Inflation target relevance in low inflation world an early challenge for new RBA boss

It's a debate that's likely to confront Dr Philip Lowe when he takes over as governor of the Reserve Bank in September.

Should the central bank's target band for inflation be lowered given today's world - including Australia - where prices have slipped into deflationary territory?

Listen to my report broadcast on The World Today

Questions have been raised about the relevance of the RBA's mandate of keeping inflation within a target band of two to three percent over time after March quarter consumer inflation went backwards by 0.2 percent and rose by just 1.3 percent year on year.

Although both readings are dramatically below the RBA's target range, a former central bank governor Bernie Fraser says now is not the time to move the inflation goal posts.

Mr Fraser, who ran the RBA between 1989 and 1996, told The World Today the inflation target is still relevant.

"I believe it is. It's a sensible, a pragmatic target and it's served Australia pretty well over the last two and a half decades," Mr Fraser said.

"It's not something to be pursued rigidly and at times we have been above the three percent limit and that hasn't caused the world to collapse.

"If you stick to two to three percent inflation over time, inflation ceases to be a problem."

The March quarter move into deflation was a key reason which prompted the Reserve Bank to cut the cash rate last week to a new historic low of 1.75 percent.

But Matt Sherwood, head of investment research at Perpetual, says the RBA's move on budget day puts the relevance of the current inflation target firmly on the agenda.

"I tend to think that the RBA is going to struggle to hit that target in the next two and a half years," Mr Sherwood said.

"I don't think they would alter that target but if you're going to be that far below the target they would probably be questioning whether it serves any true purpose any more in a world with lower productivity growth and lower wages growth."

Even so Matt Sherwood thinks the RBA is unlikely to lower the tamper band.

"It would be an admission that while central banks are good at lowering inflation they can't actually raise inflation at the moment."

The big question for the RBA is how to consumers and businesses spending to get inflation higher.

But Bernie Fraser warns that cutting rates any further is not the answer.

"If 1.75 percent won't do it, 1.5 percent, 1.25 percent, 1 percent is not going to do it," Mr Fraser said.

"Monetary policy has run its race for the time being. Fiscal policy has to be a more prominent lever to be grasped."

Money markets are betting the cash rate will stay on hold at next month's meeting of the Reserve Bank board.

But economists are tipping a cut to 1.5 percent in September as the Reserve Bank confronts a deflationary world.

Source: Reserve Bank of Australia