RBA Raises Inflation Forecast - Essay Example

?Economics Article: RBA raises inflation forecast as traders raise rate expectations Summary Monetary policy of any country plays a key role with regard to bringing about economic reforms. The key objectives the policy makers, is to ensure that the economy runs successfully and inflation is controlled at all costs. The basic underlying factor behind the formation and implementation of the policy is to ensure that money itself doesn't act as a tool of economic disturbance. This article highlights various key issues faced by Australia in recent times, and helps in understanding the manner in which the central bank's commitment to price stability helps in maintaining a desired a level of inflation by regulating money supply and helping the economy to grow and prosper. For the purpose of maintaining and achieving such stability, however, it uses various tools and strategies which are discussed in the article as well as explained elaborately in the subsequent sections of this paper. Introduction: This article titled “RBA raises inflation forecast as traders raise rate expectations” written by Michael Boutros, appeared in The Bull, on May 09, 2011 (thebull, 2011). The author is a technical / fundamental currency analyst specializing in the FX markets, and works for DailyFX (fxstreet, 2011). The article discusses the current Australian interest rates stating the RBA's (Reserve Bank of Australia) recent declaration regarding rise in the inflation forecast above the 2-3 per cent target through the year 2013. The Reserve Bank of Australia held rates at 4.75% for a fifth straight meeting. It states that considering the current rates, which are above the expected target, the central bank has very little opportunity to tolerate any further advances in its prices. The author predicts that in response to such rising inflation, the RBA might lift its cash rate in the coming months, as the investments in mining and energy sectors rise, which are likely to further accelerate the pace of inflation. Economic concepts and theories to be applied: The article deals with the variation in interest rates and the rising inflation, and discusses the ways and means to control the same. In this regard, the author has suggested tightening the monetary policy, which can be discussed in accordance with the contractionary monetary policy preceded by a brief overview of the monetary policy i.e. both the concept as well as the monetary policy of Australia. The other concepts discussed in this article include Cash Rate, and inflation targeting. Key Definitions: Inflation targeting: According to Bernanke et al., (1999: 4) inflation targeting is a framework for monetary policy characterized by the public announcement of official quantitative targets (or target ranges) for the inflation rate over one or more time horizons, and by explicit acknowledgement that low, stable inflation is monetary policy's primary long-run goal" (in Hufner, 2004: 7) Analysis: Economists often forecast a rise in inflation rates. These forecasts or predictions regarding inflation are based on various factors. One such approach is the standard economic theory which posits that a rise in inflation occurs on account of a downturn in the economy and when the production surpasses the capacity constraints. According to this approach, the measures of an economic downturn, such as capacity utilization or unemployment rates, offer valuable information regarding the manner in which inflation would turn, i.e. rise or fall. However, this is not the only approach to forecasting inflation. The other approach relies on certain key indicators of inflation. These key indicators take into consideration factors such as commodity prices, gold prices, and other composite indicators which are then used to forecast the inflation rates. According to the article, the RBA forecasts inflation to reach 3 per cent by December this year, while the forecast for the year 2013 is estimated to cross 3.25 per cent mark. The following figure indicates the inflation rates in Australia, over the course of three years from Jan 2008 to January 2011. Figure Source (TradingEconomics, 2011) Inflation targeting Inflation targeting refers to development / implementation of monetary policies with a view to commit the central banks to achieve their publicly announced levels of inflation. The RBA’s target inflation rate in Australia is between 2-3 per cent per annum on average over a business cycle, while the forecast states that it is likely to cross 3.25 per cent mark. The target inflation rates are deliberately set adequately low and are decided with a view to ensure that it does not deform the economic decisions or investments within the country; however according to Friedman’s rule "the target inflation rate should always be set at negative and must be numerically equal to the equilibrium real interest rate so that the nominal interest rate becomes zero" (Friedman, 1969; Hubbard et al., 2010). The inflation rate mentioned in the target rates, in fact refers to the underlying terms for the rate at which consumer prices increases (Bernanke, Laubach, Mishkin, 2001). Figure: Inflation Target in Ausralia, RBA Source: http://www.rba.gov.au/inflation/inflation-target.html It is of utmost significance for the country, or rather the Central Banks to ensure that these rates are maintained at all times. However, it has also been observed that globally, maintaining such rates is highly difficult in case of a narrow band, as is experienced in Australia currently (Bernanke, Laubach, Mishkin, 2001). Inflation targeting is one of the key and oft used monetary policies across the globe, in the industrialized as well as in the developing world. This policy requires the central banks to make a public announcement of an inflation target and follow it up with credible and accountable strategies to achieve the announced target. It entails changes in the laws governing central banks which entail the independence of the institution. Although the targets decided by the central banks are quite low, the achievement of the same is relatively difficult. Contractionary monetary policy A contractionary monetary policy refers to the use of monetary policy by the RBA to increase interest rates in order to reduce or control inflation. The tightening of monetary policy is also referred to as a ‘contractionary’ monetary policy. Currently, the inflation rate of Australia is expected to rise beyond the target rate, and hence the RBA is likely to tighten the monetary policy to control the same. As mentioned in the article “Further tightening of monetary policy is likely to be required at some point for inflation to remain consistent with the 2-3% medium term target.” There are various tools available at the disposal of the RBA to reduce the flow of money supply in the economy. These include - reducing the monetary base; direct banks to increase their reserve rates, thus leading to holding of a higher proportion of their assets in reserve thus leading to reduction in the money supply; reduce the discount window thus restricting future lending or directly restrict the same by reducing risk taking by financial institutions; and lastly by increasing the nominal interest rates (Hubbard et al., 2010). Figure: Graph depicting contractionary monetary policy The above graph depicts an economy operating at potential output. The implementation of a contractionary monetary policy leads to a shift in the aggregate demand from AD1 to AD2, the real GDP falls from Yp to Y2 and ultimately the gap is closed in the long run. However, with the reduction in money supply in the economy, the consumers and firms expect a fall in the price level to P3, and adapt to the expected price levels accordingly i.e. the workers and employees agree to work for minimal wages, thus leading to a shift in the aggregate supply curve from SRAS1 to SRAS2. Cash Rate: The cash rate refers to "the interest rate financial institutions pay to borrow or charge to lend funds in the money market on an overnight basis" (thebull, 2011). With reference to the RBA, cash rate is the interest rate which the banks are required to pay or charge in order to borrow or lends funds, from or to other banks on an overnight unsecured basis, a process which is alternatively referred to as interbank overnight rate. This rate is published by the RBA daily, on the basis of the data it collects from all the banks. The Reserve Bank of Australia has the power and capability to influence and manipulate the situations in the financial markets by manipulating the short-term interest rates or the overnight cash rates in the money market (McAllister, Dowrick, 2003: 210). Such power or influence possessed by the RBA is derived from the fact that it has complete monopoly in the money market with regard to central bank money supply, via its daily open market operations. It is this ability of the RBA which allows it to influence the availability and price of the short term cash fund supply in the market. The RBA uses this power and influence by implementing interest rate decisions and at the same time strives to maintain liquidity needs of the consumers, and thus play a key role in stabilizing the banking system as well. (Mayes, 2007: 281). The article states that the RBA is likely to lift its cash rate in response to expected surges in the mining and energy investment, which is likely to further fuel the inflation rate. The current cash rate is 4.75% while the inflation rate is 3.3% (rba.gov.au, 2011). An increase in cash rate would help in reducing the inflation and achieve sustainable economic growth. Figure: Effect of cash rate on aggregate demand and supply When interest rates increase, the disposable income at the hands of the consumers falls, and their spending on consumption as well as investment may fall. Higher interest rates also lead to an appreciation in the Australian dollar. Conclusion: The monetary policies discussed here, helped significantly in understanding and analysing the article. Some of the theories, concepts and discussions in the article, were more legible, when viewed against the background of the theories and concepts discussed in the book. For instance, the fundamental facts regarding the manner in which monetary policies affect the economy, and the manner in which the same can be implemented to control, or reduce the inflationary rates. Furthermore, it also helped in a broader understanding of the impact of money supply in the economy and how the same can and is controlled by the central banks, i.e., the Reserve Bank of Australia, in this case. The study also helped immensely in broadening the overall understanding regarding the various ways in which inflation could be controlled, such as through the application of contractionary policy or expansionary policy. Although there exists various debates regarding the credibility and success of contractionary monetary policy, in controlling inflation, it does provide a fair opportunity for reducing it to a certain extent. In conclusion, the study of this chapter, and the concepts and theories discussed therein, provided a wider base, against which the article was analyzed. References: Thebull (2011). RBA raises inflation forecast as traders raise rate expectations [Online] Available at: http://www.thebull.com.au/articles/a/19576-rba-raises-inflation-forecast-as-traders-raise-rate-expectations.html [Accessed: May 09, 2011] Fxstreet (2011). Michael Boutrous [Online] Available at: http://www.fxstreet.com/search/contributors/authors/author.aspx?id=1325223e-527d-461f-a0b9-deae223635fa [Accessed: May 09, 2011] Fxstreet (2011). Michael Boutrous [Online] Available at: http://www.fxstreet.com/search/contributors/authors/author.aspx?id=1325223e-527d-461f-a0b9-deae223635fa [Accessed: May 09, 2011] Bernanke, B. S., Laubach, T., Mishkin, F. S., (2001). Inflation targeting: lessons from the international experience, Princeton University Press, Pp. 223-224 Friedman, M., (1969). The Optimum quantity of money. In The Optimum Quantity of Money and Other essays: Chicago, Aldine Publishing Co. Hufner, F., (2004). Foreign exchange intervention as a monetary policy instrument: evident for inflation targeting countries, Springer Publication, Pp. 7 Hubbard, Garnett, Lewis and O'Brien (2010). Essentials of Economics, Pearson: Australia Mayes, D. G., (2007). Open market operations and financial markets, Routledge, Pp. 28 McAllister, I., Dowrick, S., (2003). The Cambridge handbook of the social sciences in Australia, Cambridge University Press, Pp. 210 Rba.gov.au (2011). [Online] Available at: http://www.rba.gov.au/ [Accessed: May 16, 2011] Read More