Inflation animal is now much tamer

This week’s inflation number was nothing to fear … hopefully the RBA will notice.

Summary: The latest inflation number was higher than many expected but, rather than hiking interest rates, the Reserve Bank should be cutting them further. Economic forces of the ‘new world’ economy suggest the central bank should sit on its hands at current inflation levels.
Key take-out: This week’s latest inflation data did everything to confirm the modern economy is successful at naturally containing inflation through market competition.
Key beneficiaries: General investors. Category: Economics and strategy.

While a lot of commentators were this week highlighting the idea that inflation surprised on the upside, the reality was a little more tame. In fact, inflation is no longer the animal it once was.

Headline inflation was 1.2% above expectations for the quarter, but the number that matters, the through-year core rate, was a mere 2.2%. This is a level that should be prompting the Reserve Bank of Australia to reduce rates, just to keep inflation in the stated target band of 2% to 3%.

There would certainly be little hesitation on the part of the RBA, if inflation was at 2.8%, to then begin hiking. Such is the nature of the Australian central bank beast. It seems to prefer to hike rates as a general historical bias. This was never more evident than in the RBA’s immediate post GFC operations. Our central bank chose to be the most aggressive central bank in the world, hiking rates all the way to 4.75% at a time when the rest of the world was, to say the least, cautious.

The post GFC rate hikes must be seen as one of the greatest blunders of the RBA in its history. Eventually the bank was forced to spectacularly correct this painful error in judgement.

As quite possibly the first commentator at the time to forecast the RBA would begin to hike in 2009 from 3% (at the time some banks were forecasting quite confidently official rate reductions all the way down to 2%), it was clear to me that while the bank should not raise rates, it would nonetheless do so.

In relation to Australian official rates, one has to ask two questions.

1. What should the RBA do?

2. What will the RBA do?

There are quite often two very different answers.

It has been clear for some time that the RBA was out of step with the reality that most people were experiencing in their lives. The domestic economy was resurgent in 2009, until the RBA basically knocked the recovery on its head.

The RBA continued to confuse aggregate data, being forced higher by how well China managed its economy, and therefore demand for our resources, with what the great majority of Australians were experiencing – an economy in trouble.

The primary fear that drove the RBA to be bizarrely so aggressive so soon after the worst of the GFC, at a time when other central banks were nursing any sign of economic improvement, was a firm belief that inflation was about to spike!

It was as if the world had not moved on, that globalisation had not engendered a new economic paradigm, and that all the ‘old world’ last century economic patterns would repeat as per the dust bound textbooks that no doubt lay in the RBA’s vault.

What has happened over the last 15 years is that advanced global communications, the internet, the means and nature of doing business, intra-regional trading patterns, the opening up of China, and the modernisation of South America, have all combined to create a new contemporary reality.

One of the great and well-established cornerstones of the new economics is that inflation is no longer the threat it once was.

There is, in fact, even less of a role for central bankers in monitoring inflation than was the case in the last century, and some of us were saying this well before the RBA foolishly hiked in 2009-10. Central bankers do not want to hear or know this, but the modern capitalist economy on both a national and global level, is reasonably self-regulating on inflation.

Forces within the economy work naturally to contain inflation

This does not mean that the prices of some goods and services do not rise, but these are largely short-term weather factors in relation to food supply, or longer-term increases in services in which governments have interfered. By and large, general inflation levels are subdued, and this is true even in economies with relatively high rates of growth.

A high growth rate no longer means high inflation

In the 1960s and 1970s, for instance, company directors would typically arrive at the office, enquire as to the cost of manufacturing their particular product, then add what they felt to be a reasonable or slightly greedy profit. Hey presto, they then arrived at the price at which they would sell their product.

Cost of Manufacture Profit = Price

Today, company directors arrive at the office very early indeed, discover what the latest cost of production is, ask what price the market will accept, and then wonder “if” a profit can be achieved? If not, it is not the price that will go up, but the drive to resuscitate the profit margin through greater productivity outcomes.

Price – Profit = Acceptable Cost of Manufacture

In today’s world, one our RBA may yet discover, from the corner store to the global corporation you cannot raise prices without losing market share.

Market share is king, and so companies do everything they can to avoid raising prices. Here is the crucial point however: businesses today avoid raising prices, regardless of the level of monetary policy.

Official interest rate makes no difference to prices charged

When the RBA raised rates to head off inflation in 2009-10, it was making two quite significant mistakes in terms of the real economics of our age.

It viewed a recovery in economic performance as immediately creating inflationary pressures, and also that the flow-through from the resources boom would be similar to other commodity booms of the previous century.

This week’s latest inflation data did everything to confirm the modern economy is successful at naturally containing inflation and therefore, even as the global and domestic economic outlooks steadily improve, the RBA should continue to sit on its hands at 2.5%.

Inflation may not be dead, but it is certainly domesticated.


Clifford Bennett is chief economist at Investor Unity. www.IU.com.au/UP