The October Board Minutes clearly indicate that the Bank is now likely to revise up its inflation forecasts: "while current forecasts suggested it (inflation) would fall in the coming year the expected trough in inflation was significantly higher than earlier thought" and "by 2011 inflation could be rising again."
A concern for the Bank is that underlying inflation built up much more rapidly through 2008 than in any period since the 1990-91 recession. This was at a time when the economy was operating near or at full-capacity, as evident from the unemployment rate which declined to just 4.0 per cent, the lowest since 1974. Housing stock shortages were a compounding factor, with rents increasing strongly.
In the aftermath of the 1990-91 recession underlying inflation slowed from 6.1 per cent in 1990 to 1.9 per cent in 1992. Over the subsequent 15 years to September 2007 the highest print for annual underlying inflation was 3.3 per cent. That was in December 2001, although even that read was indirectly affected by the introduction of the GST. By comparison, core inflation hit 4.3 per cent in 2008 – clearly indicating that underlying inflation had stepped up to a higher peak in this cycle.
Turning to the September quarter 2009, our forecast for underlying inflation is 0.9 per cent. That follows 1.2 per cent (September quarter 2008); 0.7 per cent (December quarter 2008); 1.1 per cent (March quarter 2009); and 0.8 per cent (June quarter 2009). Disconcertingly, our forecast indicates an increase in the quarterly measure. This is at a time when the lagged effect of the slowdown in spending through 2008 (domestic demand growth slowed from 6 per cent in 2007 to 3.5 per cent in 2008) and 2009 (we estimate that domestic demand growth will slow further to -0.4 per cent in 2009) should be indicating a fall in the quarterly measure as a clear beginning of a downward cycle in underlying inflation.
If the underlying CPI number does print at 0.9 per cent it would be necessary for the December underlying CPI to print 0.45 per cent to achieve the Bank's forecast of 3.25 per cent for 2009. Given the run of quarterly underlying measures that seems particularly unlikely. Even a 0.7 per cent read for the December quarter would be required to achieve a 3.5 per cent result for 2009 – any evidence that quarterly underlying inflation has troughed in 2009 would be very disturbing for the RBA. However, it is still most likely that underlying inflation will bottom out in 2010.
With annual underlying inflation printing 4.3 per cent in 2008; and forecast to print 3.5 per cent in 2009 and the Bank forecasting that GDP growth would return to trend in 2010, "and subsequently to strengthen somewhat" the substantial risk is that the lowpoint in underlying inflation which can be expected in 2010 is much higher than the current 2 per cent forecast and even substantially higher than the 2.5 per cent which might now be on their radar screen. That would be considered absolutely the maximum acceptable lowpoint in any inflation cycle for a central bank targeting "2-3 per cent on average through the cycle". Given the growth outlook of both the Bank (at trend) and Westpac for 2010 (domestic demand growth in 2010 expected to be 4 per cent up from -0.4 per cent in 2009) inflation can be expected to be rising in 2011.
The concern for the Bank should be that the starting point for the next up-cycle in inflation is too high and more urgent action needs to be taken with monetary policy.
We expect that the Bank will be very anxious to see that quarterly underlying inflation has trended down in September. Clear evidence that it has started to pick up before the impact of the usual lags would be disturbing.
It would be very unlikely that a central bank would be comfortable running a highly stimulatory monetary policy when evidence was building that the lowpoint of inflation in the next cycle was too high, thereby risking the whole credibility of the "2–3 per cent on average through the cycle" target. An associated consideration for the RBA is that there will be considerably less slack in the labour market following this downturn than after the last two recessions, with the unemployment rate now expected to peak in 2010 below 7 per cent.
Concerns about an unacceptably high lowpoint for inflation in the next cycle would certainly expose a highly stimulatory policy stance.
With policy currently seen to be exceptionally stimulatory it is reasonable to expect the Bank to accelerate any plans to withdraw the stimulus – that would put a 50bp tightening right into the forefront in November.
Bill Evans is chief economist at Westpac.