RDP 1999-08: Inflation Targeting and Output Stabilisation 6. Three Episodes in Australia's Experience with Inflation Targeting^[12]

The Australian inflation-targeting framework, since its inception in 1993, has always been a flexible rather than a strict targeting framework. It has explicitly acknowledged that there is more than one objective for policy, and it recognises the trade-off between output and inflation variability. However, the medium-term nature of the target provides a framework with which to resolve the short-term conflicts which sometimes arise between the policy objectives. This can be illustrated by the conduct of monetary policy in three episodes since the introduction of the inflation target.

6.1 Tightening in 1994

By the middle of 1994, it was clear that economic growth had accelerated strongly since 1993 and that the labour market had tightened appreciably. However, there had not been any acceleration in inflation. Indeed, inflation did not pick up until the middle of 1995. Nevertheless, the forward-looking nature of the inflation-targeting framework suggested that a policy response was necessary. Consequently, short-term interest rates were increased by 275 basis points by the end of 1994.^[13]

Thus, the rise in interest rates occurred ahead of any increase in actual inflation. The emphasis in the policy statements which accompanied the three interest rate increases was on the need to control inflation to ensure sustainable longer-term growth. The statements also stressed the forward-looking nature of the policy action. In the event, inflation did actually increase. However, the extent of the increase in inflation was limited by the earlier increases in interest rates, demonstrating the advantages of forward-looking policy.

6.2 Easing in 1996

By 1996, it was clear that the peak in inflation had been reached at a rate slightly above 3 per cent and that inflation was likely to fall reasonably quickly over the policy horizon. Policy was eased in July 1996, despite the fact that underlying inflation at the time was 3.1 per cent (and thus marginally above the target). Again, the forward-looking nature of the inflation target dictated that an easing in the stance of policy was required.

Both these episodes illustrate the way in which demand shocks are handled under an inflation-targeting regime. Pre-emptive policy actions were required to return output to potential and thereby, inflation to its target value. In this case, the goals of inflation and output stabilisation were generally in accord. Waiting until inflation had actually risen would have necessitated a larger policy response in the long run, thereby increasing the variability of both inflation and output.

In either case, more stringent policy action could have been taken to ensure that inflation was returned to the target more quickly. In the first episode, the inflation rate was expected to rise above 3 per cent, as it eventually did. Tighter monetary policy than was actually implemented could have been adopted to ensure that this did not eventuate. The resultant exchange rate appreciation would have further increased the disinflationary impetus. However, the more flexible approach to inflation targeting resulted in a more moderate policy response. Given that inflation was forecast to fall back below 3 per cent within the policy horizon (which in Australia is estimated to be somewhere between eighteen months and two years), no further policy response was seen as necessary. This allowed for reduced volatility in output.

Similarly in the second episode, although inflation was forecast to fall below 2 per cent in the short run, in the medium term, it was expected to rise back above 2 per cent. Again, policy was not eased further and the path of output was consequently smoother.

The second episode also raises the issue of the symmetry of an inflation target. Prospective breaches of the targeting band on the downside should be responded to as vigorously as prospective breaches on the upside. This also serves to reduce the variability in output.

6.3 Response to Asian Crisis

This episode dates from the onset of the Asian crisis in the middle of 1997. At that time, the Australian economy was growing relatively quickly, although underlying inflation was only 1.6 per cent. Australia's strong dependence on east Asia as an export market implied that a downturn in growth was likely as export demand contracted sharply. Furthermore, the relatively fast pace of growth in Australia compared with its trading partners meant that a widening in the current account deficit was in prospect. Reflecting these concerns and concerns about the region more generally, the Australian dollar depreciated by around 20 per cent against the major currencies.

In the past, such a conjuncture would have given rise to fears of an increase in inflation expectations and inflation, and would have generated expectations of a sharp tightening in the stance of monetary policy. While a tightening in monetary policy was considered as a possible policy response, in the end, it was not considered necessary because policy-makers judged that the inflation target was not in jeopardy. The depreciation in the exchange rate was expected to lead to some increase in inflation, but not a persistent overshooting of the target. (In the event, the expected passthrough of the exchange rate depreciation has not yet materialised.) The expected decline in output growth argued against a tightening in policy. Consequently, interest rates remain unchanged until late 1998, when they were lowered by 25 basis points. The Bank's media release at the time of this easing stated: ‘the continuing good inflation performance, and the economy's capacity to grow without generating additional inflationary pressure, mean that it is appropriate to offer some additional support to growth through the adoption of a more accommodative monetary policy stance’.

The inflation-targeting regime provided the framework in which to consider the impact of the Asian crisis on the Australian economy and the appropriate policy reaction. The flexibility inherent in the specification of the targeting framework allowed for strong consideration to be given to output stabilisation since the inflation outlook remained consistent with the medium-term target. In addition, the policy credibility that had built up since the adoption of the inflation-targeting regime also allowed the Reserve Bank greater flexibility in its policy response.

A less flexible approach to inflation targeting would have aimed to ensure that there was no possibility of even a temporary overshooting of the target. The tighter policy would have exacerbated the contractionary external shock and as events have subsequently unfolded, would likely have led to a substantial undershooting of the inflation target.

Finally, the following table prepared by Ray Brooks at the IMF summarises Australia's experience over the past six years with inflation targeting. The table shows that the inflation-targeting regime has been associated with a markedly improved inflation performance: the average level of inflation and its variability have decreased substantially. However, this has not come at the expense of slower or more variable output growth, indeed, growth has been higher and output variability, lower.

The table also shows that this outcome was not unique to Australia. The other inflation-targeting countries, as a group, have experienced lower inflation and higher output growth, and lower variability of both inflation and output, since they have adopted an inflation-targeting framework for monetary policy. While the reduction in inflation has been common to all industrial countries in the 1990s, the improved output performance and lower output variability has not.

Footnotes

This draws on Stevens (1999). [12]

The instrument of monetary policy in Australia is the cash rate, the interest rate on overnight loans made between institutions in the money market. [13]