The price we'll pay for the RBA's low-rate policy

Treasury Secretary Martin Parkinson’s warning on low rates comes too late. He and the rest of the RBA board should have been thinking about these things over the last few years -- not blindly slashing rates in some vain attempt to weaken the Australian dollar. What are we left with? A house price boom which the Treasury Secretary himself now acknowledges may threaten financial stability; and an emerging inflation problem. Warning now about the dangers of low rates is an absurdity -- the damage is done and there is little he or the RBA board can do about it.

Let’s cut to the chase: we are in this position because the RBA board has misread the economy for some years now. Growth itself has been robust through this period – above-trend most of the time -- and the unemployment rate has been low. Yet rates still came tumbling down. The common retort to this paradox was a nonchalant: “What harm will it do? Inflation is low -- they cut because they can.” And to be fair, I did have some sympathy for that view. Core inflation was barely above 2 per cent for several quarters. That isn’t the case now.

It should have been obvious to these bureaucrats that low inflation outcomes were anomalous. Food inflation, which accounts for some 17 per cent of the total consumer price basket, was running at its lowest pace in recorded history -- deflating in many cases. That was never a sustainable position, and it was one of the primary reasons why inflation was so low. The strong Australian dollar was the other.

The inflationary lift we are seeing now, then, is due to a correction in food prices coupled with a weaker currency. Fair to say that the impact of a weaker exchange rate will eventually wane, although the food price correction still has some way to run (price growth is barely a third of its historical average). I see no reason, given global trends, to expect food to revert to a deflationary path. Quite the opposite.

That doesn’t leave us with much in the way of existing disinflationary forces. So I think this hope that inflation will moderate over ensuing quarters -- a view expressed in much commentary thus far -- is empty. What’s going to drive it? Wage growth is low, yes, but this is an irrelevancy for the inflation cycle and has been for many years.

Nor should policymakers take comfort in the apparent moderation in non-tradeable inflation. The June quarter is subject to a seasonal effect which usually gives a soft result. Otherwise, the dynamics driving non-tradable inflation haven’t changed. Price pressures in housing, education, health etc are becoming more -- not less -- acute. Now consider that if forecasts for the Australian dollar’s collapse eventuate -- towards 80 US cents by year-end, apparently -- then we could see CPI inflation push towards 4 per cent.

The RBA has taken a horrific risk in targeting one financial variable at the expense of the real economy -- which is doing just fine. If the economy were as weak as some suggest, the simple fact is inflation wouldn’t be at the top of the band. Excess capacity would ensure much lower outcomes. That it is at the top of the band shows there is much less slack in the economy than widely supposed -- something consistent with our above-trend GDP growth profile, strong jobs growth and a very low unemployment rate. Yes, yes -- the mining boom is ending, run for the hills! Except that wormwoods were bemoaning the end of the mining boom before it even began. It’s not over -- we’re not even close. This is pure fantasy.

In the real world, we have a house-price boom which may threaten financial stability and inflation that threatens to spill over the top of the band. It’s not an inflation breakout, but that is certainly where the risks lie. The global recovery is in its early stages and we are going into it with inflation already at the top of the band.

Is the RBA going to do anything about it? Of course not! Rates are on hold, as far as they’re concerned, and if anything they’re still poised to cut. I doubt a rate hike is even on the agenda, to be honest. Maybe it wouldn’t do much good anyway. The Commonwealth Bank’s move to slash lending rates this week suggests it’s going to be difficult for the RBA board, when they finally do wake up, to reassert meaningful control over the term structure of rates.

The New Zealand experience suggests this as well. The RBNZ has hiked the cash rate four times in four months (100 bps), yet rates further along the curve are actually lower (55 bps or so).

This all implies that when the RBA does eventually hike, it may be forced to hike aggressively -- which of course increases the odds of another stuff-up. It’s turning out to be just one long tragedy of errors.