RBA Deputy Governor Guy Debelle gave a speech this week in which he clearly explained the Reserve Bank’s current monetary policy operating procedures and the policy framework in which these procedures are being used. At the same time, he effectively conceded that the RBA is not doing enough to meet its agreement with the government on inflation, noting that:

while the bond purchases by the RBA increase liquidity in the system, I do not see this posing any risk of generating excessively high inflation in the foreseeable future. Indeed, the opposite seems to be the more likely challenge in the current economic climate, that is, that inflation will remain below the RBA's target.

It is, of course, the RBA’s job to rise to that challenge, not to forecast an ongoing policy failure. Yet it is remarkable how many commentators and economists have internalised the assumption that the RBA can’t (or just won’t) do any better. The following comment is representative:

A notable and praiseworthy exception is the Grattan Institute, which has released a set of policy recommendations that would help Australia recover from the COVID-19 recession. The authors argue persuasively that monetary policy can and should do more, including the possibility of negative interest rates. The report includes a particularly effective visualisation (which I’m assuming is due to Matt Cowgill) of the magnitude of the RBA’s inflation target shortfall. As the visualisation makes clear, it is both the duration and the magnitude that matters.

Unfortunately, these recommendations in relation to monetary policy did not get much of an airing compared to the fiscal policy recommendations. The AFR rounded-up ‘top market economists’ to argue that negative interest rates were unlikely in Australia, somewhat over-looking the inconvenient fact that the market economist with one of the best track records in calling future changes in Australian monetary policy is a strong advocate of negative official interest rates.  

While on the subject of inflationistas, the IEA has put out a report Inflation: The Next Threat? by Juan Castaneda and Tim Congdon. Tim has impeccable monetarist credentials and is a fellow member of the Mont Pelerin Society, where we have had some great discussions, not to mention disagreements, on monetary policy. I mention this background to highlight that my own analysis of these issues is not so much a function of my monetarism, as the way in which I apply that framework.

Tim and his co-author argue that 2021 and 2022 will see an inflationary boom, with a US inflation rate of over 10%. The first thing that needs to be said about this forecast is that, from where we sit today, an inflationary boom in 2021 is not the worst problem to have!  Just as monetary policy has the ability to address deflationary or disinflationary policy mistakes, it has the tools to correct an inflationary policy error. If things are going that well in 2021, we will have much to be thankful for.

Tim and his co-author’s forecast is partly informed by the view that ‘the crisis is mainly due to a supply-side shock…and not a drop in aggregate demand or spending…However, governments have reacted to the current crisis as if the falls in output reflected a deficiency of aggregate demand, as in a “standard” recession.’

If that’s your view, then the inflationary conclusion largely follows, but I think the evidence from financial market and commodity prices overwhelmingly rejects it.

Tim also recognises that there is a precautionary money demand shock in progress. I would argue that most of what we have seen in the behaviour of monetary aggregates is a money demand shock, which central banks have accommodated. Whether this is ultimately inflationary depends on whether central banks over-accommodate the demand shock. This is exactly what we want central banks to do in the current environment. Central banks could err on the side of an even more inflationary over-accommodation, but that has not been the experience of recent years. As the money demand shocks moderates, there is no reason why the money supply cannot be calibrated accordingly.

The key point is that inflation outcomes are in the hands of policymakers. Yes, they could err in ways that are both inflationary or disflationary/deflationary. Financial markets are telling us the latter is the more likely outcome. As we noted in a previous post, inflation protection in the US has never been so cheap. The US 5-year Treasury bond is currently posting record lows in yield.

If Tim is right, then he can make a lot of money and the drinks will be on him at the next in-person MPS meeting. As a market monetarist, I’ll take the other.