Inflation is certainly lower than expected, and that has all manner of people writhing in glee about just how weak the economy must be. We ARE in a recession – see, I told you! Low inflation proves it! Unfortunately, and I do hate to cut the schadenfreude short, these views are based on a seriously flawed understanding of economics. The latest first quarter CPI numbers only confirm what I pointed out after the fourth quarter numbers – and that is that the factors that are dampening inflation are all temporary.
By now you know the drill. Lower inflation is literally due to currency impacts and food. In the absence of the correction from the floods – which is a supply side phenomenon – and the extraordinary falls in some currency sensitive areas, CPI was up 0.8 per cent, non-tradeable up 1 per cent (around 4 per cent annually). This acceleration in demand induced inflation is entirely consistent with domestic demand growth at its strongest in four years and an unemployment rate around 5.2 per cent. All the data is consistent. Overall CPI is low, sure, and on my estimates, true underlying inflation is running at 2.5 per cent (I’m not referring to the ABS’s measures here). This is a good outcome, but there is nothing in these estimates that should encourage complacency when the risks around the growth are to the upside and evenly balanced with regards to CPI – especially when the modest inflation now is largely due to supply side factors (heavy rainfall, changes in technology and the high Australian dollar).
This is a reasonable observation to make. Almost without exception price falls, or at least the magnitude of them were unusual, but they are temporary. On the flipside price gains were not unusual – they were very normal. So unless you think the exchange rate will continue to rise at about 5-10 per cent per quarter, then this impact will wane. Also consider that it is highly unlikely that fruit prices will continue to fall by 30 per cent per quarter. In contrast pharmaceuticals will continue to rise by 10-15 per cent, education by 5-7 per cent, rent by at least 4 per cent per year, etc. Non-tradeable prices, remember, accelerated in the quarter, rising 1 per cent – they are up nearly 4 per cent for the year. There is no disinflation here. Consequently it is disingenuous for anyone to claim that underlying inflation pressures have eased materially when clearly they have not. When lower CPI is due to only a few components, no broad based move.
Unfortunately there will be little recognition of this when it comes to the policy debate. The economic debate has been farcical in Australia for a very long time and the board, as biased as it is with manufacturing representatives etc, will cut for sure. As I discussed after the RBA board minutes, it was clear that even prior to the latest numbers, that a 25 basis point cut was basically baked in. This was clearly the case after the board lowered the bar to a cut by dropping the requirement that we see a material weakening in demand (which we have not).
So misleading has the discussion become that most people were pressing for rate cuts even while forecasting core inflation to be at the mid-point – with the unemployment rate as low as it is and with domestic demand at a 4-year high. People were actually arguing that even a high CPI wouldn’t, or at least shouldn’t, stand in the way of a cut. As regular readers know I think these ‘arguments’ only show that the policy discussion has had very little to do with actual economics or the state of the nation. Demand is strong, this is not debatable, yet people say the economy is weak, pointing to GDP growth – the RBA got it wrong you see. Umm, no, the pessimists got it wrong and clearly can’t read. GDP is only weaker than expected due to the extraordinary growth in imports, and the weather affecting exports. Full stop.
This all highlights one simple fact – people just want lower rates; rate cut hysteria is extreme. They want lower rates too boost the popularity of a weak and unpopular government, to boost profits, lift margins and lower the Australian dollar. Just quietly the Australian dollar is up to 1.0460 or what, about a cent and half higher than what is was before the CPI. Again, there's no recognition of this or understanding from these people as to what is actually driving the Australian dollar higher.
So we’ll get those cuts and as many have said the only question is whether it’s a 25 or 50 basis point cut. For mine, I think a 50 basis point cut would be way over the top and panic people. Note that business and consumer confidence actually fell the last time the bank cut rates, because of confirmation bias – you know, things must be bad if they are cutting. If the board can understand this, we’ll get 25 basis points this month and maybe another in June. Make no mistake, any rate cut from this point is in my judgement a mistake. If the cash rate was 50 basis points higher, then a cut might be in order. But it’s not. I mean, this more modest inflation environment now probably does allow an easier monetary stance (4.5 per cent), but I’m not sure the outlook does given the lags of policy. How many rate cuts? Given the extent of the hysteria I’d say at least 75 basis points but that’s a guess. It’s difficult to forecast what the bank will do when the debate is detached from reality.
More on all of that later. For the rest of the week and outside of the RBA’s meeting there are only a few bits of data for Australia. TD securities inflation gauge is out today (1030 AEST) as is the RBA’s private sector credit numbers. RP Data Rismark’s house price series is due tomorrow and then on Friday we have the Reserve Bank’s Statement on Monetary Policy, which will outline the new growth and inflation forecasts. I’d be surprised if there is much of a change in the growth forecasts, but inflation will likely be revised down maybe a quarter to half a per cent in 2012, although again, I wouldn’t have thought inflation forecasts beyond 2012 would have changed much, but they probably will be revised down a quarter of a per cent or so to justify the rate cuts we’re about to get.
In the US, it’s action packed as usual and some of the big releases worth watching include personal income and spending tonight, which also gives us an estimate of what the core PCE (Fed’s preferred inflation measure) did. On Tuesday night we see construction spending and the ISM manufacturing index, then factory orders Wednesday, initial jobless claims on Thursday and the big one – payrolls on Friday. The market looks for a 165,000 gain in April payrolls while the unemployment rate is forecast to remain steady at 8.2 per cent. Otherwise German retail sales and China’s manufacturing PMI (Tuesday at 1100 AEST) are probably worth a look.