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RBA lies low as inflation rears

By Henry Thornton - posted Tuesday, 7 June 2005


The Reserve Bank of Australia board gathers today after a five-week lay-off. We hope that its members have pondered its dilemma.

The things it says it worries about - namely, leading indicators of goods and services price inflation - have edged higher, building the pipeline of future inflation rate increases. But most activity measures - employment apart - are weak.

The list of adverse indicators of future inflation is swelling alarmingly.

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  • Productivity growth collapsed in the year to the March quarter, with real GDP up only 1.9 per cent while employment rose by 3 per cent;
  • Wages increases are beginning to pick up, with some indicators running now at 4.4 per cent a year and edging higher;
  • Non-tradables consumer prices increased by 3.7 per cent over the year to the first quarter - an increase from the long-hoped-for slowdown in the December quarter;
  • The GDP deflator rose by 3.7 per cent in the year to the March quarter;
  • The prospect of tradables prices continuing to fall, and so containing the pace of increase of average prices, is disappearing as the Australian dollar weakens;
  • The hope for early relief from high oil prices is gradually being downplayed. Spot prices have increased again and futures prices remain disappointingly firm; and
  • Also boosting inflation - though also hopefully only temporarily - is drought on the eastern seaboard.

It seems clear to us - and should be to the RBA board - that the 2-3 per cent inflation target is going to be exceeded in the next few months for a sustained period that could run beyond the bank's two-year forecast horizon. What is the board to do?

Bear in mind what it has done. It had governor Ian Macfarlane talk and act tough in February and March, only to be howled down - first by public opinion and later, in May, by the Treasury Secretary. Since the last meeting of the board, the governor put out a monetary policy statement that retained a bias to tighten. The market has decided this is only a Clayton's bias and, in fact, has priced out any interest rate rises in future and has marked down the value of the currency even in the face of a further rise in the terms of trade.

The exchange rate has anyway been lagging the rise in the terms of trade. Monetary policy has therefore been eased significantly.

The statement warned, however, that the top side of the inflation target was to be hit as soon as the June quarter, and core inflation was to rise to the top of the target by late next year with no hint of any slowdown before the end of the forecast period.

Until the RBA is willing to stand its ground and act to bring inflation back down, we expect the board will opt to keep its profile low.

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How does it do this? By not changing interest rates.

If pressed it will have the governor emphasise, on its behalf, that the target is only "an average over the cycle" of indeterminate duration and that temporary excesses ("deviations") - even of a period of two years or more - are permitted. Flexibility is to be put on a pedestal.

Furthermore, the governor is likely to argue that the fall in long bond yields to historically low levels confirms that longer-term inflation expectations are contained, even though this is more due to overseas influences than any judgment about the quality of domestic economic management.

Of course, deep down, the board is probably not so solely concentrated on inflation. Real activity and demand matter too and the news has not been good.

The March quarter GDP data was dreadful. The economy struggled to expand 0.7 per cent in the quarter, but only through a boost to inventories that contributed 1.2 per cent to overall growth. Among the few sectors to expand - and contribute positively to growth - was transport and storage, truly reflecting an inventories-led recovery. The "sector" with the next biggest contribution to growth was the statistical discrepancy! This ephemeral recovery from the dismal December quarter will naturally reverse in the June quarter. The outlook for farming in eastern Australia has deteriorated, too.

But a range of business and consumer indicators suggests that it is not time yet to slash one's wrists.

Lower than normal interest rates have allowed building approvals and credit growth to bottom out. Even house prices in Sydney and Melbourne - which had been falling in nominal terms - may soon stabilise, while the boom in the resource states will continue.

The key seems to be keeping the large numbers employed in a job. With profits high - though passed their cyclical peak - and skills in short supply, businesses are investing and seeking to retain staff.

Abroad, economic conditions have not changed much, and not clearly for the worse.

Bond yields globally have declined, equities are rallying (except where there are downwards earnings revisions) and sentiment seems to be moving towards a lesser rise in US short-term interest rates in the next few months.

The US economy is the opposite of Australia's - growing well and sustaining firm productivity growth - even though we of course prefer the Australian situation with a fiscal surplus (no matter how modest) over the US's big fiscal deficits.

Japan and the euro area seem to be muddling through, growing more slowly than would be desired. Both have exchange rates that are now more favourable for growth than before. China is holding up well and is, if anything, taking growth from the rest of Asia. Overall, China is having a big deflationary effect on the rest of the world as it opens up to global trade. Savings remain too high in Asia, though we find it encouraging that Thailand - the first into the crisis in 1997 - has finally recovered fully and is now again running a current account deficit. Yes, sometimes a current account deficit can be a badge of pride.

In Australia's case, the current account deficit in the March quarter should be a matter of national concern. At more than 7 per cent of GDP it has taken on traditional pre-crisis dimensions. But the central bank has convinced itself that the deficit is not its problem and the central Government has decided to set fiscal policy in a smoothed medium-term manner with no effort to lean against cyclical excesses.

So the current account deficit has been encouraged to balloon, until either fortuitous commodity price increases ride to the rescue (temporarily) or the private sector pulls its head in - something it will only do in a crisis.

To be fair, the April trade account showed a big rise in exports and a marginal fall in imports. This is no signal for celebration but it is at least a sign that Treasury's forecast of a substantial improvement in Australia's current account deficit in 2005-06 is plausible if demand can be restrained.

Until something flushes it out of its burrow, we expect the RBA board to stay hunkered down, out of the spotlight, staying quiet even as actual and forecast inflation deteriorates.

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First published in The Australian June 7, 2005.



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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at www.henrythornton.com.

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