THE DISTILLERY: The China deflator

At an event several years ago, this columnist watched the economist Ken Courtis describe Australia's future relationship with China as akin to a light bulb plugged directly into a nuclear reactor. The light bulb conveys a triple challenge. First, the blinding glow when the reactor fires up. Second, the exploding globe when the reactor redlines. And third, the light going out when the reactor cools. 

For the time being, the light bulb finds itself glowing strongly, not least because the world around it is stubbornly dim. Economic commentary today sees the release of yesterday's inflation data as adding to that glow. Michael Stutchbury of The Australian is sanguine: "the latest Consumer Price Index will disappoint the Reserve Bank. It weakens the case for an interest rate pause. A further cash rate rise ...is a lineball call. Inflation isn't breaking out. The 0.8 per cent March quarter rise in the Reserve Bank's underlying inflation measure is just a touch higher than hoped for...But the Reserve's quarterly monetary policy statement, to be released on Friday next week, is now likely to increase its mid-2010 inflation forecast from 2.5 per cent to 2.75 per cent. The risk is that rather than bottoming out within the zone, inflation won't fall much below 3 per cent just as the economy is being pumped up again by soaring mining export prices, such as for coal and iron ore.”

David Bassanese of The Australian Financial Review is also balanced. He reckons "... even with a 0.8 per cent gain in underlying inflation during the March quarter, the RBA should still be able to comfortably argue year-end inflation fell from 3.25 per cent in the December quarter to 3 per cent.” He adds, however, that strong producer prices "adds to upside risk". On the other hand, he also sees price rises as "narrowly-based", quoting the CBA's CPI diffusion index which is "at the bottom end of the range for the past twenty years – construction costs and non-trade exposed service sectors, particularly quasi-public services – are showing quite strong price gains, whereas prices in the more highly competitive retail sector are falling." He also notes the strong effect of the Australian dollar on "household goods and clothing." He offers no conclusion.

Adam Carr of Business Spectator is not so shy. He sees the same data and concludes "I don't think the RBA is going to like for one minute the fact that the average of the trim and weighted is 0.8 per cent." He concludes "today's result backs the broader strategy of getting to normal quickly. So with the data as it stands, I reckon we will see another rate hike over the next couple of months – if not May then June. Looking beyond that, I think the pace of tightening will slow (data dependent) such that the cash rate will be at 5 per cent (perhaps 5.25 per cent) by year-end.” Which seems a reasonable forecast to this column. 

The only point that this column will add is that no commentator puts much stock in the impact of housing inflation which, given the balance of forces at work in national prices, is likely to be the swing factor in pushing rates higher, sooner.

On that front, commentary by Frank Gelber of BIS Shrapnel in The Australian will give the RBA the heeby jeebies. Gelber ignores the nuclear reactor Australia is plugged into, focusing exclusively on local dynamics to explain that "the long-awaited property upswing is only now starting. Prices around Australia have risen strongly over the past year. Forecasts of a collapse have been dismissed. Owner occupiers and investors now regard housing investment as safe. Concern has swung to the problem of affordability, doubly affected by the combination of rising prices and rising interest rates. But this is just the beginning. Both housing prices and interest rates have a long way to go. And affordability will get a lot worse before this is over.” He goes on: "(the RBA) appears petrified of a housing price bubble and, with prices already rising and about to rise a lot further, the danger is that it will be too aggressive with interest rates. The RBA can stop price rises, but the collateral damage will be on housing construction. It needs to be careful. This is not about levers and levels. Interest rates are a trigger. For a long time, rising interest rates appear as though they are not working and then, suddenly, the housing market collapses. We've seen this scene played out time and again in Australia.” Gelber concludes, "All considered, we think the upswing has another three to four years to run.”

This column agrees with the contention that there is considerable momentum behind housing. However, it finds the proposed time-frame for this boom-to-come hard to believe. Chinese growth and commodity prices will likely come off in the next 12 to 18 months, perhaps considerably, as stalling US and European imports collide with increased mine supply. Moreover, Gelber's analysis contains the seeds of its own undoing. He notes the RBA's level of concern but reckons somehow the boom will run anyway. It gets worse when Gelber turns to analysing the housing market state by state. Having argued it is shortages in housing stock that has driven price rises in NSW, he says "it's no accident the housing recovery has been strongest in Victoria, where land is relatively cheap and readily available.” This column will ask why, then, has Melbourne been by far the hottest market, with the highest price rises by some distance?

The AFR has a better-argued economic comment by John Quiggin, who sees the effects of the Chinese reactor as, in part, debunking the last of the three reasons for a Queensland Rail sale. The first reason was "a comparison between dividends forgone from privatisation and interest saved, purporting to show a net gain of $1.5 billion a year.” It "was an invalid apples and oranges comparison, and there was no good reason to expect any financial benefit.” Second was the notion that "the sale of income-earning assets could finance the construction of schools, hospitals and roads, even though these assets would generate no income.” And now the third, that the reduction in state debt is essential to "preserve any capacity for public borrowing" has collapsed because Queensland's budget has "improved markedly" – by $11 billion, according to Access Economics – on the back of federal and Chinese stimulus. Quiggin concludes, "Queensland therefore has a budget hole of around $1.5 billion a year, made up of tax concessions, subsidies and tax expenditures the state can no longer afford" – with revenue about "85 per cent of the Australian average". 

Also in that paper, Robert Guy, presumably the new Chanticleer, begins with a sensible enough castigation of the dithering of European officials around the bailout of Greece. He puts his finger on the problem when he says Europe must act before "a crisis of confidence” engulfs their ability to "manage the crisis” and, more importantly, "stop it before it spins out of control”. Much the same point is made by Matthew Stevens of The Australian.

This column continues to see a bailout coming. However, with local politics driving the coordination through the IMF, there seems little likelihood of a quid-pro-quo centralisation of European fiscal control. This bailout is the brick that will smash further European integration. 

Malcolm Maiden of The Age also covers Greece with a good aggregation of figures around European debt. Karen Maley of Business Spectator sees the inevitability of Greek default, with the bailout offering only a temporary reprieve.

Returning to our theme de jour, will the fallout effect the light bulb, perhaps preventing further rate rises? Not in the near term, this column would argue, given the RBA has emphatically positioned the GFC as a North Atlantic crisis. The key, however, is how much leverage and derivative madness is piled atop the European banks' exposure to its troubled members. Bailouts must keep coming.