Why do Central Bank’s target 2-3% inflation and what are they trying to accomplish by having it in that range?

Welcome to Finance and Fury, The Say What Wednesday edition – Every week answering your questions –

Hi Louis, thank you for the great content and the research you put in! I have another question you might be able to tackle: why do central banks target 2-3% inflation? what are they trying to accomplish by having it in that range? And in a world where inflation is less than 2% and interest rates are around 0%, what happens to people who rely on defensive assets (fixed income) like retirees? It seems like this would be a world where UBI (universal basic income) would have a place. What are your thoughts on this? Thanks, Gab

Great question – break this down into two parts

1. Why does the RBA have an inflation target, why it is set the target to 2-3% p.a.
2. Looking at retirees/savers

RBA – The Reserve Bank of Australia’s – RBA – central bank that conducts monetary policy

1. Purpose is providing stability in the financial system and promoting efficiency and competition in the payments system – indirect functions through having an inflation target
   1. Direct functions: issues Australia’s banknotes and provides banking services to the Australian Government.
2. What Is the Inflation Target? Officially: “keep annual consumer price inflation between 2-3% on average, over time”.
   1. The measure of inflation is the percentage change in the Consumer Price Index (CPI)
   2. Run through this in a previous ep – ABS gathers data on the price change between a basket of goods – fuel, eggs, building materials, etc. – aims to capture goods and services that households buy
3. Why they need this – An inflation target provides the framework to monetary policy decisions –
   1. guides a central bank’s in its management of the economy
   2. The Reserve Bank uses an inflation target to help achieve its goals of price stability, full employment, and prosperity and welfare of the Australian people. This is because price stability – which means low and stable inflation – contributes to sustainable economic growth.
   3. RBA adopted the inflation target in the early 1990s – round 1993 – did this independently to the Government – 1996 the Government agreed on the importance of the inflation target and formalised this agreement in the Statement on the Conduct of Monetary Policy
      1. This is updated following a change of government or Reserve Bank Governor – adjust the agreements internally
   4. Why between 2-3% – official justification:
      1. Avoids the many costs to the economy from inflation that is too high or too low – Goldie locks ratios
         1. Based around an equilibrium model – When has the economy performed well, and how people respond?
         2. Looked at the data and worked out that around 2.5% was a good level – but the causes of inflation are not made equally
            1. One can be created by economic boom – free trade and increase in supply and consumption of goods – leads to a lot of inflation
            2. One can be created through pushing money into the economy with debt backing it
      2. 2 to 3% is determined to be low enough to not significantly influence people’s economic decisions
         1. Based on the target range set in the early 1990s when inflation of around 2 to 3 percent had already been achieved. It was decided that inflation should be kept at around that rate, given the fact that the lowest average inflation rate experienced by other countries had, over many years, been a little over 2 percent.
         2. At these levels of inflation, an economy can achieve sustainable growth in output and employment.
            1. A higher inflation target could increase uncertainty and costs in the economy.
            2. A lower inflation target, on the other hand, is costly to achieve – lower output growth and increase unemployment
               1. Limit Monetary Policy options to stimulate demand
   5. Economic theory also backing this:
      1. If inflation is too high
         1. Consumers’ purchasing power – the real value of money – is reduced. If prices are increasing faster than people’s nominal incomes, they will be able to afford fewer goods and services than before.
         2. Workers may seek wage increases to compensate for the effects of higher inflation = raises firms’ costs, which may lead firms to raise prices further and/or reduce the number of workers they employ.
         3. Spending and investment decisions may be distorted – expect higher inflation, they may make purchases sooner
         4. Returns on investment may be lower – real returns lower if inflation higher
            1. real interest paid by borrowers to lenders – inflation goes high – the lender will get less
         5. Menu Pricing – Businesses need to update their prices more frequently and consumers spend more time comparing prices – other reasons like loss of competitiveness internationally
      2. If inflation is too low:
         1. Consumers may delay purchases if they expect prices to fall. As a result, falling prices – a situation called ‘deflation’ – can lead to lower spending. Businesses could respond by laying off workers or reducing wages which, in turn, places further downward pressure on demand and prices.
         2. The worst thing for an economy which has a lot of debt (like Aus in the housing market or USA and Japan on the Government side of things) is debt-deflation, where the inflation rate goes into negative territory and makes the real value of debt go up. Hence why inflation targets are so important for Central banks, aiming to avoid the above.
            1. Debt to GDP – If GDP grows above deflation, real size of Debt to GDP grows
            2. Lack of tax revenues – if goods get cheaper and wages stay same = same costs of living but gov debts lower

How Does the Inflation Target Work?

1. Set one is running the numbers – Assessing the current and expected rate of inflation
   1. monetary policy – bases rate decisions on levels of inflation now and expected inflation in the future
   2. If you put $1bn into the economy – effects won’t show up until later – if ever –
2. The cash rate is then used to dampen or stimulate economic activity so that inflation is consistent with the target.
   1. When inflation is above the target, this can be a sign that the economy is overheating- increase rates
   2. When inflation is below the target, this can be a sign that there is spare capacity in the economy – cut rates
3. Open Market Operations – Bidding for cash by the banks where RBA injects newly created funds to banks
   1. Differ from QE – as this is where the cash is used to purchase bonds in the bank
4. That is why the Reserve Bank looks to what inflation is forecast to be in the future when deciding on the level of the cash rate today

The reasoning behind the target is I believe – twofold: Agreements between governments and Central banks

1. Reason 1 – Provides a justification to increase the money supply based around Monetarist theory of Friedman
   1. But money hasn’t been going where it has been – Where has the money been going?
   2. What isn’t measured by CPI – Hard asset price increases – property, shares, etc.
      1. i.e. inflated hard asset prices through compounding growth – from increase of money supply –
   3. Why is inflation good for Governments – who else can borrow billions of dollars at low rates and let inflation eat away repayments? No need for fiscal restraint if you can let inflation eat away your debt on a 70 year bond.
      2. At 2.5% $1bn turns to $177m over that time – interest is covered by tax payers – or another bond
   4. But with money supply going up and up in ‘uncollateralised debt’ – Governments may not be able to afford the increased interest repayments if rates do go back up
   5. What the target does is switch the old models from a simple interest outcome, to a compounding one – has drastic exponential factors the longer it goes on
   6. Analogy of after big night of drinking – Wake up and on the verge of a hangover
      1. I’ll admit there has been one or two times I have woken up hungover and kept drinking
      2. What happens the next day when the party is over? Hangover is worse than normal –
      3. We should have had a hangover by now – there is a backup plan the IMF is looking into to increase global inflation – trying to escape the true horrors of a 2 day hangover, or in this case debt collapse
      4. How to avoid a hangover from a credit crunch? Work towards that answer in the next FF ep.
   7. This is why inflation is great for Governments – If you have no real assets but are cash rich from income each year from tax payers – You need to either budget well or borrow for funding shortfalls – Every nation in the G20 is in debt – to who?
2. Reason 2 – Central banks and commercial banks doesn’t want it too high – they are the ones that lend the money
   1. If inflation is high – real returns of banks go down
   2. They don’t want it too low either – if debt-deflation then borrowers might default – so bad loans go up
      1. Financial system collapse on the commercial banking side of things

Will giving money directly to the masses though a program like UBI (universal basic income) work better than what they’re doing at the moment?

Money would go into the masses but hard to control where money goes

3. transition in monetary policy – UBI comes from a new form of monetary policy called Modern Monetary Theory (or MMT)
   1. treats currency as a monopolistic tool of the state to redistribute where it sees fit – where the concept of UBI has it’s roots, in helicopter money style fiscal policy of the government
   2. the backing of QE from the central banks to fund the deficit spending that comes along with UBI. This is in an effort to increase the velocity of money, consumption and eventually inflation…..but it is starting to look like wishful thinking in the short term – need confidence
4. RBA – it may be the case that monetary policy should be set such that real interest rates become negative
   1. very low inflation target (so that actual inflation is close to zero) makes it more difficult to reduce real interest rates to such levels – hence why inflation targets are needed
5. Trying to control people’s behaviour –
   1. What if people use UBI to pay down mortgage? Just more debt at governmental level for not outcome
      1. Using debts to pay debts –
   2. What if everyone spends money –
6. This is where – ‘be careful what you wish for’ comes true –
   1. Give every Adult in Aus $10k p.a. = $200bn a year – 50% increase to Gov spending
   2. Issue with percentage targets – Compounding – Compounding is a very powerful tool
7. Depends what is compounding – Returns (growth), interest, or inflation
   1. Returns – Investor – own assets or cash – good
   2. interest – owe money – bad
   3. Inflation – Investor, individual/consumers – bad – owe money – very good

Defensive investments like Fixed Interest – Low income yields at the moment – but less real values eaten away from inflation

1. Fixed interest is a form of debt – Real values bigger – may be the unfortunate case to sell them down to fund income
   1. Yields are driven down with QE – prices pushed up – so sell high values
2. Retirees I see fund a lot off super/pensions – Mostly have a decent allocation to shares – for dividends and FC –
3. Best way is to work out volatility losses – set up allocations to income paying shares for a portion with years worth of income in cash/other defensive funds
4. Retirees – Get Age Pension if not self-funded –
   1. Joint fully AP is $40,560 p.a.
   2. Levels of UBI won’t go to replacing this – pension payment rates grow faster than inflation

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