Aust banks warned against setting inflation target too low

SYDNEY - Central banks should not set their inflation target too low, a research paper published on the Reserve Bank of Australia's (RBA) website has warned.

This would reduce the risk of encountering the "zero lower bound" (ZLB) -- the inability to cut interest rates to less than zero -- when a central bank is trying to burst asset price bubbles and keep an economy from sinking into recession.

Co-authors of the research Tim Robinson and Andrew Stone said the Bank of Japan had run into the ZLB since an asset-price bubble collapse in the early 1990s.

Amid persistent weak economic growth Japan's official interest rate has been at zero for four years.

The authors said their study related to how policy-makers should act pre-emptively when asset price bubbles arose and also to the policy framework.

The ZLB should have relatively little effect on an policy-maker that was actively trying to prevent the asset-price bubble until the bubble became quite large.

And the constraint dissipated rapidly as the neutral nominal interest rate -- a "real" interest rate plus a premium for expected inflation -- rose above 3.0 per cent.

So policy-makers "should simply avoid targeting too low an inflation rate, so as to ensure that the economy's neutral nominal interest rate is in turn not too low", the authors said.

They also recommended a higher inflation target rate for economies which tend to recover slowly from economic shocks or respond weakly to changes in real interest rates.

The study did not consider the effect of government's fiscal policy, but hinted that Australia, with dwindling debt and a run of budget surpluses, had less to worry about than other countries.

In countries where public finances were sound, "policy-makers would be aware that fiscal policy could be called upon, if necessary, to aid in stimulating the economy and forestalling any risk of deflation becoming entrenched."

The views expressed by the authors are not the official views of the RBA.

- AAP