WEEKEND ECONOMIST: Please explain

The market has priced in an inflation rate for Australia that makes it the worst in the Anglo-American world, yet RBA Governor Glenn Stevens is not being held to account.

If we are to take the Reader’s Digest Survey of the 100 Most Trusted Australians at all seriously, then RBA Governor Glenn Stevens comes in at a very low 83, well behind Dr Harry, Bindi Irwin, Lara Bingle and The Wiggles. He did at least manage to come out ahead of Wayne Carey, Ben Cousins, Kyle Sandilands and Rodney Adler.

This measure of relative trust is not inconsistent with financial market pricing. This week saw Australian three-year bond futures post new lows in price not seen since the peak of the last cycle in early 2000. This is not the sort of price action we would expect with the US economy supposedly in recession and Australia on the brink of a major slowdown.

But back in the first quarter of 2000, Australia’s headline inflation rate was 2.8 per cent rather than the 4.2 per cent seen in the first quarter of this year. The short end of the Australian yield curve embodies a large inflation premium, reflecting the worst inflation performance in the Anglo-American world.

By way of comparison, the US headline CPI was running at 4 per cent for the year ended in March, with a core CPI (ex-food and energy) of 2.4 per cent. The more significant difference is that in the US, even a core rate of 2.4 per cent is considered unacceptably high, whereas in Australia, it would be considered a policy triumph. It is also worth recalling that the US has managed this outcome in the context of a sharply weaker exchange rate, in contrast to the exchange rate appreciation that has actually held back inflation in Australia.

In Canada, headline inflation was running at 1.4 per cent, with the core measure running at 1.3 per cent in the year to March. This partly reflects a cut in Canada’s GST rate, which has taken around 0.5 percentage points off the headline rate, but still leaves Canada’s inflation rate below Australia’s.

In New Zealand, headline inflation was running at 3.4 per cent, with a trimmed mean of 3.3 per cent compared to Australia’s 4.1 per cent. The UK CPI was running at 3.3 per cent for the year ended in May, the highest in the history of this series dating back to 1997, but still below that seen in Australia.

There is also a significant qualitative difference between Australia the rest of the Anglo-American world in terms of public accountability for inflation. In the UK, the Governor of the Bank of England is required to write an open letter to the Chancellor of the Exchequer explaining the failure to meet the inflation target and what the Bank of England is doing about it, highlighting the BoE’s institutional responsibility for inflation outcomes.

The Governor of the Reserve Bank of New Zealand, in the press conference accompanying the release of its latest Monetary Policy Statement, had to field questions from the media as to whether he still enjoyed the confidence of the RBNZ Board, with the implication the board might invoke procedures to recommend dismissal of the Governor to the Minister.

In Australia, the idea of the RBA Governor fronting a press conference to be held accountable for inflation and interest rate outcomes is almost inconceivable to a local media largely unaware of the revolution in central bank governance that has taken in place in other countries.

Instead of holding the RBA responsible for inflation outcomes, responsibility is left with the government, which is expected to bail out monetary policy with a contractionary fiscal policy.

Having posted fresh multi-year lows in price, the short end of the Australian yield curve firmed into the end of the week. US Fed-sourced stories of dubious provenance suggested that the policy statement following next week’s Federal Open Market Committee meeting is likely to use stronger language about the risks from inflation than in May, but is also unlikely to validate market expectations for a Fed tightening as soon as August.

The Financial Times reported that Fed officials "do not dispute that the next move in US interest rates is very likely to be up. But they feel the market may be pricing in too much tightening too soon." With prediction markets now pricing an 80 per cent probability that second quarter growth in the US will be positive, it will be difficult to contain expectations for a reversal in US monetary policy.

The minutes of the June RBA Board meeting argued that "on current policy settings, the necessary moderation in demand growth was likely to occur." While the data are now inching the RBA’s way, this is only partly a reflection of RBA policy settings. Instead, the RBA is still relying on the exogenous tightening in credit conditions to do the work it has been unwilling to do via the nominal official cash rate.

The risk is that tighter credit conditions are readily absorbed by the increase in national income implied by a rising terms of trade, exerting only a moderate restraining influence on domestic demand. This could result in a multi-year inflation target breach and a structural increase in inflation expectations that will be difficult to reverse in the absence of a recession.

There is little on the local calendar next week. Across the Tasman, New Zealand March quarter GDP Friday is forecast at -0.4 per cent over the quarter and 2 per cent over the year compared to the RBNZ's June Monetary Policy Statement projection of -0.3 per cent over the quarter.

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

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