Betting on inflation 12 months hence

Britain is trying the "third way" -- the conservative approach of fiscal austerity, which if maintained will in due course provide useful evidence for the great debate on "Keynesian" verses "Austrian" approaches to economic management.

My money is on inflation as the policy choice of Americans and Europeans other than Germans and current-day Austrians. Both these groups have had searing historical experience of hyper-inflation and can safely be assumed to be inoculated against the bacillus of inflation. But others have yet to experience really damaging inflation and should be assumed to choose the soft option.

China, India and other rapidly developing nations are vitally important countries whose recent policies have been inflationary. The rear-view measures show China's goods and services (CPI) inflation to be 3.6 per cent and rising; India's 9.9 per cent, down from 11.7 per cent; Brazil 4.7 per cent and rising; Russia 7 per cent, down from 10.7 per cent and Indonesia 5.8 per cent, up from 2.8 per cent a year ago. Overall, not a cheerful rear-view look for a central bank whose main objective is keeping goods and services inflation within a tight band.

Then there is Australia's own history of allowing inflation to get out of hand. The great inflation of the early 1950s was quenched with the help of a "horror budget". The Whitlam government (and Treasury) badly misdiagnosed the global inflation of the early 1970s and ignored the Reserve Bank's correct diagnosis.

Madly expansionary fiscal policy and poor industrial relations infrastructure added to the pressure of global inflation to take Australia close to a constitutional crisis as well as double-digit unemployment that took a generation to fix.

The Reserve Bank itself failed in its diagnosis in the 2000s. China's deflation was mainly responsible for low global and Australian inflation, but credit was given to the newly "independent" Reserve Bank and its supposedly effective anti-inflationary policies.

When Chinese deflation ceased to be of overwhelming importance, and Australia's terms of trade exploded upwards, the Reserve moved too little too late to head off inflation. Highly relevant warnings from people with the runs on the board were ignored, and the reputation of the RBA was only saved by the onset of the global financial crisis. Even so, the CPI shocked on the upside in reaching 5 per cent, dangerously in the red zone.

Now Australia is again enjoying extraordinarily high terms of trade, strong employment trends and expectations of another major surge in business investment.

The question that must be answered by the Reserve Bank board today is this: should these powerful expectational forces be met with a pre-emptive 50 basis point hike in cash rates, or will a 25-point touch on the brakes do the job, or can it afford again to sit tight and await further evidence of an economy headed into the red zone?