, there was a always a  greater possibility that a period of “bad” inflation due to supply shocks would lead to “good” inflation. This would happen if higher headline inflation leads to rise in wage growth.

Higher headline inflation caused by short-term factors is usually ignored by the RBA but it is still important because it could lead to a rise in inflation expectations. This is because research has proved that expectations are backward-looking rather than forward-looking.

Higher headline inflation is also important because wage and price settings have a close relationship with actual inflation outcomes. There is thus a possibility that a period of higher headline inflation, even if it is due to “bad” inflation, could lead to rise in wage growth, and eventually push underlying inflation higher.

In the end, these are possibilities but one which would bring a glimmer of hope for Lowe.

--Contact: sophia@centralbankintel.com