Rate hikes can avert crisis

We can recall no other time in Australia's post-war history when the economic outlook has changed so quickly. The change is generated by belated recognition of domestic imbalances.

It does not concern the international outlook - the twin engines of global growth, the US and China, are performing strongly.

The price of oil is high and has again set a new record, at least in nominal terms. But when adjusted for inflation, oil is still cheap and the expectation of higher prices seems widely shared and not especially worrying.

Australia is an energy exporter and probably benefits in net terms from high oil prices. Coal prices have almost doubled and Australia's uranium is worth a lot of money in a world increasingly concerned about global warming. Australia's terms of trade have not recently been higher and this is keeping the prospects bright for farmers and miners.

Australia's foreign debt is also at a record level, and yet there is a silver lining as global interest rates are still low, although the inevitable increases are well under way.

The current account deficit is about 7 per cent of GDP, the one sign, obvious for at least a year, that domestic demand has run too far ahead of the capacity of the domestic economy. The supply-demand imbalance is also likely to create serious inflationary pressures. The Reserve Bank has said inflation might rise to the upper end of the 2 to 3 per cent target range, or even higher. The RBA has not revealed the assumptions behind this prediction, but our calculations suggest it assumes the Australian dollar at current levels, only slightly faster wages growth and slightly lower productivity growth.

A serious wages surge, say to an annual rate of 5 per cent, is possible. Zero or even negative productivity growth is also within the range of the possible, as is a fall in the value of the Australian dollar to US70c - or even lower.

These less favourable outcomes would mean inflation above 4 per cent, perhaps above 5 per cent. This sort of deterioration is by no means assured, although if domestic demand continues to run at a substantially faster rate than domestic supply it will become almost certain.

We must point out that the thrust of our advice in these articles for some time now has been to head off exactly this scenario. Our advice to this effect has sadly not been followed and the RBA must now deal with a clear demand-supply imbalance that even blind Freddy could notice. The RBA board's discussion today will be of particular interest.

The secretary of the Treasury, Ken Henry, will emphasise the risk that domestic demand falls away without any further tightening of monetary policy. He will promise a tough federal budget next month and he will warn of the risk of a double-whammy hit to a weakening economy.

He might throw in an optimistic assessment of the chances of serious labour market deregulation once the Government controls the numbers in the senate. The members from the private sector may be sympathetic to this line of argument. Those with a great interest in the state of retail trade and rents in shopping centres will probably point out that consumer confidence has fallen and sales are sluggish.

Exporters will note that Australia's sluggish exports are a major problem, that the currency is too high to allow Australia to export more and that higher interest rates will worsen competitiveness by driving the currency higher.