WEEKEND ECONOMIST: Inflation control begins at home

RBA governor Glenn Stevens said in a speech this week that global monetary conditions need to be tighter. Pity Australia has one of the worst inflation rates in the developed world.

RBA governor Stevens must have made a New Years resolution to get out more. His speech this week noted that loose monetary policy in emerging market economies bore some of the responsibility for the acceleration in global inflation:

"Global monetary policy has been too easy in recent years and that is why we have seen such a major run-up in a wide range of industrial commodity prices. Any individual country might wish to treat those increases as exogenous, but they cannot be exogenous for the world as a whole if they are driven mainly by demand, which by and large they have been to date. So, as a number of commentators have been saying recently, global monetary conditions need to be tighter."

These remarks would carry more weight if Australia were not itself running one of the worst inflation rates in the developed world, a relative performance that can only be explained with reference to domestic monetary policy. The rising Australian dollar exchange rate since 2003 and tighter credit conditions since August 2007 means that much of the overall tightening in monetary conditions in Australia has effectively been outsourced. The RBA's official cash rate has made the least-timely contribution to this process, barely keeping pace with the continued acceleration in domestic inflation.

Governor Stevens went on to argue that the nine-quarter inflation target breach now in prospect is analogous to the 10 quarters that inflation ran below target between 1997 and 1999, and so would still be consistent in every essential respect with the experience under inflation targeting since it began 15 years or so ago. If you had asked then governor Bernie Fraser in 1993 whether he was an inflation targetter, he would have surely denied it. But leaving that aside, Stevens neglected to mention the one-off policy changes that exerted a
restraining influence on inflation at this time, such as the introduction of the tax rebate for private health insurance on July 1, 1997. Prior to 1998, mortgage interest rates fed directly into the CPI, so there was a different dynamic between monetary policy and inflation, such that the then easing cycle contributed to lower inflation.

Steven's suggestion that we should view CPI inflation running at over 4 per cent and an inflation rate running below 2 per cent in the same way would strike an international observer as strange, to say the least. In most comparable countries, an inflation rate in the 0-2 per cent range would be welcomed as being consistent with price stability. Having set our inflation target higher than international price stability benchmarks, we should not be surprised when a top-side target breach saddles us with one the worst inflation performances among comparable countries.

The RBA's inflation forecast for 2010 is now on a collision course with the federal government's carbon emissions trading scheme (ETS). The government's estimates in relation to the carbon price and its expected inflation impact are just that: estimates. One of the main disadvantages of an emissions trading scheme compared to a carbon tax is that there is much less certainty in relation to the future carbon price and therefore less certainty in relation to the impact on inflation. The price instability associated the RBA's flexible approach to inflation targeting will be compounded by the potential price instability associated with the ETS.

Governor Stevens has suggested that monetary policy would approach the inflation impact of the ETS in the same way as the introduction of the GST, as a one-off influence on the price level. But the impact of the GST was relatively predictable and short-lived compared to the proposed ETS. Even with the GST, the RBA washed its hands when it came to
publicly forecasting the impact on inflation. If the RBA begins incorporating the impact of ETS in its inflation forecasts, those forecasts will only be as good as the underlying carbon price assumptions, which it will probably take directly from the government for the sake of official family unanimity on the issue. With future inflation outcomes subject to such a high level of uncertainty due to both monetary policy and the ETS, the Australian economy lacks a clear nominal anchor over the next few years.

The short-end of the yield curve rallied on Governor Stevens' speech. We would normally be tempted to dismiss this as yet another RBA-inspired suckers' rally in the context of the multi-year, inflation-driven downtrend in bond futures prices. On this occasion, however, there is a much greater likelihood that the market has got it right. The further round of market-led increases in home lending rates relieves some of the pressure on the RBA to raise the official cash rate. Renewed weakness in equity markets points to weaker activity, and should give the RBA greater confidence that its economic forecasts will be realised. In this context, even a worse-than-expected CPI outcome next week may not be enough to tip the RBA's hand. The RBA is likely to dismiss even the worst possible June quarter inflation outcome as a by-gone, continuing to hang its policy hat on the downturn that it has long been forecasting, but unwilling to actively engineer via changes in the official cash rate.

The second quarter final producer price index is released Monday, forecast at 1 per cent quarter-on-quarter and 4.7 per cent year-on-year. The second quarter CPI is released Wednesday, forecast at 1.4 per cent quarter-on-quarter and 4.4 per cent year-on-year. The weighted median is forecast at 1.2 per cent quarter-on-quarter and 4.7 per cent year-on-year. The trimmed mean is forecast at 1.1 per cent quarter-on-quarter and 4.3 per cent year-on-year. These measures of central tendency are thus expected to show a slight moderation on the previous quarter's rise, but still come in somewhat higher than implied by the RBA's May Statement forecasts.

Dr Stephen Kirchner is an independent financial market economist. His blog can be found at www.institutional-economics.com


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