Steady as she goes

And Bernie Fraser, who as Governor of the Reserve Bank presided over the introduction of inflation targeting in the early 1990s, was once sufficiently persuaded of his predecessor Nugget Coombs’ assertion that “a persistent tendency for prices to rise may, like the housemaid’s baby, be very small at first - but once people get used to it being around, they may well be astonished at how rapidly it will grow” that he had it featured in big bold type on a full page of the Bank’s 1989-90 Annual Report.

Better than most, these distinguished economists would surely recollect that the reason why Australia adopted inflation targeting, and chose 2-3 per cent (rather than some other range) as the inflation target, was in order to provide a sustainable and stable “anchor” for expectations about inflation. A target of 2-3 per cent allows for the unavoidable upward bias in statistical measures of inflation, while keeping inflation below most people’s intuitive radar screens. Once inflation gets above 3 per cent, people start to notice it, as indeed they have done since the middle of last year. And once they start to notice it, they start to behave in ways that make it more likely than not that inflation will continue to accelerate - most obviously, by seeking wage increases to “compensate” for actual or expected inflation.

That’s why an inflation target of, say, 4-5 per cent is not sustainable in the way that one of 2-3 per cent is (provided, of course, that the central bank sticks to it, rather than abandoning it when it becomes more difficult to attain).

And while there may be some truth in the assertions that rising food and energy prices have contributed to the acceleration in inflation over the past year, and that the increases in food and energy prices are in turn partly attributable to global influences (including, but not limited to, the rapid growth of large developing economies), that does not detract from the fact that most of the rise in inflation over the past year has been domestically generated, not imported from overseas. Prices of “tradeable” items rose by 3.3 per cent over the year to the March quarter, while prices of “non-tradeables” rose by 5.0 per cent.

That, in turn, largely reflects the fact that over the past three years, growth in domestic demand has outpaced growth in supply by a factor of roughly half, in circumstances of diminishing spare capacity within the Australian economy to be drawn down to meet “excess demand”. That’s why domestic demand has to slow in order to bring inflation back within the target range, as the Reserve Bank has been seeking to accomplish. That task will ultimately become more costly, not avoided, by modifying or suspending the inflation target now.