It’s been obvious for several years that the field of economics has entered a new Dark Ages. Here’s another example, from a couple articles discussing Australian monetary policy. First, James Alexander sent me this gem, discussing the views of RBA board member John Edwards:
“It has never been the view that the target had to be achieved each and every quarter, or for that matter each and every couple of quarters, or year for that matter,” Edwards was cited as saying. Australia’s annual inflation rate has been below 2 percent since the third quarter of 2014.
The RBA’s first
rate cut in a year on May 3 came after data showed that some of the disinflationary pressures weighing upon economies from Japan to Europe are also being seen in Australia. The consumer price index dropped for the first time since 2008 in the first quarter, while annual core inflation growth slowed to the weakest on record, prompting the central bank to cut its inflation forecasts.
Some economists have argued that the inflation target should be lowered to reflect global and domestic forces that could keep downward pressure on prices for some time, the WSJ reported. The central bank will be forced to cut interest rates to 1.5 percent by August, according to most economists surveyed by Bloomberg.
This was a widespread view in the 1960s and 1970s. Inflation was not caused by monetary policy; it reflected other forces. By the 1990s were we out of those Dark Ages, and that view was thoroughly discredited. Actually, it was more than just discredited, it was widely mocked. And now it’s back.
Stephen Kirchner sent me another piece on the RBA:
Former Reserve Bank of Australia governor Ian Macfarlane has lashed out at financial markets – particularly those offshore – for effectively forcing the central bank into a wasteful knee-jerk official interest rate cut this month to avoid falling victim to an increasingly erratic global currency war.
In his first public comments about Reserve Bank rates policy since handing over the governorship to Glenn Stevens a decade ago, Mr Macfarlane lambasted currency traders and analysts for assuming the central bank should always adopt a slavish adherence to its 2-3 per cent inflation target.
Describing current monetary policy as “easy” – or stimulatory – he said there was nothing in the central bank’s approach that locks it into making a cut every time a statistical report shows inflation is below the goal.
Here’s the problem. Financial markets never have Dark Ages—they always understand what’s going on. So when economics enters a new Dark Ages, the views of economists will be rejected by the financial markets. Economists will then lash out at the irrationality of markets, when it’s actually the economics profession that has lost touch with reality. (And yes, I’m also talking about the Fed.) Australia’s economic policy is clearly too tight to hit their targets, and yet they continue to insist that policy is expansionary.
Mr Macfarlane’s intervention – just as Macquarie Bank predicted on Thursday that the lack of fiscal stimulus and need for a weaker currency would see the official cash rate slashed to 1 per cent – indicates a growing desire to re-educate analysts and markets about both the limits of monetary policy and the need for greater flexibility around how the target is used.
“When countries introduced inflation targeting 20 or 25 years ago, they never envisaged a world where inflation was so low that it was below all major countries’ targets,” Mr Macfarlane, who was the first to formally announce the target when it was adopted, said.
That’s right, markets that foolishly believed that the RBA would adhere to its inflation targets need to be “re-educated”. In fact, it’s Mr. Macfarlane who doesn’t understand what’s going on. The markets are well aware of the fact that the RBA is willing to let inflation stay below 2%, and that’s precisely why they are putting pressure on the RBA to drive interest rates ever lower. If markets expected 2.5% inflation going forward (the RBA target), then interest rates would probably be higher than 1.5%.
More confusion:
However, Mr Macfarlane, who is now an ANZ Bank director, suggested that one of the triggers for the surprise May cut was a fear within the central bank that markets would have reacted violently had the board left the cash rate unmoved two weeks ago because the weak inflation figures implied a cut was urgently needed to meet the 2-3 per cent target.
In the lead-up to the May rate meeting – which the Reserve Bank this week indicated was a close call – the Australian dollar traded above US78¢, an uncomfortably high level given the bank’s goal of driving down the currency to help the post-resources adjustment.
Within the board, there would have been a genuine fear that a decision not to cut could have sent the currency shooting dangerously above US80¢.
“Their problem [at the Reserve Bank] is that financial markets, particularly offshore, assume a mechanical application of what they regard as the standard model,” Mr Macfarlane said.
“The inflation targeting approach says that if inflation forecasts are below target, we should run an easy monetary policy – we already have that,” Mr Macfarlane said.
Here’s what’s actually happening:
1. Australia doesn’t already have easy money; they have tight money.
2. Global Wicksellian equilibrium interest rates have fallen sharply, and central banks have been slow to accept that fact. Just as many of my commenters are slow to accept the fact that global productivity growth has slowed to a crawl. Reality’s a bitch.
3. When the RBA (unexpectedly) holds its policy rate above the equilibrium rate, money is tight and the Aussie dollar appreciates sharply in the forex markets, which drives inflation even further below the RBA target. The lower inflation then leads to calls for even further rate cuts.
The bond market sees what’s going on:
The benchmark 10-year government bond yield crashed this week to its lowest level in 141 years on financial market predictions that more official interest rate cuts are likely in coming months.
Over at Econlog, I have a post on the new Dark Ages in international trade.