Rethinking Inflation Targets  

The Australian reports that some people (with Bernie Fraser leading the way) are finally starting to question the wisdom of raising interest rates as a response to rising inflation when the factors causing the aforesaid rising inflation (rising energy prices feeding into rising prices of everything else) will not be affected in any meaningful way by Australian interest rate levels - "Reserve 'must lift inflation target'".

This is something I've been muttering about to anyone who will listen for some months, so I'm glad to see it reaching mainstream conversation now - all interest rate rises are doing is killing highly leveraged homeowners in outer-ring suburbs and making life even more difficult for exporters who are exposed to the exchange rate - and wiping out either or both of these groups won't bring inflation that is being imported via global market prices down at all (though the rising currency does mitigate this to a certain extent).

THE Reserve Bank should tolerate inflation running above its 2-3 per cent comfort zone for the time being to support economic growth and jobs, according to former RBA governor Bernie Fraser.

He also said the Rudd Government would "probably get away" with the tax cuts due to pour into voters' pockets on July1 without damage to the economy because demand was slowing. "We are very much back into the trade-off game and central bankers are going to have to start working hard again for their money," Mr Fraser said yesterday.

His warning was backed by respected economist and former Reserve Bank board member Bob Gregory, who said Australia risked a severe downturn if the 2-3 per cent inflation target were strictly adhered to when the China-led resources boom was forcing up food and fuel prices. "We ought to be talking about how long it is acceptable to be outside the range when most of the inflation is imported," Professor Gregory said.

The two monetary policy heavyweights were responding to a call from former senior Reserve Bank officer Peter Jonson to suspend the 2-3 per cent inflation target to avoid a recession.

Mr Jonson, a former monetary policy hardman and editor of the Henry Thornton website, now believes that soaring international food and oil prices have changed the ground rules.

The comments, in a series of interviews with The Weekend Australian, confirm a debate is under way about whether monetary policy needs to be rethought to cope with the two-speed world economy in which the US and Europe face recession while China and India are feeding inflation.

Mr Fraser and Professor Gregory emphasised that inflation targeting remained the best approach for an independent Reserve Bank, and did not support a shift to another mechanism. But they believe there should be flexibility in how the regime is applied to ensure the Reserve Bank does not over-cook the response to inflation.

Interest rates have already been lifted to their highest level since 1996, yet there is no sign that inflation is under control. The latest consumer price index showed inflation at 4.2 per cent in the year to the March quarter, with prices jumping across the board.