Revisiting Monetary Policy: Current Issues, Temporary Price Level Targeting and the Productivity Norm Rule
Over the past four years, changes in the consumer price index have hovered around one to two per cent, which is below the two to three per cent band of inflation that the Reserve Bank of Australia (RBA) has committed to achieving. This has weakened the credibility of the RBA in the eyes of both the public and the markets in being able to achieve its goals of price stability and its own inflation target.
In the RBA’s latest Statement on Monetary Policy, they have primarily laid the blame on fluctuations in the inflation rate on non-monetary factors outside of their control, such as sluggish wage growth and government policy on childcare and housing. (Reserve Bank of Australia (RBA), 2021) In addition, many policymakers in Australia have conceded that monetary policy is out of ammunition and there’s nothing more that the RBA is able to do. This has resulted in much of the heavy lifting being done by the Federal and State governments through their fiscal stimulus programs.
However, the RBA should not be absolving itself from blame when it comes to the below-average growth of inflation in Australia as it’s unlikely to be true that monetary policy is out of ammunition. As Stephen Kirchner notes, given the low long-term inflation expectations priced into inflation-linked bond yields, this may suggest that this is more of a structural issue rather than attributable to one-off or temporary factors to do with the coronavirus pandemic and changes in fiscal policy. (Kirchner, 2018)
Given the state of low nominal interest rates and low inflation, the RBA needs to change course in order to hit its targeted band of inflation and to better prepare itself for future shocks to the economy because what it is currently doing right now is simply not good enough. So, how can the RBA turn this around?
The first thing the RBA could do is to look at incorporating a regime of temporary price level targeting within its current framework. To explain, a price level target is when the central bank aims to maintain stability in the price level over a long period of time, making up for past undershoots and overshoots, hence it being historically dependent. (McKibbin & Panton, 2018) The benefits that price level targeting provide is the strong anchoring of inflation expectations and its consistency with the RBA’s mandate of price stability (Bernanke, 2018), however, what makes it different to our current practice of inflation targeting?
Inflation targeting and price level targeting are quite similar in that they both target the change in the overall price level and can be flexible within the framework they operate in. The main difference, however, between price-level targeting and inflation targeting is the treatment of “bygones” (Bernanke, 2018) or deviations from the target. For instance, if inflation is unexpectedly high (low) in one period, this is followed through with below (above) average inflation in the next period to make up for any undershoots or overshoots of the target, on the other hand, inflation targeting can let “bygones be bygones” as long as inflation is on target the next period. (Hatcher & Minford, 2014)
Not only that, but this can also be communicated through Odyssean forward guidance (McKibbin & Panton, 2018) and explained as part of the RBA’s overall inflation strategy to reach two to three per cent inflation on average over the medium term (Bernanke, 2018). Hence, it does not require the RBA to move outside of its current framework and can be explained to the public and markets with ease.
Secondly, the RBA would also be wise to adopt a type of ‘productivity norm rule’. The basic idea behind the productivity norm rule is that the price level should be allowed to move opposite to productivity. (Sumner, 2020) To implement this rule, the RBA would target the expected growth rate of inputs used in production such as labour and capital (Beckworth, 2007). For instance, if the RBA expected the growth rate of labour and capital inputs to rise (fall), it would see through this positive (negative) supply shock and allow for the price level to fall (rise) to reflect changes in the productive capacity in the economy rather than distort relative price signals and create monetary disequilibrium (Cachanosky, 2013).
This would allow for greater financial stability and the stabilisation of nominal income to capital and labour overtime, fostering the conditions for future investment and current consumption. The rule would effectively allow the RBA to see through supply shocks in real-time and differentiate them from demand shocks in the economy. For example, if the expected growth rate of labour and capital inputs was left unchanged while the price level was falling (rising), the RBA would cut (raise) nominal interest rates to stabilise aggregate demand and prevent bad deflation (costly inflation), keeping in line with its price stability mandate. Hence, moving away from the one-all-approach to deflation would help the RBA see-through upcoming supply-side shocks such as climate change and artificial intelligence (McKibbin & Panton, 2018).
Overall, the current regime of inflation targeting is currently failing in Australia and not due to non-monetary factors. The adoption of a temporary price level target or a productivity norm rule could help to bolster the current framework of monetary policy in achieving its mandate of price stability and economic prosperity for all Australians.
 Reserve Bank of Australia (RBA, February 2021). Inflation: Statement on monetary policy – February 2021. Retrieved February 28, 2021, from https://www.rba.gov.au/publications/smp/2021/feb/inflation.html
 Kirchner, S. (2018, October 03). Money too tight to mention: The Reserve Bank of Australia’s financial Stability mandate and low inflation. Retrieved February 28, 2021, from https://www.sciencedirect.com/science/article/pii/S0313592618302455
 McKibbin, W. J., & Panton, A. J. (2018, April 12). Twenty-five years of inflation targeting in Australia: Are there better alternatives for the Next Twenty-five years?: Conference – 2018. Retrieved February 28, 2021, from https://www.rba.gov.au/publications/confs/2018/mckibbin-panton.html
 Bernanke, B. S. (2018, May 04). Temporary price-level targeting: An alternative framework for monetary policy. Retrieved February 28, 2021, from https://www.brookings.edu/blog/ben-bernanke/2017/10/12/temporary-price-level-targeting-an-alternative-framework-for-monetary-policy/
 Mariano Kulish Professor of Macroeconomics. (2021, January 14). Price-level targeting: How inflation-focused central banks can squeeze more from interest rates. Retrieved February 28, 2021, from https://theconversation.com/price-level-targeting-how-inflation-focused-central-banks-can-squeeze-more-from-interest-rates-127100
 Hatcher, M., & Minford, P. (2014, May 11). Inflation targeting vs. price-level targeting. Retrieved February 28, 2021, from https://voxeu.org/article/inflation-targeting-vs-price-level-targeting
 Beckworth, D. (2007, September 23). A brief look at the productivity norm rule. Retrieved February 28, 2021, from http://macromarketmusings.blogspot.com/2007/09/mark-toma-points-us-to-knzn-who-is.html
 Sumner, S. (2020, March 19). The intuition behind the productivity norm. Retrieved February 28, 2021, from https://www.econlib.org/the-intuition-behind-the-productivity-norm/
 Cachanosky, N. (2013, December 31). Hayek’s rule, NGDP Targeting, and the Productivity Norm: Theory and application. Retrieved February 28, 2021, from https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2373230