Transcript of Question & Answer Session Low Inflation

Well the Deputy Governor has kindly agreed to answer some questions, but I'm here first, so I get to ask the first two, and then we'll pass it to the floor. After question time the Deputy Governor and I will leave this platform and Brian Sheahan who's the Chairman of Morgan's will come up to propose a vote of thanks. So, Guy, my first question is my Rudi Dornbusch question, which I was saving up from before.

There's increasing discussion in economics of the foreign exchange puzzle, actually there's a couple of puzzles. And currencies no longer seem to be driven by relative interest rates, the way they used to be. Currencies now seem to be increasingly driven by momentum. So my Rudi Dornbusch question is; why do currencies always overshoot?

Well, the question is slightly different from the premise, but there does seem to have been, interest differentials seems to have played a lesser role in the recent past than they have historically. I think that's fair to say. I think they still do play a reasonable role, there's just obviously other things going on, which have contributed to that. But I still would think they do play a reasonable role. We still think there is an exchange rate transmission channel, so that when we move interest rates, there is an effect on the exchange rate, which flows through to the economy and to inflation.

The overshooting story or proposition that Rudi put was basically the exchange rate has to fall far enough, for people to have expectations that it's actually going to rise in the future and that's when you hit bottom, and that also still seems to play a role. So you can have this period of overshooting before it reverses. The Australian dollar actually used to be, particularly back in the day, the poster child for this, where we used to go up the stairs and down the elevator. So we'd appreciate gradually and get to a high level and then we'd fall a long way until we got to a point where everyone had some confidence that we were going to start appreciating again. I mean, what's interesting in the exchange rate here over the last few years, is that the Australian dollar basically just hasn't really moved. On a trade weighted basis, we've barely budged for almost three years now, and even against the US dollar we've actually traded a pretty narrow range.

One thing which I think is interesting to think about, comes back to something I think you mentioned, I spent a couple of years of my night life developing this Code of Conduct for the FX market globally, and the structure of that market has changed materially over the last decade and even over the last 5 years. So basically there are very few people left in the market, in the FX market these days, a lot more machines, a lot less people in the market these days and this partly comes to your point about momentum. A lot of the trading strategies out there at the moment are very much momentum driven. Back in the day there were a decent amount of momentum traders too, but there's a lot larger share of the market these days which trade on momentum and on headline as well and a lot of that is because they are machine driven. So machines read the headlines, they've got a trading strategy which is programmed off the back of those headlines and then they start a movement in the exchange rate and then a bunch of momentum strategies pile in on top of that, until you get a person comes in and says maybe there's profit here and I'll take it the other way.

So the market structure has changed a lot in a way which I think is actually having something of an effect on the dynamics in the market.

Okay, so my next question now. I'm only allowed to ask one more question, then we need people to stand up and there are microphones around the room and we need people to go to those microphones and ask those questions. So, my last question is; last June, a researcher of the RBA, Tom Cusbert, published the paper on the non-inflationary accelerating rate of unemployment, and he estimated that the non-inflationary accelerating level of unemployment in Australia is now 5 per cent. Now, for those that are economists in the room, I know there are a few of you, this means that if unemployment is higher than 5 per cent, inflation should fall, if its lower than 5 per cent, inflation should go up. So, my question is since that time, since last year, Australian unemployment has been consistently above 5 per cent and do you think that this relatively high level of unemployment is also a reason that the Australian inflation is so low?

Yes, is the short answer. At the beginning of my talk I said there were a number of macro factors and that's the largest one of those macro factors that have contributed to the lower inflation, we're not miles above it, the unemployment rate at the moment is 5.4 per cent, our best guess is, of the NAIRU to save me saying all of the acronym at length is, is still 5 per cent. But where there's a decently large amount of uncertainty around that and it may well be the case as we get closer to 5 per cent, it may turn out to be lower, it probably in part depends on how fast we get there. But certainly, that's been one of the macro factors that has contributed to, obviously that has contributed to the low wage growth that we're seeing for quite some time now and like I said during the course of my talk today, that's very much fed into low rates of price inflation we've seen across any number of goods. But the fact that we actually have the unemployment rate coming down to 5 per cent at the end of our forecast at the moment and as we get close to that, we'll see, whether those inflation dynamics start to change or not.

Okay, questions from the audience. No questions from the audience? Alright yes, okay.

Guy, I'm one of the non-economists in the room and as we know inflation target has been between 2 per cent and 3 per cent for a hundred years now it seems, but why is it 2 per cent to 3 per cent?

That's a good question. It's only 25 years, not a 100 years. So why is it 2 per cent to 3 per cent? There are a number of explanations for that, one is; that if you have an inflation target too low then you potentially get too close to deflation and that can lead to dynamics that you don't want to see. I also think 2 to 3 fits, back in the day, Greenspan used to have this definition of inflation, the appropriate level of inflation is one where nobody actually pays attention to the rate of inflation, and I think 2 to 3 per cent fits that bill. No one really thinks about the aggregate, all that much, we do, but other people don't think all that much about the aggregate rate of inflation when it's in the sort of 2 per cent to 3 per cent zone.

There's not massive science as to why exactly it's that number versus some other number fairly close to it, but it's a number which has worked effectively for the Australian economy over the last twenty-five years or so. We actually had a conference, we, the Reserve Bank, had a conference earlier this year where we looked at 25 years of the inflation target and you know, the general opinion, and it wasn't just us saying this, was that the regime has actually worked pretty well. Why 2 per cent to 3 per cent? I think one way to think about it in, particularly for a non-economist, is basically it's a rate of inflation where you're not really going to notice it. If it's much higher than that, you probably would notice it, if it's much lower than that, then you're potentially straying too close to deflationary territory.

Question from Doug McTaggart.

It's good to see the Reserve Bank focusing on the entrails of inflation which I think is an appropriate thing to do. Two quick but unrelated questions, one; a recent Brookings study came out which substantiated or verified previous work over the last two decades, asserting that the rate of inflation constantly overstates, the published measure constantly overstates inflation by about 1 per cent. Which is effectively 50 per cent overstatement in the current numbers, and you did comment on some of the adjustments, the ABS makes, but do you think our numbers are about the same? And secondly; unrelated, but inflation related, would you care to comment on the causes of inflation in Venezuela?

That one's an easy one, I mean Rudi would have, Doug, sorry, Michael mentioned earlier about Rudi giving unwanted gratuitous advice, mostly actually to South American dictatorships, so Venezuela obviously very much fits that bill and he would have long ago given them any amount of unsolicited advice. But back on the Australian inflation rate, so some, one of the things that, so I mentioned during the course of my talk, the ABS is now updating the basket annually. So that substantially reduces thet known substitution bias, sorry for the non-economists, but I'll just use that term, but basically as prices go up, you shift to stuff which is cheaper, that's the quick version of substitution bias. Economists give these things fancy names but actually they're often quite straightforward.

So that's gone away, we don't think it was all that large but, we had a few of those things and you start to get close to that 1 per cent number you were talking about. By the way, that was actually something I should've mentioned in answering the previous question. That's one of the other reasons why we had 2 to 3, we came up with 2 per cent to 3 per cent was to allow for the problem that this, in trying to actually measure the actual inflation rate, so if you really wanted to have stable prices, you probably have to have a positive inflation rate just because, you can't measure it as accurately as you might like. So there's no slur on the ABS, they actually do a really good job on measuring inflation, it's just hard for them to actually do it but I do think, I haven't seen our latest research on this but I would guess that our estimate of the bias is actually a bit lower than 1, in part because now, the ABS has moved to updating the basket more frequently. The quality adjustments that I talked about during the course of my speech that the ABS does, are very similar to those that the BLS in the US does, so whatever that research showed around that for the US numbers would be pretty much the same as it is here.

So on Venezuela, in the long run, inflation is always and everywhere a monetary phenomenon. Print a stack of money, you generally end up with inflation. There's any number of countries in Latin America which have been good examples of that over the year and Venezuela is very much the poster child of that at the moment. When I was working for Rudi when I was doing my PhD, I was his general gopher and research assistant and one of the books we worked on, was on was hyperinflation in the Weimar Republic back in the 20's and hyperinflation in a number of Latin American economies. What the Venezuelans did yesterday, where they just lopped 5 zeros off the end of the currency, as you do, so that actually is very much out of Latin American inflation playbook 101.

Back in the day when the Brazilian and Argentinians were, and the Bolivians were past masters of this, this used to happen about once every six months, you'd just lop 5 zeros off the end of the currency. Saves you actually having to print a bunch more notes as well by adding 5 zeros, you just lop them off the end.

Back to Ross Elliott, I think.

Thanks Michael. Guy, a quick one, because we're short of time. You've made the comment that there's no one single housing market and likewise there's no really one single economy in Australia but there's only one single instrument, at the Reserve Bank's disposal which is the cost of money. When you start to see, the perception is at least that Sydney and Melbourne economies are becoming increasingly dominant, in Australia. How do you balance that? When you make those evaluations that, trying to cool activity in Sydney and Melbourne, will have a much more dramatic impact in Mackay or Gladstone or Townsville.

So I'm from Adelaide, so that's just something altogether different. I suppose, in the end, you're right, we, the Reserve Bank only have one instrument which is the cash rate and that affects the whole economy. Other arms of government most obviously, the federal government have fiscal policies is a way where you can deal with some of those regional differences. But in the end we only have the one instrument for the economy as a whole. The ABS … going back we aggregate up the economy in proportion and I certainly don't think we're driven by any one market disproportionately. For instance at the moment there's Sydney, Melbourne house prices are falling so, but other prices in other parts of the country are actually rising. One thing which is interesting to note in terms of the regional differences is that at the moment, at least state by state, they are about as low as they have ever been. So the difference in unemployment rates across the states, I'm not talking about different parts of the states, but across the states, basically is low as it's ever been. My home state, South Australia, now has the third lowest unemployment rate in the country, which is probably the first time in a few decades that's been true.

But the regional differences as of today have actually narrowed quite a bit but it is something we take into account. So one thing we do do is that we, and here's a plug for Paul and our liaison program here, so we have a business liaison program in each state. And they don't just hang out here in Brisbane, they get out to some of the places you were talking about to get a better understanding of what some of those regional differences are, to get a better insight into the way, just looking at the aggregate data isn't going to tell you and talk to the businesses and the community groups in each of those different parts of the country. So we do try and get a lot more colour than just looking at the aggregate numbers.

But in the end as you say we just have, we do only have the one instrument and to some extent, given our mandate, we've got to set it for the country as a whole but not disproportionally focusing on any one particular region.

Okay, so our last question has to come from Tim who's a former president of the state of the Economics Society of Australia Queensland division.

Thank you very much. You mentioned just a second ago, the relationship between printing money and interest rates. The United States have printed quite a bit of money, and maybe we, I don't think we've seen the effect on their interest rates, even though it's crawling up from the last of couples of years, do you have any comment on why we're not seeing, maybe a more dramatic impact from them printing the money?

Yeah, that's a good question and one which is asked a lot. So, one of the reasons the Fed expanded their balance sheet as much as they did was because … if you look at the sharp reduction in the banking sector, over that period of time, then they basically filled in that hole. If you put it in basic economics terms, the velocity of money went down a hell of a lot or has gone down a hell of a lot over the past 10 years ago and the Fed basically intermediated what the banking sector had disintermediated. Now that the US economy is very much on firm footing and is going along really well at the moment, they're reversing the course on that so not only is the Fed, it's something that people may fully aware of, not only has the Fed been raising its interest rate for the last few years, it also started to shrink its balance sheet as well and that's to unwind what it did over the previous 10. But it was those countries which their central banks expanded their balance sheet was very much to offset the effect of the massive financial disintermediation that we saw over that 10 years, or since the crisis.

Okay, so that's the end of our questions, we'll now leave the platform and then Brian Sheahan, the Chairman of Morgans Financial will come up and give a vote of thanks.

Ladies and gentlemen thank you all for attending this important lunch today. Morgans is again proud to be a sponsor of the event and on behalf of my colleagues and fellow sponsors from UQ, NAB and the Economics Society of Australia, I'd like to thank the Deputy Governor for his address today. Today, the Deputy Governor has given us some rare and interesting insights into the workings behind the all-important CPI number. And his address today serves as a strong reminder to what a great job the RBA has done in reigning in the volatility of inflation rates since the early 90s and it's really comforting to hear his outlook for the future in terms of where this inflation rate is going.

I was reflecting down there listening to the Deputy Governor that in my lifetime I've seen inflation rates ranging from 0 per cent to 17 per cent and certainly when I bought my first house the mortgage rates were about 17 per cent, 18 per cent on the back of a 10 per cent inflation rate or just under 10 per cent inflation rate. So as you'd imagine for most of you who are a fair bit younger than me here, that if you were trying to manage that either as a, from a personal budget basis or a business basis it would be a bit of a challenge. So certainly really comforted that the Reserve Bank has done a great job in setting those targets and certainly been able to keep to them. I think I looked at numbers and I think since the year 2000 the range has been from around 0 per cent to 6 per cent so it's been very well tracked.

Certainly, I think that judging by the number of people here Deputy Governor obviously, these insights that we get, are very valued or highly valued by Queensland business community so thank you very much for that and thank all of you for attending. I'd also like to express my thanks to Julian and the ESA for their great work for facilitating today and also for the great initiative in bringing forward these lunches once a year to Brisbane and given your commitments, I know the Deputy Governor it's great to take the sacrifice for your time to come up here today and give us a presentation so, ladies and gentlemen, please join me in thanking the Deputy Governor for his presentation today.