“Too little, too late” is Henry’s considered view about monetary policy in Australia. This view seems to be catching on more widely, with market participants saying this month’s rate hike is “virtually certain” and increasing the odds on at least one more hike in February 2007.
As a famous Australian central banker, the late Austin Holmes, used say of such adjustments, these folk are “stumbling reluctantly toward the truth”.
There are mixed signals from the real economy, as we shall discuss. But the key point is that “core” or “underlying” inflation is rising steadily and reached the top of the target range in the September quarter. Unless this trend is reversed, Australia’s hard-won reputation as a low inflation economy will be put at risk. Indeed, it already is.
There is a strong case for a pre-emptive rise in cash rates of 50 basis points. This might just jolt inflation expectations back into the zone of relative stability, and thus protect a fundamental pillar of the strong economic prosperity enjoyed by Australians for the past 15 years.
The more likely outcome of today’s meeting of the Reserve Bank board is the widely expected 25 basis point hike. The risk is that that decision would not have much effect in curbing inflation, meaning more anguished debate and further rate hikes well into 2007.
The political fallout from this would be ugly. Although the Reserve Bank board should of course ignore such a matter, Henry and his readers in Canberra need not.
The global economy has experienced offsetting forces in the past month. In summary, the US economy has weakened while the Chinese boom has possibly strengthened. The net effect is that the price of oil has fallen substantially, reducing one of the main risks to continued strong global growth.
There is in fact concern at the highest levels of international policy-makers at China’s ability to contain its boom, and continued double digit Chinese growth will ignite inflation there. Chinese inflation would reverse the great global force of Chinese deflation, removing a powerful anti-inflationary force from the global economy.
The world has also, quite suddenly it seems, realised that global warming is a massive threat to continued growth and that adjustment to a more sustainable future economic path must begin soon or it could be very painful. Despite the fall in oil prices (which might in part be a response to lesser perceived geopolitical threats), the overall situation in the Middle East remains parlous.
So the global background continues to feature strong growth but with more of an inflationary bias than we have seen for the past decade and a half.
Australia has experienced mixed economic trends. There is the distress felt by farmers as the worst drought in a century or more tightens its grip. Retail sales seem to be slowing, suggesting that on average households are tightening their belts, and no doubt the poorer members of society are hardest hit. But overall credit growth is still far too high, especially growth of credit card debt.
Employment growth remains strong, and casts into doubt the relatively subdued growth of real GDP. Unemployment is below 5 % of the measured workforce and seems still to be falling. Skilled labor is hard to get, and in its first decision the Fair Pay Commission saw fit to award almost the full amount demanded by the ACTU. Despite this decision ignoring the government’s submission, the Prime Minister described it as an act of “genius”.
Various measures of business confidence are weakening, except for the resource companies and some parts of the service sector, which remain in boom time condition. (No businessperson can fail to recognize the difficulty and cost of obtaining competent accounting services, for example.)
House auction clearance rates are strong and housing approvals have shown signs of recovery. The banks and resource companies are producing record profits and share prices continue to set new records. Overall, Australians as a group are accumulating wealth at rates not seen since the gold rushes of the nineteenth century.
Inflation is the joker in the statistical pack. The June quarter consumer price index (CPI) shocked with an annual increase of 4 %. This was correctly ascribed in part to large increases in the prices of petrol and bananas. “Underlying” or “core” inflation, it was pointed out, was at 2.9% still (just) within the target zone of 2 to 3 %.
September’s CPI provided an even bigger shock. Overall or “headline” inflation was slightly lower, at 3.9 %. This was only a slight reduction, which immediately sounded an alarm. But when the measures of “core” inflation were published shortly afterwards by the Reserve Bank, the shock was palpable.
The so-called “trimmed mean” rose by 2.9 % and the “weighted median” rose by 3.2 %.
As the graph shows, these two measures of “underlying” inflation have risen inexorably since late 2005. These increases were well above those expected by the econocrats of Treasury and the Reserve Bank, and leave them sitting very uncomfortably in relation to the 2 to 3 % inflation target they have embraced so enthusiastically.
Whether gradual and drawn out, or larger and pre-emptive, increases in interest rates will inflict real pain. For most Australians this pain is able to be coped with, and provide valuable lessons about risk management to those who take note.
For the poorer members of society, including many farmers badly impacted by drought, the pain will be bad, and in some cases intolerable. Social policy must alleviate the pain, as it already is doing to some extent for struggling farmers.
Holding back necessary tightening of monetary policy would be a bone-headed response to a real problem.
My considered view is the 50 basis points now (accompanied by relevant assistance for those who need help) would be the policy most likely to minimize the overall pain of getting the Australian economy under control again.
Source: RBA and HenryThornton.com
Published today in The Australian.