Jonathan Reeves

As it tries to find a way out of its debt ceiling crisis and the economic doldrums, a consequence of US policy is that inflation is being exported to the world, and that includes Australia.

Unlike the European Union, or indeed any other enterprise in the world, the US Federal Reserve has the unique ability to print more US dollars if it – and the US Treasury – deems that this is in the US economic interest.

We have had QE1, we have had QE2, and as a result of the debt ceiling compromise we may well also have QE3. The US debt deal includes major fiscal cut-backs, increasing the likelihood that the US will continue to rely on heavy monetary stimulus in its post GFC recovery phase.

It is a policy which is keeping the value of the greenback down and contributing to the record high values for the Australian dollar, a factor which is not necessarily good for our economy. Just ask the Australian education, tourism and manufacturing sectors how they are faring right now.

Inflation is a global issue and the Americans are only one, albeit large, factor in fuelling its momentum. Energy costs are rising, as is the cost of food around the world.

The reality is that US policy has intentionally devalued the $US through the mass printing of money, putting substantial pressure on the AUD$ exchange rate and the Reserve Bank’s inflation and interest rate policy.

Currently, the RBA has an inflation target of between 2 and 3 percent. Referring to this target has been a major reason why the RBA’s official cash rate have progressively risen to 4.75 percent. With a widening interest rate differential it is no surprise that the $AUD has climbed so high against the greenback, as speculators pile into a currency which – like the Brazilian real – is one of the hottest in the world right now.

All this calls into question the wisdom of the RBA’s target inflation numbers. The 2 to 3 percent per annum target is far too low in the current economic climate, and adhering to it can only exacerbate the developing exchange rate, interest rate and export issues we are currently experiencing.

Instead, the RBA should raise its inflation target to 4 percent, a move which would help us avoid some of the economic problems we have seen internationally. Raising the target would certainly take some of the pressure off the RBA to raise interest rates, and it would also take some momentum out of the $AUD’s strength.

Mining magnates may be sitting on unprecedented wealth, but a look at the rest of the economy shows that personal debt levels are at record levels – comparable to struggling economies such as Ireland. Raising rates to fight inflation would create significant financial distress and prompt sharp falls in property values, further dampening already fragile consumer and business sentiment.

Inflation at 4 percent would assist in reducing debt levels, as it did in World War II following the Great Depression.

It seems that the RBA may be mindful of this, despite maintaining its current inflation targets. Earlier this month RBA Governor Glenn Stevens said the board believed “it was prudent to maintain the current setting of monetary policy” in view of the “acute sense of uncertainty in global financial markets over recent weeks.”

The RBA has not raised rates since November 2010, and inflation has been creeping upwards and currently sits at 3.6 percent. Officially amending the inflation target would take the wind out of ongoing expectations of a rate rise and could prompt some easing in the value of the $AUD.

At 3.6 percent, Australian inflation is not high by current international comparisons and does not pose as much of a threat to our economy as record highs for the currency. Given two “evils” – inflation or an appreciating currency – it is clear that our current level of inflation is by far the lesser evil of the two.

In fact, tolerating a higher level of inflation could be the key to helping Australia navigate the turbulence of the global economy.

 

Dr Jonathan Reeves is a financial economist at the Australian School of Business at the University of New South Wales.

A version of this opinion piece appeared in the Australian Financial Review on the 9 August 2011.