Keep policy tight lest inflation slips anchor

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.

Should the anchor keep slipping, a "Stevens crunch" will be needed because of the way inflation has surprised on the upside, both globally and in Australia. Oil and food prices have rocketed, but in the brutal world of macroeconomics this is not yet perceived to be a primary problem, though it may become of primary importance. Certainly the rocketing price of oil is a matter for debate everywhere. "Oil rage" is afflicting Euroland.

People everywhere who cannot afford to eat, or to eat properly, are desperately worried about food prices. Householders are finding rising rents or mortgages more than an inconvenience. People on low incomes are suffering a multiple whammy of expensive food, petrol, housing and money. This makes inflation a major political problem.

The graph puts our current inflation into long-term perspective. Clearly, inflation was far worse at the time of the Korean wool boom or at the time of the first two oil shocks in the 1970s.

Inflation is (so far) nowhere nearly as bad as it was in the early 1950s or the 1970s. Inflation exceeded 20 per cent in the early 1950s and reached a bit over 16 per cent in the 1970s.

The basic reason for current low inflation is that an earlier US Federal Reserve chief, Paul Volcker, bravely broke the stick of inflation in the world's most powerful economy. Falling US inflation led global inflation down. Volcker's brave action reduced inflationary expectations everywhere.

Australian inflation was effectively zero in 1998. This reflected our own monetary crunch - the "(Bernie) Fraser crunch" - a decade after the Volcker crunch.

The effects of this were reinforced by the maximum of imported deflation associated with the rise of China as a major force in global manufacturing.

Ominously, Australia's inflation has been rising since 1998. Inflationary expectations reached a low of around 2 per cent in 1998. The latest reading, for April 2008, is 5.2 per cent. Inflation that matters, especially to people on low incomes, is far above 4 or 5 per cent.

There is cold comfort in the fact that this is a global problem.

In a recent issue The Economist explains: "Inflation's back ..." The world average rate of inflation, it says, has risen to 5.5 per cent, the highest since 1999. Global monetary policy is at its loosest since the 1970s and average world "real" (inflation adjusted) interest rates are negative.

The damage originated in the US, with first Alan Greenspan and now Ben Bernanke creating negative real rates of interest. Massive global liquidity growth was fuelled from the developing economies, whose fixed currencies and purchase of US and other developed nations' assets helped create an asset bubble. Monetary policy is loosest in developing nations, which are now undergoing goods and services price inflation that feeds back into developed nations' goods and services inflation.

The Economist says double-digit price rises are about to afflict two-thirds of world.

"In countries such as China, India, Indonesia and Saudi Arabia even the often dodgy official statistics show prices have risen 8-10 per cent over the past year; in Russia the rate is over 14 per cent; in Argentina the true figure is 23 per cent and in Venezuela it is 29 per cent."

The global risk is that the developing nations repeat the mistakes of the developed nations in the 1970s.

"With an economic serial killer on the loose, one way or another monetary policy will have to tighten and exchange rates rise." Henry adds that, with inflation already out and about, a serious global economic slowdown will be needed.