Why relaxing inflation targets would be bad for investors

Key points

• Rising food and energy prices are leading some to argue that inflation targets need to be relaxed.

• This would be a big mistake. The 1970s experience tells us that allowing higher inflation to become entrenched will lead to more, not less, economic pain.

• Sustained high inflation would be bad news for investors as the boost to investment market valuations from the move to low inflation (which drove strong investment returns in the last 25 years) would reverse.

• A permanent 2% rise in inflation could knock A$140 billion off the value of Australian’s superannuation investments.

Introduction

There is much debate about whether inflation targeting should be abandoned or the target increased. The basic argument is that the Reserve Bank of Australia (RBA) (and other central banks) can’t do much about surging global food and energy prices and that to attempt to do so will result in unacceptable economic pain. In Australia’s case some have suggested the inflation target should be raised from 2% to 3% to say 3% to 4%. While one can debate the appropriate level of interest rates necessary for inflation to meet the current target over time, raising the target itself would be a big mistake. It would entrench the recent rise in inflation and risk taking us back to the slippery slope that led to the high inflation and economic calamity of the 1970s. Moreover, such a move would be disastrous for investors – including all Australian superannuation fund members.

Inflation targeting

Setting inflation targets and charging the central bank with achieving them has been central bank best practice since the early 1990s. It was first introduced as a way of anchoring inflation expectations such that when there is a price shock – such as a sharp rise in food or fuel prices – it doesn’t set off a self-perpetuating wage price spiral like in the 1970s. New Zealand was the first to have a target but now many countries have them. Both the European Central Bank and the US Federal Reserve (Fed) target inflation below or close to 2% (although the Fed’s target is not formalised).

Australia’s inflation target was first introduced in 1993 and became formalised in 1996. At 2% to 3% it is actually a little higher than in many other countries. It is also interpreted as being over the course of the business cycle, which means the RBA is prepared to accept inflation being outside the target for a year or two providing it is confident it will come back within the target over the medium term. For example, it currently expects inflation to exceed 3% until 2010.

Over the last 15 years or so inflation has been pretty low in most countries. Since 1993 inflation in Australia has averaged 2.6% per annum (pa). This of course is in stark contrast to the 1970s and 1980s when inflation averaged 10.7% pa (with a high of 17.6%) and 8.3% pa respectively. See chart below.

The problem with inflation

After such a long run of low inflation and benign economic conditions it is natural to forget the pain that out of control inflation can cause. In the current environment some see allowing a little bit of extra inflation as a good thing, as a way of avoiding the higher unemployment that might result if we try and bring it to heel. However, this is exactly what was thought in the late 1960s and early to mid 1970s, but the result was disaster. Because inflation leads to higher nominal growth, particularly faster wages growth, it may seem good at first but it is ultimately bad:

• It reduces the value of cash - if inflation is high $100 won’t buy nearly as much in a year as it does today.
• As a result, high inflation results in an incentive to spend and hoard rather than save and produce.
• It leads to higher interest rates as savers demand a higher return to compensate for inflation. In fact, the 1980s highlighted that average interest rates rise even more than the rise in inflation because in a high inflation world savers/lenders require compensation for the extra uncertainty caused by high inflation. So rather than just the current cyclical rise in interest rates, borrowers would have to pay even more on a sustained basis if inflation was allowed to stay high. In the 1980s, 90-day bank bill rates averaged 14.5% and 10-year bond yields averaged 13.5%, double current levels. On our rough estimates, a sustained 2% average rise in Australia’s rate of inflation above the 2.5% average of the last 15 years would mean a sustained average standard variable mortgage rate of 10.25%. This would wreak havoc on home borrowers given current debt levels. It would add to downwards pressure on house prices.
• High inflation leads to a focus on investments which protect against inflation (eg, property speculation) rather than productivity enhancing investments.
• As a result, high inflation leads to relatively low productivity and gross domestic product (GDP) growth. Over the decade to 1984 Australia’s real growth rate averaged just 2.5% pa.