Lowe biffs Macfarlane

As this blogger has noted before, former Reserve Bank governor Ian Macfarlane enjoys an unchallenged reputation as a pioneering asset-bubble buster, despite being in some significant part, responsible for same said bubble.

Not any more.

Last week, Deputy Governor Phil Lowe stepped up and during a speech dedicated to the subtleties of inflation targeting, delivered this:

This more flexible approach has two advantages. The first is that, in the event that inflation turns out to be unexpectedly too high or too low, the central bank has some flexibility about the pace at which inflation is returned to the target range. Provided the central bank's commitment to medium-term price stability is credible, this flexibility can deliver better outcomes for the real economy.

The second advantage is that this flexibility provides greater scope to take into account not just the central forecast, but also the medium-term risks around that forecast.

Let me try and make this a little more concrete by asking you to think about an economy that experiences a positive supply shock, say an improvement in productivity or lower world prices for the goods that it imports. Normally, this type of shock would be expected to boost economic growth, increase asset returns and lower inflation, at least for a time.

What then is the right monetary policy in this economy? In a world in which the setting of policy is determined solely by the two-year-ahead inflation forecast, the answer may well be to lower interest rates. If inflation is forecast to be below the target midpoint in two years time, lower interest rates, at least for a while, would help get inflation closer to target.

But would lower interest rates be the best response? To answer this I would need to tell you some more parts of the story. If asset prices were rising very quickly, investors were exuberant, and the financial sector was making credit liberally available, then lowering interest rates simply to hit the inflation target at one specific point in the future may not be the best response. Experience has taught us that low interest rates at a time of rapid increases in leverage and asset prices can pose significant medium-term risks to the outlook for the economy and for inflation. Ignoring these risks, and making leverage cheaper by lowering interest rates, simply to ensure that the short-term inflation forecast was at the target, is unlikely to be the best policy.

The general point here is that while the central forecast for inflation itself will often provide a good guide for policy, this will not always be the case. On some occasions, the medium-term risks are just as important.

Regular readers will recognise that these are the precise conditions that prevailed during the first half of Ian Macfarlane's tenure at the top of the bank. As Lowe's graph clearly shows, in 1996 Macfarlane inherited an economy in the midst of a productivity shock:



One couldn't exactly say that Lowe is blaming Macfarlane for the Great Australian Housing Bubble, but he is a definitively rejecting the doctrine deployed by him.

And in doing so he has intrinsically redefined the former governor's legacy from one of bubble-buster to one of bubble-creator.

In the gentile terms of public debate around rates, this is pretty close to a right cross to the temple.

The RBA is so hot right now.