The Reserve Bank of Australia has cut its official interest rate to 0.25%. The bank’s governor, Philip Lowe, reckons this is as low as the bank can go.
The cut – the first this century to have been decided outside the normal monthly meeting of the bank’s board – underlines the economic threat posed by the COVID-19 pandemic. It follows the bank cutting the rate by 0.25 points to 0.50% at its February meeting.
Australia and the US have joined nations across Asia and Europe where rates are near zero and policymakers have run out of wriggle room to cut them further.
US President John F. Kennedy said: “The time to repair the roof is when the sun is shining.”
Conditions are already gloomy, but before the next storm hits it is imperative we think about what we are going to do.
The option most often discussed when rates approach zero is quantitative easing, in which the Reserve Bank (and similar institutions) use newly created money or reserves to buy financial assets such as government and corporate bonds.Joel Carrett/AAP
But here I want to explore an alternative policy that should make monetary policy powerful even when interest rates are zero, by changing expectations of where future rates will be.
To achieve it, central banks need to make a subtle but significant change to the target that drives monetary policy.
Inflation versus price
They have less ability to achieve the inflation target when cash rates are close to zero.
The drawback is permanently higher average inflation, which is known to be costly for society.
The difference is small but significant.
Let’s say the consumer price index begins the year at 100.
An inflation target of 2%-3% would aim at having the consumer price index reach 102-103 by the end of the year. If at some point during the year inflation was higher or lower than 2%-3% annual growth, the goal would be to get it back to that growth rate.
After than was done, the index might end up somewhere higher or lower than 102-103.
A price-level target differs by aiming to stick to a path for the level of the index, and return it to that level if there is any deviation. So if the price level target was 102-103, the target would return to 102-103.
These diagrams compare what would happen under inflation targeting (IT) with what happens now under price-level targeting (PLT).
- ^ 0.50% (www.smh.com.au)
- ^ More than a rate cut: behind the Reserve Bank's three point plan (theconversation.com)
- ^ just below 1.25% (www.washingtonpost.com)
- ^ near 0% (www.theguardian.com)
- ^ buy government bonds (theconversation.com)
- ^ 'Yield curve control': the Reserve Bank's plan for when cash rate cuts no longer work (theconversation.com)
- ^ 2% to 3% (rba.gov.au)
- ^ 'Guaranteed to lose money': welcome to the bizarro world of negative interest rates (theconversation.com)
- ^ increasing the inflation target (www.imf.org)
- ^ price-level target (www.investopedia.com)
- ^ The Fed will have to do a lot more than cut rates to zero to stop Wall Street's coronavirus panic (theconversation.com)
Authors: Mariano Kulish, Professor of Macroeconomics, University of Sydney