Guy Debelle: Twenty-five years of inflation targeting in Australia
Address by Mr Guy Debelle, Deputy Governor of the Reserve Bank of Australia, at the RBA
Conference 2018, Sydney, 12 April 2018.
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This draws on a number of pieces I have written on inflation targeting over the past two decades,
both at the RBA and the IMF. Thanks to Claudia Seibold for her assistance with the data.
Introduction
It has been 25 years since Australia adopted an inflation-targeting regime as the framework for
monetary policy. At the time of adoption, inflation targeting was in its infancy. New Zealand had
announced its inflation target in 1989, followed by Canada and Sweden. The inflation-targeting
framework was untested and there was little in the way of academic analysis to provide guidance
about the general design and operational principles. Practice was very much ahead of theory.
Now 25 years later, inflation targeting is widely used as the framework for monetary policy. While
there are differences in some of the features across countries, the similarities are more
pervasive than the differences. And generally, the features of inflation-targeting frameworks have
tended to converge over time.
It is interesting to firstly examine how the inflation-targeting framework in Australia has evolved
over the 25 years. Secondly, it is also timely to reassess the appropriateness of the regime. The
first is the main task of my paper, the second is the task of the conference collectively.
In terms of the first, the main point I will make is that the Australian framework has not changed
much over the past 25 years. The flexible nature of the framework, which was there at its
inception, has proven to be resilient to the quite substantial changes in the macroeconomic
environment that have taken place since. This is in contrast to some other countries that have
moved from an initially rigid definition (which may well have been appropriate at their inception)
toward something more flexible. The framework in Australia was adaptable from the start, which
caused some issues in convincing some people of the seriousness with which the Reserve
Bank was adopting an appropriate monetary framework.
While the specification of the regime has not materially changed, one thing that has changed is
the degree of confidence that the regime might actually work. Australia, like other countries,
came to inflation targeting after trying a number of alternative approaches to monetary policy.
These approaches had not delivered either the desired price stability nor acceptable
macroeconomic outcomes. Inflation targeting was the next attempt to try and better achieve
these outcomes. There was no guarantee of success. Now, after 25 years, there is considerably
greater confidence that the regime can contribute to sound macroeconomic outcomes in terms
of both inflation and growth. The proof of the pudding has been in the eating. There is greater
confidence and understanding about the framework from the public, from the political process,
from financial markets and from the policymakers themselves.
There is also now a large academic literature supporting inflation targeting and examining and
advising on various questions about the appropriate design and operation of the framework. That
has validated many of the decisions taken by policymakers in setting up their inflation-targeting
frameworks, but has also questioned some features of the framework.
One noteworthy change in the inflation-targeting framework in Australia (and elsewhere) is
communication. The content and scope of the communication has increased considerably over
25 years. I will spend some time outlining these changes and the motivation for them.
As I said, the second question about the appropriateness of the regime is very much the theme
of this conference. What, if any, changes to the framework might be worth considering? In the
final section I will raise some questions that will be considered by later speakers at the
conference and provide some brief observations on them.
When Glenn Stevens and I wrote in 1995 about the motivations for the (then) new
inflationtargeting framework in Australia, we said: 'if, some years hence, we can look back and observe
that the average rate of inflation has a "2" in front of the decimal place, that will be regarded as a
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success'. We are now quite some years hence and we can look back and observe that the
average rate of inflation has a "2" in front of the decimal place.
How did the regime come about?
Unlike a number of inflation-targeting countries, the adoption of an inflation-targeting framework in
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Australia was evolutionary rather than revolutionary. It was not accompanied by a change to the
central bank's legislation as was the case in New Zealand. Nor did it result from a rapid departure
from an exchange rate regime as in the UK and Sweden. But, like those other cases, it reflected
the recognition that previous monetary frameworks had not been successful in delivering either
price stability in the form of low inflation, nor desirable macroeconomic outcomes in terms of
sustainable full employment.
The inflation target in Australia was outlined in a number of speeches by the then Reserve Bank
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Governor Bernie Fraser in 1993 and 1994. It was a low-key launch, in part reflecting the political
climate of the time. As Steve Grenville and Ian Macfarlane noted, it was in the context of locking
in the low inflation that had occurred in the aftermath of the early 1990s recession.
The target was the operational interpretation of the goals of monetary policy set out in the
Reserve Bank of Australia's founding legislation in 1959, namely:
the stability of the currency of Australia
the maintenance of full employment in Australia; and
the economic prosperity and welfare of the people of Australia.
The stability of the currency goal reflects the fact the legislation was written when fixed exchange
rates were the norm. It has been interpreted as preserving the purchasing power of the currency
and hence is consistent with the maintenance of low and stable inflation.
As noted, the inflation target was first adopted by the Reserve Bank in 1993. It was verbally
endorsed by the government of the day. But it was not formally endorsed by the government until
1996, when the first Statement on the Conduct of Monetary Policy was signed jointly by the
incoming government and the new Reserve Bank Governor, Ian Macfarlane. The political support
for the inflation target has been bi-partisan. The Statement has been renewed at the start of the
term of each of the subsequent two Governors. It has also been endorsed with each change of
government.
The Reserve Bank Act 1959 states that monetary policy has both nominal and real objectives.
Consistent with that, the Statement on the Conduct of Monetary Policy makes it clear that the
inflation-targeting framework recognises both nominal and real objectives. The flexibility of the
target in terms of specifying that the inflation goal will be achieved over the cycle (subsequently
adjusted to be 'in the medium term') is the feature that recognises the dual mandate.
To maintain full employment requires that the economy be on a sustainable path. Thus the
trajectory of economic growth matters, as does the presence of low inflation and financial
stability.
In the case of demand shocks, there is not a material conflict between the real and nominal
objectives, as the monetary response is effectively the same. That said, the flexibility of the target
potentially allows for greater inflation variability to achieve lower variability in the real economy.
However, the experience of other inflation-targeting central banks suggests that this difference is
not substantial in practice.
In the case of supply shocks, where the monetary response to achieve the real and nominal
objectives is likely to be in conflict in the short term, the medium-term horizon of the inflation
target in Australia allows for a greater weight to be placed on output stabilisation and a more
gradual return of the inflation rate to target, than with a strict inflation target. Again, the practice of
most central banks over the past two decades has tended to evolve towards the sort of flexibility
explicitly recognised in the Australian target, notwithstanding the lexicographic ranking of inflation
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and output objectives in the specification of some other inflation targets.
The Statement has not undergone much change since 1996. The current formulation is: 'the
appropriate target for monetary policy in Australia is to achieve an inflation rate of 2-3 per cent,
on average, over time.' Beyond some drafting changes that simply reflect the passage of time,
the most substantive change has been the articulation of the financial stability objective of the
Reserve Bank, which I will return to later. In terms of the description of the inflation target itself,
the only change has been the objective from keeping 'underlying inflation between 2 and
3 per cent, on average, over the cycle' to keeping 'consumer price inflation between 2 and
3 per cent, on average, over time'. I regard this as purely a presentational change without any
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operational consequences.
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As I noted in a speech at the Bank of England last year, inflation targeting and central bank
independence are sometimes conflated given their similar birth dates in a number of countries. In
large part, this is because both were a response to the inflation experience of the 1970s and
1980s. In Australia, just as the inflation target was evolutionary rather than revolutionary, so too,
greater central bank independence also evolved through time rather than there being a distinct
break from past practice. As Ian Macfarlane stated: 'the Reserve Bank, by virtue of its Act in
1959, was always given a high degree of general independence as an institution. The fact that it
had been unable to exercise this independence in monetary policy for much of the post-war
period was due to a practical impediment - it did not possess the instruments of monetary
policy.' As these impediments were removed, the Reserve Bank was able to become more
independent in its setting of monetary policy. Thus while the formal recognition of this
independence was not completely visible until the first Statement on Monetary Policy in 1996, the
practical independence had been there some time before that.
The inflation target in practice
How has the inflation target in Australia actually delivered in practice?
The inflation target can be thought of as a 'thick point'. This doesn't mean that inflation with a 2
in front of it implies a zone of policy inaction. It simply acknowledges that inflation will obviously
vary through time and that there is probably not much to be gained from being too precise about
the appropriate inflation rate, whilst also recognising that the specification of the inflation target
plays an important role in anchoring inflation expectations. It would appear that the latter goal has
been achieved because the inflation expectations of the public have generally been consistent
with the target.Graph 1 shows the outcomes for inflation and unemployment (as well as the cash
rate, the instrument of monetary policy) and Table 1 summarises the macroeconomic outcomes
since the early 1970s. It updates a similar table in Stevens (2016). The table shows that the
average inflation rate over the inflation-targeting period has been 2.5 per cent. So the inflation
target has been achieved over its period of operation.
At times, the inflation rate has been above the band, at times it has been below the band (though
none of these deviations have been that persistent). This also illustrates the flexibility of the
framework, which I will discuss in more detail in the next section. Of note, as is apparent in the
graph, the inflation outcomes in the past decade have been at the lower end of the distribution of
outcomes over the period. That is, as in other countries, inflation in Australia has been lower in
the post-crisis period than in the decade preceding it. I will return to this point later in discussing
some of the current challenges.
While the average inflation rate has been consistent with the target, the real economic outcomes
have also been good. The average unemployment rate in the most recent decade is lower than
the one in the decade preceding it, which in turn was lower than the one prior to that.
Clearly, these outcomes are also a function of the macroeconomic environment, and cannot be
solely attributable to the inflation target. Part of the first period of inflation targeting was the
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NICE decade and macroeconomic outcomes in the late 1990s and early 2000s were better in
many countries, regardless of whether they had a (formal) inflation target or not. That said, many
of the early adopters of inflation targets had continued to experience sub-par economic
outcomes in the 1980s, particularly in terms of high inflation, when other countries had been able
to achieve successful disinflations.
But it is important to note that the period for which the inflation-targeting framework has been in
place has not been that benign. Most obviously, it has included the Asian crisis and the global
financial crisis, as well as one of the largest rises (and falls) in the terms of trade in Australia's
economic history - an event that has been the undoing of the Australian economy a number of
times in its history. Moreover, to paraphrase some words from Glenn Stevens in his final speech
as Governor: 'had anyone [in 1993] accurately forecast all the international events and
simultaneously predicted that things would turn out in Australia as they have, they would not have
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been believed. But here we are.'
The variability in global output has been higher in recent years, but by contrast in Australia it has
been lower. At the same time, the table shows variability of inflation has been lower in the
inflation-targeting period than in the period prior to that.
When inflation targeting was in its infancy, there was a lot of research in central banks examining
the trade-off between output and inflation variability and assessing the ability of different policy
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rules to achieve different points on that trade-off. This work followed on from that of John
Taylor, along with Dale Henderson and Warwick McKibbin. The inflation target has been
associated with the inflation/output variability curve in Australia shifting in, notwithstanding the
volatility of the world more generally. As Glenn noted, one significant contributor to the lower
output volatility in Australia has been the avoidance of a large downturn. But the avoidance of a
large downturn is in part a function of the avoidance of an inflation breakout, which in turn, I would
argue can be attributed, to a reasonable extent, to the operation of monetary policy under the
inflation target.
Hence, when we look back over the past 25 years: the inflation target has been achieved; real
growth has been robust; average unemployment has declined through time; and nominal and
real variability has been lower. So, I think it is reasonable to argue that the inflation-targeting
framework in Australia does seem to have played some part in contributing to the improved
outcomes.
Flexibility in practice
I will use four episodes over the past 25 years to illustrate some different features of the
operation of the inflation target in Australia, in particular illustrating the flexibility of the target in
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practice, as well as its forward-looking nature. The first episode is the first tightening cycle with
the inflation-targeting framework in 1994/95; the second, the response to the Asian crisis a few
years later. The third episode is the introduction of the Goods and Services Tax (GST) in 2000
where the price level was boosted by 3 per cent overnight. The fourth episode is the period
around the onset of the global financial crisis in 2007-08.
1994/95
By the middle of 1994, inflation pressures were building as economic growth was accelerating.
The unemployment rate had declined by 3 percentage points in two years and wage pressures
were evident.
There were doubts about whether the Australian inflation-targeting regime was sufficiently
serious enough to be able to curtail these burgeoning inflation pressures. Indeed there were
doubts about whether we even really had an inflation-targeting framework. One manifestation of
this was that the Bank of England was organising a conference on the nascent area of inflation
targeting and wasn't sure whether Australia should be invited or not. Graciously they did end up
including us and invited Glenn Stevens and me to talk about the Australian model alongside the
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stricter frameworks of New Zealand and Canada.
The flexible specification of the inflation target in Australia was seen as a vulnerability. It didn't
have the electric fence of the more hard-edged inflation targets in some other countries. The
'over the cycle' language was too 'fuzzy'. Reflecting such concerns, bond yields had risen quite
significantly in 1994 in anticipation of a material increase in inflation.
But inflation was still at its post-recession lows of 2 per cent when the Bank increased the cash
rate by 275 basis points in three moves over the second half of 1994. This pre-emptive tightening
was assessed to be necessary to curtail the Bank's forecast that inflation would rise. It is
noteworthy that the tightening occurred with inflation still only 2 per cent. Financial markets had
anticipated that significantly more tightening would be required, reflecting their lack of faith in the
new framework. Subsequently, inflation did actually rise to slightly above 3 per cent. The flexibility
of the target allowed the avoidance of an unnecessary cost to the real economy of trying to cap
the rise in inflation to below 3 per cent, consistent with the dual mandate.
In 1996, as demand pressures were easing, the Bank's forecast was for inflation to decline. The
stance of policy was eased, even though inflation was still above 3 per cent. The flexibility of the
target, and its forward-looking focus, allowed the assessment of whether the inflation target was
at risk in the medium term sense to determine the appropriate policy response.
That episode went a long way to enhancing the credibility of the framework with wage and price
setters as well as with financial markets. It also increased the confidence within the Bank that the
inflation-targeting framework would be successful in achieving the Bank's legislated goals.
The Asian crisis and exchange rate shocks
At the onset of the Asian crisis, the Australian economy was growing at around trend rates, with
domestic demand beginning to accelerate, and underlying inflation at 1.6 per cent. Monetary
policy had been eased over the prior year or so in anticipation of the decline in inflation that
subsequently occurred. Thus the Asian crisis hit the Australian economy at a time when it was in
reasonable shape with the stance of monetary policy already relatively expansionary.
Exports to east Asia accounted for around one-third of Australia's exports at the time. In the year
following the onset of the crisis, Australia's exports to the region declined by nearly 20 per cent,
directly subtracting around 1 percentage point from aggregate growth. Thus the decline in output
in the east Asian region represented a significant negative demand shock to the Australian
economy. Australia's terms of trade also fell sharply as commodity prices declined, further
exacerbating the decline in export demand.
In the event, inflation in Australia rose by less than was forecast, in part because of the decline in
the pass-through of the exchange rate depreciation, as well as a greater-than-expected
disinflationary impulse from the Asian region that put downward pressure on import prices.
If policy had been set to ensure that inflation did not rise above 3 per cent, the necessary rise in
interest rates would have exacerbated the contractionary shock to foreign demand. With the
benefit of hindsight, given the lower-than-expected inflation outcomes, this would have resulted in
a significant undershooting of the inflation target.
The flexible inflation target served as a useful framework to think about the Asian crisis. Strong
consideration was given to the goal of output stabilisation because the inflation target in the
medium term was not felt to be in jeopardy. 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.
Gst 2000
On 1 July 2000, a 10 per cent goods and services tax was introduced. As a result, the price level
as measured by the CPI increased by 3 per cent overnight. Hence inflation as measured by the
CPI was boosted, in a year-ended sense, by 3 percentage points for the next 12 months. The
increase in the price level was fully anticipated by the public and financial markets.
The Bank did not seek to offset the effect of the GST on the price level. Its assumption was that
the boost to the price level would be once-off, and that the (by now well-enhanced) credibility of
the inflation target would ensure that medium-term inflation expectations would remain well
anchored. The Bank communicated that this was its assessment well in advance of the
introduction of the GST to help condition expectations.
Again, the specification of the regime allowed the Bank the flexibility to look through the increase
in the price level. It is worth noting that such flexibility would be more problematic under a price
level targeting regime, or even a nominal income target. With a strict price level target, the effect
of the GST in boosting the price level would have to be unwound over some period of time,
notwithstanding that households were compensated for the change by income tax cuts.
In the event, the credibility of the target and the Bank's strategy was demonstrated. Inflation
expectations remained anchored. Nearly all of the public discussion at the time focused on the
inflation rate net of the GST effect. While policy was tightened around that time, it reflected
standard sources of price pressure such as strong growth, a rise in oil prices and a depreciating
exchange rate, not the effect of the price level shock.
While the mid 1990s episode went a long way to building the credibility of the framework, the
GST episode confirmed that the framework was well entrenched in wage and price-setting
behaviour in the Australian economy.
2007/08
From around 2006, it became clear that inflation pressures were again growing in the Australian
economy. The Bank's forecasts for inflation were revised upwards in late 2007 and into 2008.
Monetary policy was tightened to contain the rise in inflation as the Australian economy was
overheating. Inflation reached as high as 5 per cent.
But as the events in the global economy turned south sharply, the Bank was able to change the
settings of monetary policy quickly and rapidly, even with inflation still high. As the facts changed
and the outlook changed, in this case quite dramatically, the Bank changed its assessment about
the appropriate setting of policy. The fact that inflation was still high as these events unfolded did
not constrain the decision to reduce the cash rate. Again, the flexibility and forward-looking nature
of the framework together with its recognition of both the real, as well as the nominal goals, of
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monetary policy provided the necessary scope for action.
So throughout its 25 years, the specification of the framework has allowed the Bank to focus on
the medium-term outlook for inflation and not be unnecessarily constrained by any current level
of the inflation rate. That seems obviously appropriate behaviour now, and reflects the
decisionmaking process in all inflation-targeting frameworks today. But it was not obvious that this was
the appropriate approach to monetary policy back at the inception of inflation targeting. While the
confidence in being able to use the flexibility in the framework has undoubtedly increased, the
willingness to use it has always been there. You will note that I have not included the current
cycle of monetary policy in this assessment. That is still to play out and I will leave it to a later
iteration of this conference to conduct a post-mortem.
Communication
While the flexible operational approach to inflation targeting has been present throughout, the
communication by the Bank has changed quite substantially.
Prior to the introduction of the inflation target, the principal vehicle for the Bank's economic
commentary was the Annual Report and the RBA Bulletin. This commentary often ran to no
more than a few pages. There were speeches on macroeconomic issues by the Governor and
Deputy Governor. Changes in the stance of monetary policy had been announced since 1990
(which was quite innovative at the time), but were generally a one line statement announcing the
decision to change the cash rate. That was the extent of the public communication. There was
not much information to understand the central bank's general approach to monetary policy or
the central bank's reaction function. Financial markets had to employ large teams of analysts to
divine the central bank's intentions.
The advent of the inflation-targeting framework saw communication increase, though it should be
noted that this was a worldwide phenomenon and not confined to inflation-targeting central
banks. Why was there such an increase in communication? One reason that I have stated
before is that the inflation-targeting central banks did not have a good track record of monetary
policymaking. So there was a need to build that track record. A track record requires a track and
inflation targeting provided that track. But then you also need to make it clear to people how you
are progressing along that track and that is where the communication is important.
Given the relatively poor starting point, a high level of communication and transparency was
necessary to build credibility as quickly as possible, to enhance the effectiveness of monetary
policy and to help anchor inflation expectations. Mervyn King described this as 'trust building by
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talk'. That was very much the goal of communication when inflation targeting was in its infancy.
Similarly, communication was a mechanism to deliver accountability. As I noted earlier, inflation
targeting often went hand in hand with greater central bank independence. The quid pro quo for
greater independence was greater accountability. In Australia's case, the need for accountability,
and communication as one mechanism to deliver that accountability, was reflected in the first
Statement on the Conduct of Monetary Policy, which stated that 'it is important the Bank report
on how it sees developments in the economy, currently and in prospect, affecting expected
inflation outcomes'. It noted that this would include the Statements on Monetary Policy, public
addresses and required semiannual appearances of the Governor before the parliament.
Today, the extent and nature of communication have increased still further. The Statement on
Monetary Policy is a comprehensive document detailing the assessment of the current
conjuncture, the Bank's outlook for the economy, the risks and uncertainties around that outlook,
and an explanation of the Board's assessment of the monetary policy settings. The scope and
content of these documents have grown materially over the past 25 years.
All monetary policy decisions are accompanied by a statement explaining the basis of the
decision (whether the stance is change or not). Minutes of the Board's decision-making meeting
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are published two weeks later. The number and frequency of speeches by the Governor and
Deputy Governor, as well as other senior Bank staff, have increased. The Financial Stability
Review is published twice each year providing the Bank's assessment of those issues. There is
a website which makes this material, as well as other material describing the monetary policy
framework, readily available to the public. There is an extensive business liaison program and
recently an increase in focus on public education about the Bank's role.
So the volume of communication and overall transparency have increased materially.
In considering the changed nature of the communication, it is important to ask two questions:
what is the objective of the communication, and to whom are we communicating?
One of the critical roles of communication is a vehicle for accountability. That communication is
directed to the parliament and the public, to whom the Bank is accountable. It is also important
that the public and parliament have a good understanding of the inflation-targeting framework to
enhance understanding as to why policy decisions are being taken. They may not always agree
with them, but it is important that they can understand the rationale behind them.
Communication can help anchor inflation expectations, which in turn helps enhance the
effectiveness of the regime. There is strong evidence that anchoring of inflation expectations has
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been enhanced over the past 25 years.
It is also important the central bank's reaction function is understood. That is helpful for the
effective and timely transmission of monetary policy. It helps ensure that inadvertent monetary
policy surprises don't occur, which serves to enhance the overall credibility of the regime. This
communication is important for businesses and households in their decision-making. On the
basis of their outlook for the economy, they can have confidence in how the central bank is likely
to react and what that would imply for their borrowing costs. An understanding of the reaction
function is also important for financial markets participants in setting financial market prices that
form an important part of the transmission mechanism of monetary policy actions.
The effectiveness of communication or transparency is sometimes measured by interest rate
surprises. While this might be appropriate in some cases, sometimes the surprise happens
through a previous signal by the central bank. In my view, the surprise should be primarily
confined to data or event surprises. That is, with a well-understood reaction function, the vast
bulk of surprises should come from unexpected developments, not unexpected actions by the
central bank.
The amount and content of communication has been one of the most substantive changes over
the past 25 years. That has, in my opinion, been clearly beneficial for the accountability of the
Reserve Bank, as well as the effective functioning of the inflation-targeting framework. That said,
it is always worth checking that the increased communication is delivering signal rather than
noise. That is, the quality of the message is more important than the quantity.
Open issues
I have argued that the inflation target has delivered macroeconomic outcomes that have been
beneficial for the Australian economy. I think a strong case can be made that it has contributed
materially to better economic outcomes than the monetary frameworks that preceded it. I have
also noted that the framework in Australia has not changed much over the 25 years of its
operation, with the notable exception of communication.
So does that mean that the current configuration of the inflation target is the most appropriate or
that even that is the most appropriate framework for monetary policy? What changes could be
contemplated? Those questions are going to be addressed in other papers at this conference.
But let me raise some here and discuss issues worth considering around each of them.
The first is the role of financial stability in an inflation-targeting framework. The Reserve Bank
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research conference last year considered this issue at some length. As I said earlier, financial
stability is now articulated in the Statement on the Conduct of Monetary Policy. I talked about this
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issue at the Bank of England last year and Ben Broadbent is addressing it at this conference.
One question that arises is how the financial stability goal interacts with the inflation target. Is it a
separate goal that sets up potential trade-offs or is it aligned with the inflation-targeting goal? In
the latter case, a potential reconciliation is the time horizon. When it materialises, financial
instability is likely to be detrimental to inflation and unemployment/output: the global recession of
2008 and the subsequent slow recovery in a number of economies bears testament to the
potential costs of financial instability (althoug