Suddenly, the RBA seems to think missing its inflation target is a good thing

RBA governor Philip Lowe says lower inflation in the near-term is “good news”, because it eases cost of living pressures for households.
But low inflation is only helpful because the economy is running at a sub-optimal level, and wage growth remains low.
A better scenario for the central bank would be if stronger demand – underpinned by higher wage growth – drags inflation back within the 2-3% target range.

Last week, the RBA unexpectedly cut its near-term inflation forecast to 1.75% in 2018.

The Reserve Bank maintains a 2-3% target band for inflation growth. So on current trends, inflation is on track to fall short of the bank’s target for the third straight calendar year.

In comments to parliament on Friday, RBA Governor Philip Lowe said that may be a good thing — for a while at least.

Here’s how Lowe explained it (emphasis ours):

Utility prices have declined recently in some cities and policy changes are likely to reduce the measured price of child care. There have also been some policy changes at the state government level that will reduce other measured prices. Collectively, these changes will help with cost-of-living pressures and free up income to spend on other things. From this perspective, these changes are good news.

At the same time, Lowe said the central bank remains committed to its 2-3% target range for inflation over time.

In a research note this week, Westpac chief economist Bill Evans questioned whether the RBA’s target is achievable in the medium-term.

Instead, he said broader market expectations are that inflation will remain below the RBA’s target range.

“With inflationary expectations potentially anchored at or below 2%, it might be a tough target to achieve unless the RBA was willing to signal that it was prepared to pursue its target more aggressively,” Evans said.

One way to pursue inflation more aggressively would be to cut interest rates. But Lowe reiterated today that the next move in rates is still likely to be up (although still a long way off).

It raises the question: Is the RBA actually happy with low rates of inflation in Australia?

According to Alex Joiner, chief economist at IFM Investors, the answer is probably not.

“From a policy perspective, I very much doubt the RBA is comfortable with inflation being so low,” he told Business Insider.

“Indeed, it was the threat of weaker inflation that prompted its move to ease policy further in 2016.”

Joiner said Lowe’s comments about cost of living added some nuance to the debate, although “this is a silver lining argument in terms of his position”.

The key point, Joiner said, is that low inflation is only beneficial because Australia’s economy isn’t operating at full capacity, and wage growth remains low.

JP Morgan economist Ben Jarman agrees.

“If you take it as given that progress on growth/spare capacity will be slow, and that there is a global element to the weakness in nominal incomes growth, then the RBA doesn’t have much choice but to actually favour lower inflation for a while,” he said.

By “global element to the weakness in nominal incomes growth”, Jarman is referring to the experience of the US and UK. Both countries have record-low rates of unemployment, but that is yet to translate into a material lift in wage growth.

“It’s pretty clear the RBA needs a steady improvement in disposable incomes so that households can work off some of the debt burden,” he said.

So in the current environment, low inflation (particularly from supply-side forces — think cheaper retail prices) helps release more income to households.

“It also allows rates to stay low, which further supports disposable incomes and equity contributions into housing,” Jarman said.

“The worst scenario for the RBA would be one where they had to hike rates in a low income growth environment due to concerns about inflation.”

So it’s not a worst-case situation. But a better scenario was outlined by Joiner:

“The RBA would much rather have significantly stronger wages and strength of demand underpinning inflation at the mid-point of its target,” he said.

“In my opinion, broader economic growth remains less robust than the RBA would like. This is because it is being driven to a large extent by population growth.

“This population growth is also adding capacity to the labour market, making it more difficult than it otherwise would be to get the unemployment rate low enough to assist in generating wages pressure.”

For now, the RBA has been forced into a delicate balancing act on inflation, as the economy plugs along and wage pressures remain muted.

Markets will get another update on the bank’s inflation outlook on Wednesday, when deputy governor Guy Debelle gives a speech called “Low Inflation”.