SCOREBOARD: Inflation trap

Inflation appears to have been contained, but remains volatile, making it difficult to align with the real state of the economy.

Twelve months ago it looked like Australian inflation was surging to very dangerous levels again, following a brief post-GFC lull. This was a result that took us all by surprise, but the RBA took a very serious and unnecessary gamble in not hiking rates at that point. It was reckless and driven, not by expectations of moderating inflation, but rather political and industry pressure – the non-mining recession and all of that. This proved to be false and we know the Australian economy was accelerating all throughout. Just as the economic data had been telling us all along – indeed the economy is strong. Fortunately though, for the RBA board and the country, inflation just as unexpectedly and just as quickly, moderated. Indeed over the last six months inflation has effectively been flat with core measures around 0.5 per cent or 2 per cent annualised.

That inflation is contained is the new consensus although given the consensus – only some months ago – that the Australian economy was weak, I don’t think readers should put much faith in that view. Inflation has just been too volatile which is one reason why I have been arguing for much more conservative policy responses. With so much uncertainty (upside and downside), policy should be calibrated for either outcome, but it isn’t. Growth is strong, yet monetary policy is calibrated toward recession. Policy makers are simply living in hope that inflation remains modest, but history has shown that it can rebound sharply and unexpectedly. If domestic growth remains strong, this is the more likely outcome. What will policymakers do then? Will they hike? So we live in hope that strong growth will yield modest inflation. It looks like we may be in luck for another quarter at least. We get the June quarter CPI print on Wednesday at 1130 AEST – the expectation is that CPI will be modest again, rising 0.6 per cent for the quarter ( 1.3 per cent year-on-year). Core inflation is also expected to rise by a reasonably modest 0.6 per cent quarter-on-quarter.

The problem in just assuming these headline rates equate to genuinely modest inflation pressure is that these headline rates can be misleading. Just as simply referring to headline GDP last year led many economists, and the RBA Board, into thinking the economy was weak. You see the softness is all in the ‘tradable ‘component (-1.5 per cent year-on-year) which declined suddenly and rapidly over the last three quarters.

Naturally the Australian dollar is helping here. Non-tradable inflation, unfortunately, is actually accelerating (3.6 per cent year-on-year). For mine, it can’t be argued then that underlying inflation pressures (defined as the persistent inflationary trends) have eased, as the softening in inflation is not broad-based. Analysis is complicated by the fact that financial markets are so volatile. Think about the Australian dollar and commodity prices. Both of these are very important feeds into inflation, but they’re bouncing around all over the place – one reason why people were taken by surprise on the trade prices front last Friday. Both export and import prices rose in the quarter, which may suggest and end to the disinflation brought about by ‘tradeables’. We’ll see what happens. In any case, we get producer prices at 1130 AEST today. Like trade prices they have a low correlation with CPI, but are useful in trying to determine upstream price pressures. Then in terms of central bank action, it’s worth looking out for the RBA governor's speech (I haven’t seen a topic yet) tomorrow at 1305 AEST.

For the rest of the world this week, there is a decent amount of information to contend with and with eurozone concerns flaring up its going to want to be good. Apparently one of Spain’s regional governments requested a bailout by the central government on Friday and Spanish yields just keep pushing higher. This obviously had a significant sentiment sapping influence on Friday’s session, but overall for the week, equities were higher as were commodities more generally.

Things to look out for include the swathe of US earnings reports that we get most days this week. In addition to that we see the Richmond Fed manufacturing index on Tuesday night, new home sales Wednesday night and durable goods Thursday night. Friday night we see the first estimate of June quarter US GDP where most expect a slight moderation in growth – from 1.9 per cent to 1.4 per cent.

Elsewhere we see the eurozone PMIs and also HSBC’s China PMI. Now these are both 4th and 5th tier indicators at best and as I have noted before, aren’t useful really very useful for analysis. For some reason they do get a lot of press though. More importantly we see the German IFO survey, CPI and UK GDP – all worth watching.

Adam Carr is a leading market economist. See Business Spectator's glossary for definitions of technical terms used in SCOREBOARD articles.

@AdamCarrEcon on Twitter.


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