Keep calm, Stevens, and carry on

It would be unwise for the Reserve Bank to raise rates amid a temporary inflation spike. Doing so would threaten economic rebalancing and the dollar's depreciation.

Inflation is on the rise but the effect is likely to be temporary. The Reserve Bank should look through the volatility and avoid compromising the tentative rebalancing of the Australian economy by raising rates at its February board meeting.

Consumer prices rose by 0.9 per cent in the December quarter, exceeding market expectations to be 2.6 per cent higher over the year. And in a rare situation, the headline and core measures – the trimmed mean and weighted mean – are saying the exact same thing.

The major contributor to inflation in the December quarter was food, with fruit (up 8.1 per cent) and vegetables (up 6.9 per cent) particularly strong. Offsetting this – albeit to a small degree – was a 1.1 per cent decline in automobile fuel.


Graph for Keep calm, Stevens, and carry on

It is a data release that will certainly set the cat among the pigeons. Suddenly it appears certain that annual inflation will push above the Reserve Bank’s 2 to 3 per cent target band. I’d go so far as to say that it is inevitable, and that there is very little that the RBA can do right now to curb inflation.

This is a really good test to see how reactionary the RBA is. If it believes that inflation will return to within its target band reasonably quickly – and I believe it does – then there is little point reacting to a temporary pick-up in inflation.

It takes several quarters for an interest rate change to have an effect on inflation; a rate rise now might begin to have an effect by the September or December quarter this year. The RBA needs to base its decision at its February board meeting on where it believes inflation will be toward the end of this year, rather than make a snap judgement on where inflation is right now.

These are the practical considerations that must be at the forefront of the Reserve Bank’s thinking. It is, in my view, important that they don’t overreact to a couple of large inflation numbers simply to appease market expectations. Rather, the decision to raise rates must be based on solid expectations that inflation can remain high when faced with a prolonged period of below-trend growth.

I have three general thoughts regarding the outlook for inflation.

First, a lower Australian dollar ensures that prices on tradable products will rise significantly, resulting in headline inflation exceeding 3 per cent by the end of the June quarter.

However, monetary policy will have limited success pushing down tradables inflation, particularly in the short-term. The decision to take on international market forces is not even in the best interests of the Australian economy, which desperately needs a lower exchange rate.

The RBA has reiterated the importance of a low exchange rate for the Australian economy. A side-effect of that is the prospect of a temporary rise in inflation while the Australian dollar depreciates. Communication from the Reserve Bank indicates that they understand this perfectly well.


Graph for Keep calm, Stevens, and carry on

Second, the Australian economy is likely to run at a below-trend pace for the foreseeable future. With the mining investment cliff approaching, I’d argue that the risks to the RBA’s economic outlook are to the downside.

This, coupled with a weak labour market, points to a fairly subdued economy in 2014 and 2015. With spare capacity rising, any pick-up in the rate of inflation – driven by tradables – could prove to be relatively short-lived.

Third, the carbon tax will come to an end on July 1 2014. That will push down inflation in the September quarter and year-ended inflation through to the June quarter 2015.

In its November Statement on Monetary Policy, the Reserve Bank stated that it believed the removal of the carbon tax would reduce annual headline inflation by around 0.75 percentage points and core inflation measures by around 0.25 percentage points.

Annual inflation is set to rise in early 2014, but the key question the Reserve Bank needs to ask is whether this will be a temporary or long-run trend. If it is the former, then the RBA should not raise rates, particularly given the lengthy lag with which interest rates affect the domestic economy.

Instinct suggests the Reserve Bank will not hike in February or before they get their next read on inflation in three months’ time. There is a reason why interest rates currently sit at historically low levels: it is becoming increasingly obvious that there is sufficient weakness across the economy to justify those interest rates.

If anything, higher inflation would actually be useful right now, given it effectively amounts to another cut to real interest rates. I see no reason why the RBA would want to potentially compromise the rebalancing of the Australian economy and the depreciation of the Australian dollar by a premature tightening.