Can the Aussie dollar ignore inflation?

The December CPI report has changed the game for the Reserve Bank and, potentially, for the Aussie dollar.

Today’s central bank meeting, as always, will be closely watched by many. What makes this gathering a little different to the last few is the December CPI report. The RBA often annualises a consumer price inflation over a rolling six month period in order to get a sense of the trend in prices. Measured this way inflation in the second half of 2013 increased to an annualised rate of 2.9%, up from 2% six months prior and higher than the headline 2.7% reading. Such a sharp rise puts it at the top end and only just inside the RBA’s band which is sure to make them feel more than a little uncomfortable. Higher inflation also threatens to send the Aussie dollar higher so the RBA has a battle on its hand.

Normally one would not be so surprised with elevated inflation. They have after all dropped the cash rate by a whopping 225 basis points from 4.75% in November 2011 to 2.5% in August 2013 which is an inflationary action by nature. It is also expected that there would be a lag between a reduction in the OCR and an increase in CPI. This is because it takes time for lower interest rates to feed through to the economy and show in data releases. As is often the case it’s not the first few cuts that have the most impact on the economy but the last few as consumer behaviour also takes time to adjust.

Perhaps this time around the RBA has become a little too complacent on CPI, not expecting inflation to rise so sharply. The world is after all in a low inflation environment. If we look abroad over the last few years extraordinarily low interest rates, zero per cent in the U.S plus quantitative easing has had very little impact on inflation stateside. Japan is trying hard to raise inflation and Europe is in the midst of an inflation spiral with many fearing deflation.

The chart below shows annual CPI readings in both Australia and the U.S since December 2011. We can see that it wasn’t until the RBA moved rates to 3.5% in June 2012 that inflation started to rise from 1.2%. Whilst in the U.S, similar to Europe, inflation is still in decline.

Graph for Can the Aussie dollar ignore inflation?

Should the RBA consider raising interest rates to halt inflation?

While inflation is not the only consideration but it is a major one. Enough for some market commentators to call for a rate hike by year’s end. It depends to a large degree on whether or not the central bank thinks inflationary pressures will persist and if so for how long. If the view is that a breach of 3% would only be temporary (I believe it may be) then they should ignore inflation and keep rates on hold.

There are some major differences in the economies but I think it is worthwhile taking a look at how the Bank of England handled high inflation between 2010 and 2012. For every month over a two year period annual UK CPI was more than 1% above the 2% target. In fact in October 2011 it peaked at 5.2% well above target. Did the BoE change interest rates? No. In fact interest rates have not changed since March 2009. Their actions, based on economic theory, should have made matters worse – they embarked on a quantitative easing program that should be inflationary.

The point here is that they looked through high inflation, made the call they thought it was temporary and other economic factors took precedence - in January 2014 it finally fell back to 2%.

Slightest change could be enough

It will be interesting to get a take on the RBA’s view on inflation and the broader economy this week, not only through their statement accompanying the decision today but even more so from the Monetary Policy report that follows on Friday.

There are a number of risk factors for the currency with the slightest change in rhetoric, towards a less dovish stance by the RBA will put some upward pressure on the Aussie dollar. In particular I am looking for: a softening of the “uncomfortably high” currency line, some concern over inflation and/or removal of their easing bias – any of these will see some AUD buying – all of them most likely back above 90 cents.

So while the RBA should probably ignore a higher inflation rate, at least until we get another quarter or two CPI reading the Aussie dollar may not.

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