Money explosion to blame for inflation

The Reserve Bank would be irresponsible not to raise interest rates when its board meets today.

After rising solidly for several years, money growth has exploded - as shown in the graph - to cap off the case for alarm over our inflation prospects.

This is a complicated matter with many nuances, but you don't have to be an unreconstructed "monetarist" not to be surprised by the rise in both actual and underlying inflation. The Reserve Bank, however, has been unhappily surprised.

In the year to December, "headline" goods and services (CPI) inflation in Australia was 3 per cent, right at the top of the Reserve's "target band" of 2-3 per cent. This itself was probably above expectations, but not so far that immediate action was demanded.

However, the Reserve has decreed that it will be guided more by measures of "underlying" inflation - measures that remove rises or falls in goods and service prices deemed to be outliers - either too large or too small.

Just to keep us on the ball, it developed two measures of underlying inflation: the "trimmed mean"; and the "weighted median". These measures of inflation were 3.4 per cent and 3.8 per cent respectively in the year to December - demanding the response of higher interest rates, for reasons I shall come to.

First, however, some comments on political economy.

Fortunately for the Reserve Bank, the Rudd Government fully recognises the risk of inflation and is vigorously doing two things. The first is blaming the Howard government for its failure to properly manage the economy - how sweet that line must be to deliver. The second is to shape its economic policy around the primary aim of putting the tiger of inflation back into its cage.

I do not need to play the blame game except to note that the Reserve has as its most important task the control of inflation. It has been given the tools (a floating exchange rate and a deregulated financial system), its officers have had their salaries (and pensions) greatly increased, and the organisation has been given "independence" from political government. All this, former central bankers fought for and won.

The more recent holders of their high offices were favoured by extraordinarily low global inflation but ignored the obvious warning signs and now we all must pay the price. The price will include the necessary higher interest rates at a time of considerable uncertainty and angst in the global economy.

We leave for another day the question of what is an appropriate sanction if an independent central bank fails to contain inflation. When the government was ultimately responsible, the electorate could sack it.

There will be those who try to resist the necessary hikes to rates - not including Rudd and his Government. What will their arguments be?