Next week will likely see the worst underlying inflation outcome in Australia since the great disinflation of the early 1990s. However, the RBA has already responded to the expected inflation outcome with rate hikes in February and March.
The acceleration in inflation is also already discounted in the RBA’s inflation forecasts. The main influence the Q1 result will have on the monetary policy outlook will be to tweak the baseline for these forecasts. The continued inflation target breach in Q1 tells us that the RBA was not doing its job properly 12-18 months ago. Whether the RBA is doing its job properly today depends on whether the RBA is right in its judgment that domestic demand will moderate sufficiently to return inflation to the 2-3 per cent target range, without the need for further increases in the official cash rate.
The minutes of the RBA’s April meeting said that inflation was now expected to "fall by a little more than earlier thought", a conclusion supported by the recent moderation in some indicators of activity. At the same time, financial indicators traditionally correlated with the business cycle may be pointing to a pick-up in activity. The 3-10 bond futures spread turned positive again this week, before slightly inverting again at the end of the week. The spread was around –60 basis points in early November last year at the peak of its inversion.
This week’s price action was a ‘bear steepening’ driven by long-end underperformance, which in turn reflected a rebound in equity markets during the week. Both the slope of the yield curve and real equity prices have predictive power for future economic growth. This week’s trends in the yield curve and equity prices may not be sustained and are not necessarily inconsistent with a near-term moderation in domestic demand, but it does point to the risk that Australian economic growth will accelerate again before inflation has been tamed. While this largely reflected movements in offshore markets, it is the RBA’s rhetorical stance that has underpinned the outperformance of the short-end of the yield curve.
As we noted last week, the steepening in the yield curve, expectations for an easing in the official cash rate later this year and heightened inflation expectations have conspired to ease the effective stance of monetary policy. This demonstrates that the RBA’s public comments have a powerful conditioning influence on markets, but also shows that the RBA is not leveraging its policy stance as effectively as it could. The RBA would be better served maintaining a tougher rhetorical stance, which could then be quickly reversed when there is greater confidence that inflation will return to target.
This week’s data offered little relief on the inflation outlook. February housing finance saw a sharp downturn, exceeding our below market forecast, even before the March increase in official interest rates. It is not unusual for housing finance to take a hit following increases in official interest rates, before once again trending higher. However, given the sensitivity of housing finance to changes in both interest rates and consumer sentiment, further weakness is likely in the months ahead. A study in the April RBA Bulletin suggests that, contrary to our previous assertions, financial markets do in fact give a predominantly supply-side interpretation to the housing finance data. According to the RBA, "the result for housing finance suggests that a larger-than-expected outcome would cause a decline in the Australian dollar, albeit very small. This result is not in line with expectations and is difficult to explain". In fact, this result is consistent with the idea that strength in housing finance foreshadows increased housing supply and downward pressure on inflation, all else being equal. It is the RBA’s interpretation of this result that is in error, not that of financial markets.
The other major data release this week was Q1 trade prices. The trade prices release confirmed renewed strength in the terms of trade, even before the increases in bulk commodity contract prices flow through in Q2.
At the same time, the upside surprise on Q1 import prices points to upside risks for next week’s Q1 final PPI, forecast at 1.1 per cent q/q and 4 per cent y/y.
As mentioned last week, the Q1 CPI Wednesday is likely to see a headline inflation rate of 1.2 per cent q/q and 4.1 per cent y/y. The weighted median is seen at 1 per cent q/q and 4.1 per cent y/y. The trimmed mean is seen at 1 per cent q/q and 3.9 per cent y/y.
The average of the two measures, the RBA’s preferred measure of underlying inflation, is seen at 1 per cent q/q and 4 per cent y/y.
In New Zealand, the RBNZ is expected to leave its official cash rate steady at 8.25 per cent at its April 24 intra-quarter policy review. Data released since the March MPS point to a sharp moderation in activity in H1 2008, but with inflation pressures remaining pronounced, the RBNZ is expected to keep its official cash rate steady for the foreseeable future.
Dr Stephen Kirchner is an independent financial market economist. His blog can be found at http://www.institutional-economics.com.