Australia: Inflation and Monetary Policy

Australia: Inflation and Monetary Policy Monetary policy refers to the Central bank's effort to regulate the financial markets with the help of taxes or Interest rates. Just like the United States where Federal Reserve Bank steps in with monetary measures each time market requires regulation, other free market economies also take help of monetary policy to stimulate or de-stimulate the economy.

Whenever the economic situation is such that investment and borrowing level have decreased and consumer spending is at an undesirable stage, then central bank of that country is required to take some measures to increase economic activity in the country. The measures taken by the central bank are termed as the monetary measures while those that government takes directly are known as fiscal measures.

Monetary policy has been very successful in the United States and it can work well in free market economies like Australia where inflation rate has usually been below the targets set by Reserve Bank of Australia. Reserve Bank of Australia is the central bank of this country which is responsible for introducing all monetary measures and for formulating an effective monetary policy. RBA has been setting targets for inflation in the country and they normally stand at 2-3%. Interestingly the real inflation has always fallen short of this target.

In 1995, for example, the RBA issued a paper indicating its inflation goals and explained: "The inflation objective in Australia is to maintain an average rate of increase in consumer prices, in "underlying terms," of around 2-3 per cent over the medium term." The paper further explained what was meant by this 2-3% goal: "The "2-3" should be interpreted as a broad central tendency for inflation, a "thick point," rather than as a narrow "target band," in the usual sense of that term.

It is not a range within which the Bank feels inflation must, or necessarily can, be maintained at all times and under any circumstances. Such a narrow band would in our view be much too ambitious, given the difficulties of short-term forecasting and control of inflation - an issue to which we return below. Given some cyclical variation in inflation and the occurrence of myriad minor shocks affecting prices, some deviations will almost certainly occur." (Debelle, Stevens, 1995) Interesting even after 14 years, the same problem exists.

RBA's targets for inflation still stand at 2-3% but Australia has not been able to meet it recently. As recently as end of the last month, inflation stood at 1.7% which is actually lower than 1.9% in July. The role of monetary policy is to either control the supply of money or to expand it depending on the current situation of the economy. In Australia, government would want to adopt more expansionary measures in order to raise the inflation level because too low inflation indicates lower consumer spending.

But for this paper, let us assume what will happen if Australia's inflation level actually went beyond the RBA targets. Australia has now become of the countries which actively target inflation. This framework was adopted because previous monetary measures had been unable to keep the inflation rate low (Agrawal ). Now the inflation is consistently low for some years which may be a cause of concern for the country but apparently Australia is still more concerned about the possibility of rising inflation than low inflation.

Let us now assume what will happen if inflation actually goes beyond the 2-3% target set by RBA. What are the repercussions of low and high inflation? This is very critical question and one that must be understood in order to see why Australia might be concerned about high inflation and what needs to be done in expansionary or contracting market.

When there is high inflation, it indicates that prices of goods are rising, which in turn indicates that people have additional money to spend and hence money supply is far beyond the levels expected by the central bank. In such a case, central bank can use monetary measures to control inflation. These are usually in terms of interest rate increases which can curtail lending and borrowing and drains excessive money out of the economy. This can help in bringing down the prices and hence the rate of inflation.

However when inflation is low, the opposite of these measures is adopted to allow more lending by the banks and people can borrow more easily hence accelerating economic activity in the country. If Australia's inflation rate rises, it is not a cause of concern if it is still close to the target but can turn into a serious issue if inflation is much beyond the target. This is because Australia depends on low inflation for its prosperity.

In the last few years, the robust growth in economy has been due to low interest rates. In a high inflation scenario, these rates can no longer be offered to the public which can cause problems as economic activity would slow down. This is what had happened in 1970s and 1980s when inflation was much higher than what RBA had expected. These two decades of high inflation forced RBA to actively target inflation rate to keep it around 2-3%.

Australia's consistent drive to bring down the inflation rate is grounded in the fear that high inflation would result in economic slow down. Meredith and Dyster add: "High inflation rates persisted in Australia from the early 1970s to the beginning of the 1990s. During that period, economic growth was on average below the levels of the previous two decades and there were recurrent bouts of economic stagnation. The full employment conditions of the post war period were gradually eroded, with double digit.