Brave RBA should raise rates

It’s official - monetary policy can be tightened during an election campaign. So there is no impediment to further rate hikes this year - indeed, the public would hold the Reserve to account if it failed to raise rates when needed just because of a minor matter like a political contest under way.

"I'm not going to do what some dick-head minister tells me," said a previous RBA guv'nor. Current guv'nor Glenn Stevens has placed a further stake in the sand, and good luck to him.

The global economy is booming. The US sub-prime lending crisis has produced wobbles in financial markets, but First World central banks have lent freely, thereby softening Baghot's classic advice. Third World central banks have been printing money freely.

Third World central banks, of course, lack the formal independence of established central banks - indeed, in many Third World nations, the politicians are "independent" of the people they govern. So in these nations the central bankers are mere arms of government, as was the Reserve Bank of Australia in the 1970s.

Watching China's "crawling peg" currency co-existing with burgeoning money supply growth reminds Henry of Australia's situation in the early 1970s. China's deflation of goods and service prices has been replaced by inflation. In a spooky echo of Australia in the early 1970s, food price inflation is seen as the "special factor" at work in China.

In reality, China's goods and services inflation is due to lax monetary policy and soon this will be clear to all.

China's economy, like those of other emerging economic powers such as India and Brazil, is growing fast, boosted by the steroid of easy money. Already the hundreds of millions of new industrial workers are asking for a bigger share of the economic pie. As in Australia in the 1970s, this tendency will strengthen. The reality of global inflation originating in Third World nations is no doubt why US Fed chief Ben Bernanke is trying to hold the line on interest rate cuts. At Jackson Hole's recent monetary conference, Bernanke reportedly had a bet each way, but equity markets surged - so market participants obviously think they got a nod and a wink for ease to come. Soon the global equity market correction that started in July will be just another slightly painful memory.

The domestic economy is running well, to the point where capacity constraints are biting. This much has been strongly confirmed by Stevens. Late last week we learned that credit growth is still running fast, business fixed investment is booming (well ahead of economists' expectations) and retail sales for July are booming. Henry heard a leading retailer speaking of "nearly insatiable" demand for flat-screen TVs, as just one example. While there are battlers in Australia, the top and the middle are getting better paid - and richer - almost at will. The China boom is expected to maintain strong growth for the foreseeable future.

Released with mining giant Rio Tinto's stellar results was a study by Professor Ross Garnaut and colleague Ligang Song. China's resources demand is "at the turning point". And the turn is upwards rather than downwards. In releasing the study, Rio Tinto Australia managing director Charlie Lenegan said: "The increase in China's demand for metals over this period (2000-2020) may be comparable to the total demand of the industrial world today. If Garnaut and Song are right, the implications for the global economy are staggering."

China will struggle to restrain inflation - Henry's prediction is that it will fail. The current resources boom will intensify and Australia will also struggle to avoid inflation. The world failed to avoid inflation in the 1970s, during the previous (and much smaller) resources boom, and the costs in lost production and lost jobs were dreadful.

But there are differences to China now or Australia then. We have a floating exchange rate and independent central bank.

The graph and table shows how the Australian dollar has behaved (relative to the US dollar) since its float in 1983. Note the considerable volatility. Note, too, the possibility of a significant change of trend. Last time I showed this graph (in June 2006) the best interpretation was that it demonstrated the continuation of a century-long depreciation against the mighty greenback.

Now it seems the trend may be rising. This is a sign that, relative to the mighty US economy, our economic performance is improving, just as it sagged for a century or more - actually since the last great resource boom in the 1880s. The floating exchange rate is vital as (if coupled with a strong enough monetary policy) it allows Australia to largely avoid the contagion of global inflation. I say "largely" for two reasons. The first is that Australia's independent central bankers can only press so hard, and their theoretical power to isolate Australia from world inflation is limited by cultural and economic reality. The second point is more technical. We just do not understand the dynamics of how economies interact.

Clearly, even with a floating exchange rate, a boom or bust in US equity markets has strong echoes here. Asset markets are not totally decoupled, and cannot be. But it is interesting that moves in Australian equity prices have outperformed US markets. This is further confirmation the Australian economy is doing better than the US economy.

What should the Reserve Bank board decide today? Simply, it is to press as hard as it dares to keep Australia's economy out-performing the mighty US economy. Global inflation is on the rise. If the Reserve dares to keep Australian monetary policy tight enough to contain domestic demand, now clearly running too strongly for comfort, it will be doing most Australians a good turn.

I fear the RBA will not be brave enough. I urge Glenn Stevens during his board meeting today to remember the "almost insatiable" demand for flat screen TVs.