Show Me The Monetary Policy

Sun Herald

Sunday August 31, 2008

Penny Pryor

Just what should central banks be looking at when deciding interest rates?

THERE'S a new debate raging among the economist hoi polloi. Well, it's actually an old debate, The discussion is all about prices and inflation and what measures the Reserve Bank of Australia should really be looking at when it comes to fixing interest rates and monetary policy.

So it's a fairly important debate for everybody who has been feeling the pinch of higher interest rates and is praying for them to come down.

Central banks around the world all use inflation measures when they meet each month and decide what to do about interest rates. If inflation is above their preferred numbers - 2 to 3 per cent in Australia - they may raise interest rates; if it's below it, they may lower them to stimulate the economy. But the problem is there are many different measures of inflation. What you usually see reported is the core CPI number - now sitting at 4.5 per cent - this generally includes everything.

Central banks, on the other hand, look at "underlying measures" of inflation. In the case of the US the underlying measures exclude oil and food. The argument for this is that food prices are influenced by weather, rather than demand or supply, and oil prices are influenced by the whims of OPEC, rather than demand or supply. That was the old argument, anyway. The new school of thought says that that food and oil prices are very much influenced by demand and supply and their increases are going to be ongoing and should therefore be considered when looking at how to tweak monetary policy to speed up or slow down the economy.

This is already the case in Australia. The Reserve Bank looks at underlying inflation but those measures don't automatically exclude oil and food. What they do do is take a "trimmed mean" that excludes those categories that have had the highest increases. Recently that would obviously be oil and or food but it doesn't have to be.

Another measure weights each item by importance. With inflation well above our RBA's preferred level of 3 per cent, and possibly to remain there for at least another 12 to 18 months, there has been the suggestion that the target band should be changed. After all, if the RBA's target was higher we would have avoided the recent rate hikes. Well, we might have, but if the band is raised then inflationary expectations usually follow that prompts wage increases and the cycle of inflation could just continue.

The important thing to keep in mind is that monetary policy - i.e. the movement of interest rates - is a blunt instrument. It always will take between 12 and 18 months for their impact to be felt on the economy. Let's just hope that the interest rate hikes of earlier this year don't start to hit the economy at the same time as a global recession.

© 2008 Sun Herald

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