Mind the Lowe Gap
The long-term drift in the price level
Expectations for inflation implied by US 10-year break-even inflation rates are now at their highest since the 2013 taper tantrum, while 10-year BEIs in Australia are now running at their highest rate since 2016, the same year Phil Lowe became Governor.
This is good news, especially compared to where we were this time last year in the midst of the pandemic deflationary demand shock. I argued last year that a lot of things would have to go right before the macro policy response to the pandemic gave rise to any sort of inflation problem.
In the event, a lot has gone right, as reflected in the year since the onset of the pandemic being one of the best years for US equities since at least 1957. Inflation now looks like returning to something more consistent with targeted rates. We will likely see inflation at the top of the target range in Australia this coming quarter, as the pandemic deflation shock in the second quarter last year washes out of the annual calculation, leaving the third quarter rebound in the headline figure, although that too will drop out of the annual figure in due course.
Oddly enough, many of those now fretting the most about inflation are the same people who claimed monetary policy was ineffective. Of course it is difficult to disentangle the effects fiscal and other policies might have had, but fiscal policy can’t do much of anything without monetary accommodation. Fiscal policy is relatively slow to deploy and is subject to numerous offsets. Monetary policy actions still have the more pronounced announcement effect on financial markets and yet strangely get little credit from the many market participants whose own behaviour contradicts any notion of monetary policy ineffectiveness.
If people in the US are worried that fiscal policy is doing too much, people in Australia are worried fiscal policy won’t now do enough. Shane Wright suggests that:
The notion that fiscal policy could start being tightened at a jobless rate of 5.5 per cent while monetary policy is flat to the floor trying to get unemployment down below 4 per cent is an economic disaster in the making.
But monetary policy is not flat and the floor metaphor is misplaced. Monetary policy can still offset contractionary fiscal policy, assuming we get some. The rise in inflation expectations in Australia does not suggest premature monetary or fiscal tightening is of concern to financial markets.
Before getting too excited about the inflation outlook, it is worth recalling the long-term drift in the price level associated with previous undershooting relative to target. Here I show the evolution of the log of the trimmed mean-implied price level relative to inflation target-consistent values since Phil Lowe became Governor.
The price level implied by trimmed mean inflation is around 4% below the level consistent with the inflation target midpoint. Note the drift in the price level somewhat pre-dates Governor Lowe’s term in office, so the gap relative to a target-consistent path is actually somewhat larger than shown here.
The US has much the same problem. As Menzie Chin highlights, the Fed has some work to do to restore the price level to a path consistent even with the subdued 2015-2020 trend in inflation:
But US inflation expectations suggest the market believes the Fed will make good on its shift to an inflation targeting strategy that more closely approximates a flexible price level target. In his previous testimony to the House Economics Committee, Governor Lowe indicated that such an approach was not on the RBA’s radar. If anything, Lowe was signalling an expectation the price level gap would grow even larger over the next two years.
The gap highlights the problem with the ‘let bygones-be-bygones’ approach to inflation targeting, which is far too forgiving of policy mistakes. Those expecting their nominal income might grow at a rate consistent with the inflation target over the last few years have been consistently disappointed. If you want to understand why nominal wages growth has disappointed, this is a good place to start. As I showed in my USSC report on compensation and productivity in Australia and the US, there is a long-run relationship between nominal aggregate compensation of employees and nominal GDP in the inflation-targeting/decentralised wage fixing era since the early 1990s. I showed how weak inflation expectations account for the weakness we have seen in nominal wages growth. Waiting for wages growth to lift inflation has the relationship backwards.
Inflation expectations have, up until recently, fallen to reflect weaker outcomes, reducing the magnitude of the disappointment, although also making it more difficult to raise expectations and the flow through to price and wage setting behaviour. The fact that expectations have risen more recently is a particularly positive development in view of this experience.
This highlights the broader problem of the RBA pitting its inflation forecast and policy outlook against the market’s. An alternative approach would be to forecast target-consistent inflation rates and then calibrate policy instruments based on market expectations for those rates. The RBA can then work with, rather than against, market expectations. This approach can also be used for nominal GDP level targeting.
While it may not be realistic to fully close the price level gap that has emerged in Australia and the US since the middle of last decade, there is a case for letting inflation run hot to narrow the gap and maximise gains in employment. Compared to where we were a year ago, that would be a very good outcome. Hopefully Governor Lowe see its that way too. But it’s not his forecast.
Last week’s post on the super wars is quoted in a story by Ron Mizen in the AFR.
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