Low inflation gives the Reserve Bank reason to pause

Consumer inflation for the December quarter surprised just about everyone, including Henry, and gives the Reserve Bank a reason to delay the necessary monetary policy tightening.

Much of today's board meeting should be devoted to understanding what is going on with goods and services inflation both globally and in Australia.

Part of this discussion will be devoted to what Australia's low December figure means for the bank staff's forecast for inflation. The effect of the dramatic summer floods in eastern Australia will also be discussed. The Treasurer has already said the floods will detract 0.5 per cent from GDP growth and add 0.25 per cent to inflation in the current financial year.

The real impact will come in 2011-12, however. This is when the renewed resources boom will be hitting its stride and there will be considerable pressure on inflation. It is also when the rebuilding and refurbishment in the vast flooded areas of eastern Australia will be at their height.

The National Broadband Network rollout will presumably also be adding to demand for skilled labour. We have been told there are massive delays in the granting of 457 visas as traditional working class protectionism returns under a Labor government.

Global inflation is also on the rise. This is most noticeable in China, India, Indonesia, Brazil and other developing nations. Goods and services inflation in the US and euro-zone nations is held down by unemployment at 10 per cent or higher, while budget deficits and loose monetary policy are creating the preconditions for serious inflation once recovery gathers pace.

The Reserve's board has to decide whether a low December quarter's inflation is due to some previously undetected deflationary offset to global inflation, domestic resources boom, NBN rollout, and flood repairs. With lags of 12 to 18 months for inflation to respond to monetary policy, it might be rational, on the balance of probabilities, to decide to continue tightening of monetary policy.

Australia's sensation-seeking press has already described Glenn Stevens as "useless" (The Daily Telegraph, April 5, 2008), and he and the RBA board would be brave indeed to raise interest rates today. Having stubbed his toe on the downside of a two-speed economy, Stevens is likely to hit his head on the effects of the upside in 12 to 18 months' time.

Global monetary policy needs reform

ALMOST 70 years after the post-war Bretton Woods conference that endorsed the US dollar as the de facto global currency, America's severe economic problems coincide with China's rise.

US monetary policy became extremely easy under Fed chairman Alan Greenspan and the result was a bubble in American shares and then house prices.

In the wake of the global financial crisis of 2007-08, Greenspan's successor, Ben Bernanke, has again created highly expansionary monetary policy, with cash rates almost zero and two doses of "quantitative easing", a fancy name for printing money. It is my belief that China has studied the history of capitalism, and in particular the history of boom and bust in asset prices, far more closely than senior Americans.

The key question is whether there is a better system than monetary policy based on discretionary (ad hoc) inflation targeting via the instrument of "official" cash rates in a myriad of individual countries, which is the current mainstream approach.

One should at least consider a modern version of the gold standard. In place of a standard based on gold, one could imagine a commodity standard including preset weightings of gold, silver, platinum, copper, aluminium and even uranium.

There would be a preset annual growth (say 5 per cent) of the overall commodity bundle produced by an agency such as the International Monetary Fund.

The IMF would be responsible for acquiring the commodity bundles on a more or less continuous basis and feeding it to central banks in proportions based on each nations' real GDP. This idea is not, of course, original but rather is closely related to Keynes' Bancor system. Bancor is the name of the supranational currency that John Maynard Keynes proposed in the years 1940-42 and which Britain suggested after the Second World War. This supranational currency would, Keynes argued, be used in international trade as a unit of account within a multilateral barter clearing system.

The British proposal for a supranational currency could not prevail against the interests of the US, which at the Bretton Woods conference established the US dollar as the world's key currency.

Since the outbreak of the global financial crisis in 2007-08, Keynes' proposal is winning adherents. In a speech delivered in March 2009 entitled "Reform the International Monetary System", China's central bank governor, Zhou Xiaochuan, called Keynes' Bancor approach "farsighted" and proposed the adoption of IMF SDRs (special drawing rights) as a global reserve currency.

He argued that a national currency was unsuitable as a global reserve currency because of the difficulty faced by reserve currency issuers in trying to simultaneously achieve their domestic monetary policy goals and meet other countries' demand for reserve currency.

A similar analysis can be found in the UN's 2009 report, "Experts on reforms of the international monetary and financial system", as well as in a 2010 IMF publication, "Reserve accumulation and international monetary stability".

There are two essential differences between current arrangements and a Bancor system based on a bundle of commodities or SDRs.

Setting cash rates country by country, even by similar Taylor rules in pursuit of a common target for goods and services inflation, de-emphasises "quantity of money" targets. Setting and implementing a global "base money" target would de-emphasise interest rate targets. It is not at this time possible to decide which system might prove most robust, but clearly both need to be analysed carefully.

Along with rules for containment of bank lending, either a quantity focus or an effective interest rate focus is needed if capitalism is to minimise unhelpful financial system instability.

My more conservative friends will fear a global quantity-based monetary system would put too much power in one centralised agency.

While the head of the global central bank would wield considerable power, he would serve only at the pleasure of his political masters, although with a fixed term or terms. He would have a clear mandate to control inflation. The primary target would be goods and services inflation, with asset inflation as an important secondary target to be varied as the world gained experience of the proposed new system.

Nations could retain their own currencies if they wished, although sensible leaders would link these currencies to the global currency. Devaluation of national currencies would be possible, though serial devaluers would find it increasingly necessary to prepare contracts in a strong currency, which might increasingly be the global currency

The modern capitalist world is sitting uneasily between two radically different systems of monetary policy.

The discretion allowed with the flexible Taylor Rule method of setting interest rates in each nation contributes to the imbalances that so bedevil global economic development. Moving to a global system of base money control, administered by a global monetary authority independent of political government, is the logical alternative to the current system.

It may take a very damaging outbreak of inflationary global boom and bust for this idea to be taken seriously.