WEEKEND ECONOMIST: Inflation myths and reality

This week's inflation data, the worst since December 1995, should put to rest the myth that Australia's inflation problem is imported.

The June quarter saw the worst GST-adjusted headline inflation outcome since the December quarter 1995, exceeding even our own above-market forecast, and the worst underlying inflation outcome on the RBA’s preferred measure since the current expansion began in the early 1990s.

The June quarter inflation outcome should put to rest the myth that Australia’s inflation problem is imported from abroad. The tradeables component of the CPI, those goods and services for which prices are determined in global markets, was in fact the only component running at
an annual rate consistent with the RBA’s 2-3 per cent medium-term target range, at 2.8 per cent. Excluding the transport group from the CPI, the component most directly affected by higher oil prices, still yields an inflation rate of 1.2 per cent over the quarter and 4.1 per cent over the year.

With the exchange rate at quarter-century highs, Australia is well insulated from the worst of global price pressures, including higher oil prices. But this only makes our inflation performance all the more inexcusable. Non-tradeables inflation, prices that are largely determined in domestic markets, rose 1.4 per cent quarter-on-quarter and 5.6 per cent year-on-year compared to 5.0 per cent year-on-year previously. This partly reflects a spike in deposit and loan facilities, which were under-estimated in the previous quarter, and the influence of the global credit crunch. The domestic component of the final producer price index was running at an annual rate of 6.0 per cent.

The RBA’s preferred measure of underlying inflation is the average of the weighted median and trimmed mean, and this measure remains
entrenched at a quarterly growth rate in excess of 1 per cent and an annual rate well above 4 per cent. The RBA will be hoping that this measure peaked in the March quarter, but given that these measures are designed to capture the persistent component of inflation, there is little room for optimism on this score in the absence of a dramatic slowing in economic activity.

The RBNZ commenced a new easing cycle across the Tasman this week, but this only serves to illustrate the dramatic economic slow-down that will be required in Australia to tame inflation. The New Zealand economy saw an outright contraction in the March quarter and the June quarter is
also shaping-up as soft. It should also be recalled that the RBNZ is coming down off a much higher official cash rate, alongside a lower inflation rate. The statement accompanying the RBNZ easing suggests that the move was partly a straight substitution for the market-led tightening in credit conditions seen in recent months. The RBNZ also warned that further easing is partly conditional on the future path for the exchange rate (who said the monetary conditions index was dead?)

So if you thought rising inflation and interest rates were bad, wait until you see the economic conditions that will be needed to bring inflation back under control. This is why even a short-run inflation target breach needs to be taken more seriously by policymakers. The larger and more persistent the target breach, the more painful the subsequent disinflation will be.

Next week, RBA Assistant Governor Debelle speaks on recent debt market developments on Monday. June building approvals are released Wednesday, forecast at -4.6 per cent month-on-month, extending May's 6.5 per cent month-on-month slump. The June trade balance is released Thursday, forecast to show a surplus of $437 million, driven by a 3.8 per cent month-on-month rise in exports and a 2.5 per cent month-on-month decline in imports. June retail trade is expected to show a 0.3 per cent month-on-month rise, with second quarter retail trade volumes forecast to decline 0.8 per cent quarter-on-quarter.

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

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