Rifts risk economic prosperity

One of the rules of good parenting is for mum and dad to show a united front on important matters. The mandarins who are in charge of Australia's monetary policy are now in clear and obvious public disarray.

The bubbling issue of the prime ministerial succession is another fact that can damage Australia's economic prospects.

The Reserve Bank has made its position known - albeit not as systematically, or as continuously, as would be ideal. The Reserve is concerned that, with existing policies, inflation is likely to get too high, and as a consequence it has a tightening bias for monetary policy.

Treasury, whose secretary sits on the board of the supposedly "independent" central bank, is against tightening, and has warned us all that attempting to achieve a "soft landing" for the economy risks something far harder. Treasury has led the "dash for growth" faction we have previously written about, but now seems pessimistic about the immediate future.

Prospects for the world economy now do seem less encouraging. Various indicators of US growth, including initial estimates of overall growth in the March quarter, have been below expectations. The risks posed by the size of US budget and external deficits have, for the time being, come more clearly into focus.

There are fears that housing and share price booms have come to an end and that these engines of consumer demand may go into reverse. The high price of oil is also weighing on consumers throughout the industrial world and is adding costs to businesses everywhere.

Inflation is on the rise in the US economy, and the fear of "stagflation" - simultaneous growth stagnation with accelerating price inflation - absent since the 1970s, is stirring. The US Fed seems determined to limit inflation by raising interest rates from the very low levels of recent years.

Japan is showing every sign of slipping back into the state of chronic deflation that in late 2004 seemed finally to have been banished. In “Euroland”, unemployment remains high and growth is best described as sluggish.

Only China continues with the heady growth that has overheated the world's commodity markets and that has driven the price of oil to levels that threaten sustainable growth in the leading industrial nations.

It is not clear that China's leaders have the tools necessary to engineer a controlled slowing to their juggernaut economy. They have not appreciated coaching on this matter from the US - another "squabbling mum and dad" theme. China will resist attempts to have it substantially raise the value of its currency, a way to help bring greater balance to the US current account deficit that appeals to US politicians.

Australia's economic indicators are mixed, a classic sign that a turning point is close. Infrastructure bottlenecks have been recognised and remedies are being applied when it is easy to do so as, for example, in the case of the Dalrymple coal loading facility. Providing the necessary increased infrastructure will take years and is no solution to our current predicament. But the attempts to overcome structural bottlenecks will keep relevant activity high.

Housing markets have stabilised and there are fears that the absence of house price increases, or in a worse case substantial falls, will cut into household demand. Exports remain sluggish, constrained by shortages of infrastructure and capacity as well as lack of competitiveness because of a relatively high domestic cost base.

Australia's terms of trade will stabilise or even fall when global growth slows from its recent unsustainable rate, removing a welcome source of external stimulus.

The growth pessimists of Treasury may emphasise these points in their notes for today's meeting of the board.

Of course, Australia's current account deficit remains at a dangerously high level, above the traditional crisis trigger of 6 per cent of GDP. This is despite high terms of trade and low global rates of interest - both factors that may be about to take a distinct turn for the worse.

Treasury is probably still in the traditional Canberran camp of CAD unconcern. But Treasury will be mighty embarrassed if Australia suffers a traditional current account crisis, and the Reserve will share the discomfort - this issue should occupy a fair bit of discussion today.

The main focus will, however, be on inflation. CPI inflation in the March quarter was a "mere" 0.7 per cent, or 2.4 per cent in year-on-year terms, much to everyone's relief, with the Treasurer looking as happy as he gets on national television.

Yet the danger signals for inflation remain. It was low traded goods and services prices that kept overall consumer inflation down in the March quarter - against the trend as the price of oil was lower than it had been and the currency is the high end of its likely future range. Non-traded goods and services prices, including a range of prices heavily influenced by governments, increased at rates well above the Reserve Bank's target range.

With commodity prices rising and, if the price of oil stays high and the currency falls, overall inflation in future will be ever closer to the rate of non-traded goods and services price inflation - well above the target 2-3 per cent target range.

In the latest half year, prices are up 1.5 per cent and the next two quarters will see overall inflation over the year at a rate above the target ceiling, rather earlier than the RBA had expected.

We do not expect the Reserve to raise interest rates at 9.30am tomorrow. It failed to do so last month and since then the news on global and Australian economic activity has been weaker. Inflation is rising in the US and therefore ultimately globally, but - at least in the March quarter - local inflation seems not to have provided the trigger.

And Treasury will be powerfully advocating no rate hike, with the Treasurer's and Prime Minister's overt coaching clearly in everyone's minds. Yet the dangers remain. Late last year the main risk was hubris throughout the "miracle economy".

Now the over-optimism has receded and there is a new danger. It is the major and overt difference of view between Treasury and the Reserve Bank. To this must be added the obvious leadership tension within the Government.

Internationally, the stand-off between the two most important trading nations - China and the US - is adding to the uncertainty.

Nothing worries small children so much as a squabble between mum and dad. If current leadership tensions both at bureaucratic and political levels are not soon resolved, the risks to Australia's economic prosperity will rise exponentially.