It's the best of times, but the party's peaked

It would be too much to expect our central bank to be moving interest rates yet. For a start, it is most un-Australian to try to spoil a party.

And what a party we are having.

Inflation at 2.5 per cent in the June quarter was firmly in the middle of the Reserve Bank's target range, export prices are rocketing, equity markets are booming, housing markets are still rising fast in resource states and may be recovering elsewhere, bond yields have remained low, the currency hasn't collapsed and the new era of economic reform has arrived with a Coalition majority in the Senate.

Internationally, good news far outweighs bad news. The US is showing firm growth with low inflation. China is still booming. India is following closely. Japan's long-delayed recovery is sputtering into life again. Russia, Brazil, and even Argentina are growing strongly.

To be sure, Euroland is growing only slowly and spasmodically, but we are used to that.

We cannot ignore Australia's new prominence in the global pecking order. The Prime Minister has been travelling the world, advising President Bush, supporting Prime Minister Blair at a time of national trauma and visiting the troops in Baghdad.

It turns out we have been playing a key role in creating a new group to fight global pollution and climate change. Even the Association of South-East Asian Nations has decided we may join their councils.

Almost certainly it doesn't get any better than this, and all the good news is probably priced into Australian assets - equities, house prices and the Aussie dollar.

Only bad news and downward revisions to expectations lie ahead. The deterioration in the outlook is creeping up while we bask in the economic sunshine. We firmly believe that interest rates should have been higher earlier, and as a result rates might by now be coming down.

In reality - rather than in our dreamtime - it is going to be very hard for even a pre-emptive central bank to act, to raise rates before the inflation genie has done its damage. Instead, waiting until we can all see the threat - when it is by then far too late - will be the outcome. This is how hubris leads to nemesis.

Short-term interest rates at 5.5 per cent are simply too low in a world of 3 per cent goods and services price inflation and asset price inflation many times that.

US cash rates are also too low at 3.25 per cent, but at least the US Fed has signalled clearly that it will keep removing monetary ease at a steady rate of 0.25 per cent every six weeks, and this schedule is more likely to be extended than terminated shortly.

The global economy has performed much better than expected. A systematic reason for this is the continuing reaction to the flood of liquidity that enormous US budget deficits and super-low US interest rates unleashed from 2002.

The size of the liquidity flood explains stronger than expected global growth; high, strongly rising, commodity prices; and generalised asset inflation in many places.

But note that this flood has peaked - the pace of increase in global holdings of international reserves has been declining for a year now. The long-awaited Chinese revaluation has begun with perhaps surprising lack of impact on financial markets. The knock-on effect from a minimal 2 per cent appreciation was minor - a touch higher in US bond yields and some jockeying for competitive advantage by China's neighbours.

The good news is that China will eventually be better able to manage its economy with a more flexible currency regime, which over time will further restrain the growth in global liquidity.

With China becoming an exporter of what it used to import, and high productivity growth there and in the US, there has been little impetus to global goods and services inflation.

This is in spite of, and is in fact a catalyst for, higher oil prices. Oil and many other commodities, most asset prices plus the overall strength of economies are at levels that signal increases in goods and services inflation down the track.

We see no prospect that the Reserve Bank of Australia will choose to surprise markets with rate moves until those moves have been well telegraphed. Thus all the interest swings from the RBA board's almost certain "no change" decision today to what the RBA governor will say in his quarterly Monetary Policy Statement in a week. This of course will be positioning for his subsequent appearance before the House of Representatives Standing Committee on Economics, Finance and Public Administration.

We fully expect the governor to say the outcome owes much to luck and something to good policy (if he is sensibly humble), and he retains a tightening bias.

This will be just as well. The bad local news is only just below the surface. Productivity growth has slowed, and on some measures is negative. Wages are beginning to stir, with the unions beginning to pick off their political brethren at the state levels.

The shake-up to the industrial relations landscape is likely to have a surprising outcome as employers scramble to retain workers the only way they know will work - wage rises.

The TD Securities Melbourne Institute monthly index of inflation has shot up to 3 per cent in July. Oil prices remain at high levels and each surge reaches a new higher level. Indeed, with wages growth rising and zero or negative productivity growth, inflation into 2006 is set to rise well clear of the ceiling of the 2-3 per cent target range. No doubt, when it happens, the RBA will reiterate that the target is only an "average over the course of the economic cycle". We doubt the bond market - with its global origins - will be so complacent.

Whether or not Australia can retain its "miracle economy" status as inflation builds and with a monster current account deficit is the big question and only time will tell.

Resource booms like the one we are now enjoying almost always end in tears. We would have preferred that our central bank had played a far more cautious game, but instead must enjoy the boom while we can.