The Australian Financial Review
22nd May 2000

The recent large $A depreciation has revived memories of the 1980s and the monetary policy tightening that ended in the recession we "had to have" (but should not have). Indeed, with the $A running near all time lows, one "expert" whose voice had scarcely broken spluttered on the ABC that this is the dollar's worst crisis! And, with the Federal Reserve's official cash rate now half a per cent above the Reserve Bank's 6.0 per cent, many say  the Reserve must follow to "protect" the dollar.

However, such thinking is quite outdated. There is absolutely no reason why Australia cannot now run an independent monetary policy and avoid further rate rises. Even apart from the much greater US inflationary pressures, our situation today is totally different to the 1980s. Then, Labor's basically Keynesian macro policies kept inflation running well above the OECD average and, until far too late, the Reserve Bank had to accept an inflation rate largely determined by wages set through Accords with unions.

Today, both Government and Opposition are at least committed to balancing the budget over the cycle. Further, while this year's Budget leaves something to be desired, "estimates" of considerable forward surpluses indicate it is substantively "on track", even allowing that such estimates need discounting. Most importantly, in a too-little-noticed structural change, the responsibility for controlling inflation has passed to a Reserve Bank that has substantial independence and is committed to maintaining low inflation.

We now have a monetary policy target to keep underlying inflation to an average of 2-3 per cent pa over the cycle and a rate currently well within that target. Accordingly, the main argument today is not about how to get inflation down, but how  to maintain medium term price stability without adversely impinging on growth. We could be so lucky!  

But, what about the dollar? Shouldn't we be concerned about its fall? With one main proviso, the answer to that question is a firm "No" in circumstances where macro policies and inflation are basically on track - which is clearly so at present. The proviso is that, if markets became "disorderly", there may be a case for the Bank to intervene in the foreign exchange market to "smooth" fluctuations in the rate. But the  Bank should stick to its stated policy of not targeting an exchange rate and, hence,  not changing monetary policy to influence it.

Of course, if a depreciation pushed inflation above the target range on a sustained basis, the Bank might need to tighten  policy. But, the first round inflation effects from increased import prices flowing from the recent $A depreciation are one-offs comparable to the GST. Indeed, from one perspective all depreciations are a tax - but levied by foreigners!

Importantly, the recent $A depreciation does not reflect excess demand in the domestic economy or a current account deficit out of control. That depreciation is also a one-off in that both macro policy settings and the current account provide no basis for supposing any further substantial depreciation. Indeed, with a real effective exchange rate significantly below its long term average, there could be a substantial reversal over the next 18 months, particularly if the world economy strengthens as forecast.

Accordingly, any first round effects from the recent depreciation should not be counted in the underlying inflation rate and, hence, should not cause any tightening in monetary policy. If inflation moved above 3 per cent, that should be treated as a one-off until it became clear that the flow-through had become embedded. Even then, given the existing target provides for an average of 2-3 per cent over the cycle, there would be a case for waiting to see if natural competitive forces responded to higher import prices and worked the effects off over time (who remembers the "J curve" effect?!)

The Bank's Semi-Annual statement of 3 May correctly suggests the pass-through effects of the latest depreciation could be stronger than in 1997 and 1998 when more competitive conditions prevailed. However, competition remains strong and the statement also indicated that "on present assumptions, inflation on a year-end basis, and net of tax effects, is projected to be between 2 and 3 per cent in the second half of 2001".

In short, the Bank is "forecasting" inflation to stay within target over the foreseeable future. The clear implication is that, provided "present assumptions" are met (including presumably those allowing for the inflationary effects of depreciation),  there is no reason to expect a further increase in interest rates. So much for the speculation that the Bank is taking a different view to Treasury!