F-Why relaxing inflation targets would be bad for investors

F-Why relaxing inflation targets would be bad for investors...

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Edition #17 27 May 2008 Why relaxing inflation targets would be bad for investors Key points Rising food and energy prices are leading some to argue that inflation targets need to be relaxed. This would be a big mistake. The 1970s experience tells us that allowing higher inflation to become entrenched will lead to more, not less, economic pain. Sustained high inflation would be bad news for investors as the boost to investment market valuations from the move to low inflation that drove strong investment returns in the last 25 years would reverse. A permanent 2% rise in inflation could knock $140bn off the value of Australian’s superannuation investments. Introduction There is much debate about whether inflation targeting should be abandoned or the target increased. The basic argument is that the Reserve Bank of Australia (and other central banks) can’t do much about surging global food and energy prices and that to attempt to do so will result in unacceptable economic pain. In Australia’s case some have suggested the inflation target should be raised from 2-3% to say 3-4%. While one can debate the appropriate level of interest rates necessary for inflation to meet the current target over time, raising the target itself would be a big mistake. It would entrench the recent rise in inflation and risk taking us back to the slippery slope that led to the high inflation and economic calamity of the 1970s. What’s more such a move would be disastrous for investors – including all Australian superannuation fund members. Inflation targeting Setting inflation targets and charging the central bank with achieving them has been central bank best practice since the early 1990s. It was first introduced as a way of anchoring inflation expectations such that when there is a price shock – such as a sharp rise in food or fuel prices – it doesn’t set of a self perpetuating wage price spiral like in the 1970s. New Zealand was the first to have a target but now many countries have them. Both the European Central Bank and the US Federal Reserve target inflation below or close to 2% (although the Fed’s target is not formalised). Australia’s inflation target was first introduced in 1993 and became formalised in 1996. At 2 to 3% it is actually a little higher than in many other countries. It is also interpreted as being over the course of the business cycle which means the RBA is prepared to accept inflation being outside the target for a year or two providing it is confident it will come back within the target over the medium term. For example, it currently expects inflation to exceed 3% until 2010. Over the last 15 years or so inflation has been pretty low in
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This note was uploaded on 04/28/2010 for the course ECON ECON2001 taught by Professor Tonyblake during the Spring '10 term at University of St Andrews.

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F-Why relaxing inflation targets would be bad for investors...

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