Fortune to determine whether Stevens emerges as a hero

Last week's fall in retail turnover and dramatic slowdown in credit growth shows that monetary policy is working.

Despite alarmingly high inflation relative to the "target range", there is now a fair chance inflation will return to the target range of 2 to 3 per cent by 2010.

By then of course, the Government's Emissions Trading Scheme (ETS) may be in place, but probably with a very low carbon price and petrol prices quarantined so that consumers will feel little obvious extra pain.

With a bit more luck, with continuation of the latest trend, oil prices will be lower, there will be relief at the bowsers - and for battlers forced by lousy public transport to drive their cars to work. The job losses now building will nip in the bud any general tendency for excessive wage hikes.

And Stevens' joy will be complete if the credit crunch retreats rather than worsens and pressure on loan margins (above cash rates set by the Reserve) eases.

If all these happy things occur, before long the Reserve will be able to cut rates, relieving pressure on households. They'll look like heroes, or at least fail to look like idiots.

If things go badly, of course, the idiot possibility will re-emerge. There are two ways in which the idiot scenario might come to pass.

The first is that the price of oil rises again to new records, the credit crunch gets worse, business and household confidence sags further, consumers stay shell-shocked in their homes, and businesses lay off many workers, compounding householders' woes.

Even in Australia, house prices are now said to be declining, and the fear-mongers are suggesting far bigger falls are in prospect.

In this "worst case" any rate cut will be seen as too little, too late, compounding the current perception (at least in the popular press) that "The Enforcer" has played too hard with his famed "independence".

Or, second, if the global scenario is more positive, the resource boom roars on, Australian consumers perk up quickly and begin to spend their tax cuts while demanding higher wages which add to inflation, putting 2-3 per cent by 2010 out of reach.

The sad fact is that the future is ever clouded and unsure.

My guess is that the second scenario is most likely - with the economy quickly regaining its robust growth.

The possibility of a quick return to growth scenario is why the Reserve Bank will not cut rates too quickly. Having allowed inflation to get away from it by allowing domestic demand to overheat, premature easing would compound the idiot scenario to a point that central bank "independence" would become seriously compromised.

We have been criticised as "seriously misguided" for proposing that inflation targeting be suspended or modified.

However, the Reserve has failed to mention its "target range" in the four sets of minutes released since our Anzac Day article on the subject.

More directly, the Reserve has declined to raise interest rates since then, despite surprisingly high inflation and consumer inflationary expectations reaching 5.9 per cent.

It is also noteworthy that the Bank for International Settlements (BIS), the central bankers' central bank, has recently suggested a more sophisticated approach to managing monetary policy.

"Monetary policy might be tightened even with projected inflation under control, given a sufficiently worriesome combination of rapid credit growth, rising asset prices and distorted spending or production patterns."

The graph is designed to put simple goods and service inflation into perspective. It shows US, Australian and Japanese share prices since 1984. Also shown is Australia's goods and services (CPI) inflation over the same period. By comparison to movements in share prices, goods and services (CPI) inflation seems trivial.

If we apply the BIS logic to this graph, the big drops in share prices are part of a case for cutting interest rates.

The Bernanke Fed has already cut rates to a dangerously low 2 per cent, only 100 basis points above Greenspan's 1 per cent. This is now widely agreed to have encouraged the subsequent share price boom and global inflation of goods and service inflation.

Comparison of the three share price indices is instructive in other ways.

Japan had the mother of share price hikes in the late 1980s. This was followed by the best part of two decades of economic stagnation as Japan's asset bust - that included big drops in real estate values as well as share prices - ended the run of the then "miracle economy". The fear-mongers see the US as the most likely candidate for a decade or more of stagnation. They argue that the "sub-prime ripples" have a lot of damage to do yet and that the US financial sector will remain shaky for years.

Then there is the Australian case. We missed the tech boom of the early noughties but fully shared in the resource boom of the mid-noughties. It is this share boom, and the accompanying credit and housing bubble that, the BIS says in retrospect, should have led to monetary policy being tightened faster and sooner.

We note in passing that Henry made this case, but failed even to be invited into the RBA for a cup of tea and a chat.

If the Reserve Bank has understood why it allowed goods and services inflation to get away from its target it is likely to cut rates sooner than now expected.

I expect a further period of waiting and watching, however. The speed of the economic slowdown overthrows any case for further rate hikes plus (we dare to suggest) the "flexible" application of inflation targeting in the face of powerful food, petrol and housing inflation. Further falls in asset prices will make the case for rate cuts, signalling as they would more economic pain to come.

"We like to watch" is, of course, a favourite positioning of the Rudd Government. The Reserve will be applauded for waiting and watching so long as the economy does not turn turtle or begins to generate new inflationary pressure.

And it will be fascinating to see what Peter Costello's book makes of the RBA's performance and "independence".

After all, it is his reputation that has been damaged by the RBA's failure to contain inflation.