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Lesson M06.L04: Inflation Targeting in Australia: History and Performance

Module: The Reserve Bank, Monetary Policy and the Economy Level: intro Duration: 30 minutes Learning Objective: Evaluate Australia's inflation targeting framework adopted in 1993 and assess RBA performance against the 2โ€“3% target band over three decades. Data as of: 2024 Provenance: RBA Education | RBA | ABS Price Indexes

Explanation

Inflation targeting is a monetary policy framework in which a central bank publicly commits to keeping inflation within a specified range. Australia was among the world's earliest adopters, with the RBA and Treasury jointly establishing a 2โ€“3% average inflation target in 1993 under Governor Bernie Fraser. New Zealand was the first country to formally adopt inflation targeting (1990).

The target band is 2โ€“3% measured by the Consumer Price Index (CPI), published quarterly by the Australian Bureau of Statistics (ABS). The word "average" is important โ€” the RBA is not required to keep inflation inside the band in every single quarter, but to ensure it averages within the band over time. This gives the RBA flexibility to respond to temporary shocks (like oil price spikes) without triggering extreme interest rate swings.

Why 2โ€“3%? Zero inflation sounds ideal, but can be risky โ€” if unexpected shocks push inflation below zero (deflation), central banks have limited room to cut rates further. A small positive inflation buffer provides room to manoeuvre. Too high and inflation erodes purchasing power and creates economic distortions.

Performance over three decades: - 1993โ€“2007: The framework worked well. CPI averaged near 2โ€“3%; the RBA established credibility. - 2008โ€“09 (GFC): Inflation briefly exceeded 5% (2008), then fell sharply. The RBA cut aggressively. Recovery was smooth. - 2010โ€“2019: Inflation ran persistently below the 2% lower bound (sometimes near 1%), raising questions about whether the target was too high for a low-inflation world. - 2021โ€“22: Post-COVID supply shocks and stimulus pushed CPI to 7.8% (December 2022 quarter, ABS) โ€” the highest since 1990. A substantial breach of the top of the band. - 2023โ€“24: Rapid rate hiking (13 increases from May 2022 to November 2023) brought CPI back toward 3% by late 2024.

The 2022โ€“23 inflation surge tested the RBA's credibility. However, inflation expectations remained reasonably well-anchored โ€” a sign that three decades of inflation targeting had built public trust.

Worked Example

Scenario: Assess whether the RBA met its inflation target over a five-year period.

CPI data (annual, ABS):

Year Annual CPI Inflation
2018 1.9%
2019 1.6%
2020 0.9%
2021 3.5%
2022 6.6% (annual avg)

Step 1 โ€“ Compare each year to the 2โ€“3% target band: - 2018: 1.9% โ€” just below the lower bound of 2% โ†’ borderline miss (below target) - 2019: 1.6% โ€” below target โ†’ miss - 2020: 0.9% โ€” well below target โ†’ miss (COVID demand collapse) - 2021: 3.5% โ€” above the 3% upper bound โ†’ miss (supply shocks) - 2022: 7.8% โ€” well above the 3% upper bound โ†’ significant miss

Step 2 โ€“ Calculate five-year simple average: Average = (1.9 + 1.6 + 0.9 + 3.5 + 6.6) รท 5 = 14.5 รท 5 = 2.90%

Step 3 โ€“ Evaluate: The five-year average (2.90%) sits just inside the 2โ€“3% target band โ€” a useful reminder that the "average over time" framing absorbs large temporary deviations. The framework is designed precisely for this. The 2018โ€“2020 period saw persistent undershooting. The framework allows for temporary deviations; the 2022 miss was large but driven by global supply shocks beyond the RBA's direct control.

Conclusion: The RBA broadly maintained inflation within target through most of the 2000s and 2010s. The 2021โ€“23 episode was a significant deviation, but the inflation targeting framework itself remained intact and helped anchor long-run expectations.

Common Misconception

Misconception: "If inflation goes above 3%, the RBA has failed and must immediately raise rates to bring it back inside the band."

Correction: The target is to keep inflation within 2โ€“3% on average over time, not in every quarter. Temporary overshoots โ€” especially those driven by supply-side factors like oil prices or COVID supply chain disruptions โ€” do not automatically require aggressive rate rises. The RBA must weigh the costs of a sharp rate rise (higher unemployment, recession risk) against the benefit of faster inflation reduction. Gradualism is often appropriate. The "over time" framing is a deliberate design feature giving the RBA flexibility to respond proportionately.

The Policy Reaction Function and the Taylor Rule

Inflation targeting gives the RBA an objective (2โ€“3%). But how does the RBA decide how much to move rates? Economists describe this using a Policy Reaction Function (PRF) โ€” a rule linking the RBA's interest rate setting to observable conditions:

  • Cut rates when: output is below potential (Y < Y*) and/or inflation is below target (ฯ€ < ฯ€_T)
  • Raise rates when: output is above potential (Y > Y*) and/or inflation is above target (ฯ€ > ฯ€_T)

The best-known version is the Taylor Rule (John Taylor, 1993):

i = r* + ฯ€ + 0.5(ฯ€ โˆ’ ฯ€_T) + 0.5(Y โˆ’ Y*)/Y*

Where i = nominal cash rate, r* = neutral real rate, ฯ€ = current inflation, ฯ€_T = inflation target.

Worked example (USYD style): Inflation = 5%, target = 3%, output gap = 0, r* = 1%: - Real rate: r = 1% + 0.5 ร— (5% โˆ’ 3%) = 1% + 1% = 2% - Nominal rate: i = r + ฯ€ = 2% + 5% = 7%

This is the kind of rate setting Australia saw in 2022โ€“23 as inflation surged.

Hawks and doves: Central bankers are described as hawkish (prioritise low inflation, willing to raise rates aggressively) or dovish (prioritise employment and growth, prefer lower rates). A more hawkish PRF shifts upward โ€” higher rates for any given inflation. A more dovish PRF shifts downward.

Practice Prompts

  1. In what year did Australia formally adopt the 2โ€“3% inflation targeting framework, and who established it? โ†’ Answer: 1993, established jointly by the RBA (Governor Bernie Fraser) and the federal Treasury. It was the first formal statement of Australia's inflation target.

  2. CPI inflation is recorded at 1.5% for two consecutive years. Is this inside or outside the RBA's target band, and what might the RBA do? โ†’ Answer: 1.5% is below the 2% lower bound โ€” outside the band. The RBA might consider cutting the cash rate to stimulate demand and push inflation back toward the 2โ€“3% range, as it did in 2019 when the cash rate was cut to record lows.

  3. Why did inflation surge to 7.8% in late 2022, and what actions did the RBA take in response? โ†’ Answer: Inflation surged due to COVID-19 supply chain disruptions, strong demand from pandemic-era fiscal and monetary stimulus, and global commodity price spikes (including from the Ukraine war). The RBA responded by rapidly raising the cash rate from 0.10% (April 2022) to 4.35% (November 2023) โ€” 13 consecutive rate increases โ€” to bring inflation back toward the 2โ€“3% target.

Further Resources