![Problem solved? Lowering the inflation target makes it more likely inflation will keep falling.](/content/dam/images/z/r/h/g/w/image.related.afrArticleLead.620x350.gr9u71.png/1473154898752.jpg)
![Philip Baker](/web/20160907150228im_/http://www.afr.com/content/dam/images/1/4/1/y/s/n/image.imgtype.afrAuthorAvatar.120x120.png/1435901920075.png)
It makes sense there is so much talk about the Reserve Bank of Australia's inflation target now Glenn Stevens' term as governor is coming to an end.
That's because it is inflation that will probably determine if the bank ends up cutting the official cash rate again, and it has always been a rule to renew the "conduct of monetary policy" between the bank and the government whenever the governor of the Reserve Bank changes.
The other trigger point for a review is when the political party in government changes, but not when the prime minister changes.
With Philip Lowe, the incoming governor, set to take over on September 18, all the talk about the inflation target is indeed very timely.
![Paul Dales, Chief Australia & New Zealand Economist at Capital Economics says it would be a mistake to cut the inflation ...](/content/dam/images/g/p/m/1/2/t/image.imgtype.afrArticleInline.620x0.png/1466151364704.jpg)
Low inflation is not just a feature here in Australia, but also around the world, so there is a school of thought that says the Reserve Bank should think about lowering its inflation target.
In short, the argument goes that the low level of global inflation makes the current RBA target, set at between 2 per cent and 3 per cent on average over the cycle, pretty much unachievable.
Some inflation experts, such as Roberto Rigobon, a professor of applied economics at MIT's Sloan School of Management, think central banks should do away with inflation targets and instead just try to "maximise the prosperity" of countries.
Rigobon is a co-founder with State Street of PriceStats, a real-time price indices that tracks inflation by looking at the daily prices of about 5 million products on sale at hundreds of e-commerce sites around the world.
He points out there is a disconnect between official inflation figures and how everyday consumers can still feel like the cost of living is quite high, thanks to house prices, the cost of a private education, electricity, petrol prices and even the cost of insuring your house and car.
"Just how much data do central banks need before they change their models?" he asks.
In the past, low inflation has been linked to an economy that is not growing, but maybe that's not the case these days.
Perhaps all the improvements in technology, along with a range of global factors, such as cheap labor in China, are the real reasons behind the low level of inflation, and it doesn't mean an economy can't be growing at the same time.
A case in point is Australia's second-quarter national accounts that are slated to be released on Wednesday and could show the economy grew at an annual pace of 3.4 per cent. Handy by any standards.
If that is all true, then maybe the RBA can put up with a lower inflation rate for longer, although economists at the Commonwealth Bank, citing low growth in wages, still expect another rate cut, to 1.25 per cent, when the bank meets in November.
The problem for any central bank that lowers its inflation target is that it makes it more likely inflation will keep falling.
The problem then becomes worse.
Paul Dales from Capital Economics says there are two reasons why it pans out that way.
"First, the experience of central banks that have changed their inflation targets (RBNZ, Bank of Canada) shows that the inflation expectations of businesses and households always move in the same direction as the change in the target. So if you lower the inflation target, you lower inflation expectations, which then exacerbates the current disinflationary pressure," he said.
Second, by cutting the inflation target and lowering both expected and actual inflation, then real interest rates, the nominal rate less inflation, will start to rise.
"That's essentially a tightening in policy, which would reduce GDP growth and inflation, thereby making inflation even lower," said Dales.
Put simply, a central bank would have less ammunition to support the economy if it used a lower inflation target.
Indeed, central bankers at Jackson Hole talked about raising inflation targets so they would have more room to cut interest rates in the event of a slowdown or a recession.
"In short, I don't think the RBA will change its inflation target and I certainly don't think it will lower it. That would be crazy. If anything, it should consider raising it," said Dales.
"At some point, targeting nominal GDP may become a more compelling alternative. But for the foreseeable future, the inflation target will remain the same and policymakers will use macro-prudential policies to contain risks in asset markets."