Today the Reserve Bank board needs to decide if monetary policy is tight enough for inflation to decline, reversing the upward trend of a decade.
The key question is whether the Australian economy is slowing sufficiently to ensure that in two years time inflation will be back within the Reserve Bank's 2 to 3 per cent target band.
Recent data includes credit growth and retail sales slowing, consumer confidence well down and various measures of business confidence also reduced. Capital spending also seems to be slowing, albeit to a still healthy rate.
Employment, traditionally a lagging indicator, has surprised on the upside, but the negative implication of this with a slowing economy is a weak productivity performance. Despite sharply rising inflationary expectations, wage rises seem still to be running at an acceptable annual rate of 4 to 4.5 per cent. There is, however, plenty of rhetoric from union leaders that workers deserve compensation for inflation plus "catch up" from the Howard government years - when real wages rose strongly, as it happens.
Declining productivity, unless combined with falling wage inflation, will severely erode Australia's international competitiveness.
The RBA will, of course, take note of the fact that the budget was not nearly as tough as people had been led to expect. This increases the odds that the bank will conclude that it still has some heavy lifting to do.
Henry has been taken to task (with others) for suggesting that continuing to tighten monetary policy in the face of severe oil and food inflation is not a great idea. Such suggestions were "seriously misguided", said the Treasury Secretary Ken Henry (obviously no relation). Inflation targeting was needed, Dr Henry asserted, to keep any inflationary expectations "anchored".
With respect, Henry Thornton was concerned with inflationary expectations when Ken Henry was in primary school.
Clearly, the "anchor" of low inflationary expectations has already slipped. This is partly due to global developments over which we have no influence. But we have argued for several years that failing to tighten monetary policy sufficiently early would mean that eventual rate hikes were higher than they needed to be. We have now reached that point.
Having let slip the "anchor" of stable inflationary expectations the Treasury and (especially) the RBA face the invidious choice of punishing us further with higher rates or risking a larger slippage, one that would damage the real economy and lead to the usual consequences of inflation: a "prolonged period of economic difficulty".
This is a risk that will encourage the hardheads, struggling to overcome the consequences of acting too little too late, to keep monetary policy tight despite the pain to battlers from rising prices.
Indeed, the logic of the hardheads, playing catch-up, leads to more rate hikes yet, possibly as early as today.
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