Blame Martin Place

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This week’ s September quarter CPI outcome cements the case for a further increase in the Reserve Bank of Australia’ s (RBA) official cash rate, from 6.50 per cent to 6.75 per cent, at its November Board meeting.

The headline CPI rose 0.7 per cent over the September quarter and 1.9 per cent at an annual rate compared to 2.1 per cent for the year-ended in June. The headline rate of inflation was held down by changes in the eligibility criteria for childcare rebates, which subtracted 0.2 percentage points from the CPI over the quarter.

However, the RBA expresses its forecast for underlying inflation in terms of the average of its two statistical measures of CPI inflation, the ‘ weighted median’ and the ‘ trimmed mean’ which are obtained by modifying the figures used to arrive at the headline rate. Here’ s the official definition of how they’re arrived at:

The ‘trimmed mean’ is calculated by ordering the CPI expenditure components by their price change in the quarter and taking the expenditure-weighted average of the middle 70 per cent of these price changes. The ‘weighted median’ is the price change of the component in the middle of this ordering.

These measures are designed to capture the persistent component of inflation that is most likely to influence future inflation outcomes and eliminate big one-off price movements from the equation .

Despite the moderation in headline inflation at an annual rate, these measures of underlying inflation point to a broad-based acceleration in inflation pressures. The weighted median rose 1.0 per cent over the quarter and 3.1 per cent over the year to September compared to 2.9 per cent for the year-ended in June. The trimmed mean rose 0.9 per cent over the quarter and 2.9 per cent over the year – compared to 2.7 per cent for the year-ended in June.

These measures of underlying inflation are thus running at or above the top-end RBA’s 2-3 per cent medium-term inflation target range. The RBA’s August Statement on Monetary Policy noted that:

Taking into account the effects of the August policy decision, along with other factors including the dampening effect from the appreciation of the Australian dollar, underlying inflation is forecast to be around 3 per cent over the year to December 2007. Ongoing pressures are currently forecast to keep both underlying and CPI inflation near the top of the target range during 2008.

Inflation is now running ahead of these forecasts, suggesting that the RBA has fallen behind the curve in inflation control.

The continued strength of domestic demand is expected to maintain upward pressure on medium-term inflation outcomes. This is most obvious in relation to the unemployment rate, which posted new 33 year lows at 4.2 per cent in September. There has been no sign of a ‘ credit crunch’ in Australia, with the widening in credit spreads in wholesale financial markets not flowing through to retail interest rates.

Growth in private sector credit in Australia is in fact at its strongest since the peak of the last economic cycle in the late 1980s. The RBA will interpret the strong growth in private sector credit as evidence that monetary policy is not yet overly restrictive, despite an official cash rate that is the highest in more than a decade, an inverted yield curve and an exchange rate at multi-decade highs.

The recent volatility in global equity markets has also not prevented the ASX 200 share price index from posting new record highs. The chance of a further easing in US monetary policy in late October is unlikely to sway the RBA’ s decision-making, with the Australian economy having largely decoupled from the US economy since 2001.

The Federal election on 24 November is also not seen as an obstacle to further tightening. RBA Governor Glenn Stevens, in his testimony before the House Economics Committee in August, clearly indicated that the upcoming Federal election need not stand in the way of an increase in interest rates. Stevens told the Committee that:

If it’s clear that something needs to be done, I don’ t know what explanation we can offer to the Australian public for not doing it. I don’ t think there’ s any case for the Reserve Bank Board to cease doing its work in the month the election is going to be. I doubt that members of the public would see that as appropriate.

The Government will inevitably cop a lot of flak as a result of the expected election campaign tightening, for which it largely has itself to blame. Having taken credit for the cyclical downswing in interest rates in 2001, it can hardly avoid taking responsibility for the other side of the interest rate cycle.

The irony is that the Government’s campaign on interest rates during the 2004 election set it up to be a victim rather than a beneficiary of future economic prosperity. Interest rates are rising because the Australian economy is enjoying an unprecedented economic expansion that shows few signs of slowing, but rising interest rates have prevented the Government from capturing the political benefits from a strong economy.

While many will blame the Government for higher interest rates, this is unfortunate, because it distracts attention from the fact that the RBA is ultimately responsible for interest rates and inflation outcomes. As the then Deputy Governor of the Reserve Bank, Ian Macfarlane said in 1992:

if you don’t like how monetary policy has turned out, if you think it is a terrible mess, blame us. Blame Martin Place.

The RBA was already forecasting an increase in inflation for 2008 in its August Statement on Monetary Policy, even with the benefit of the August rate hike. The baseline for the underlying inflation forecast in the November Statement will be 3.0 per cent, based on the average of the statistical core series in the September quarter.

In the US, which prefers to keep inflation below 2 per cent, an underlying inflation rate of 3 per cent would be considered a monetary policy disaster. Even with the benefit of a November tightening, it will now be difficult for the RBA to publish a target-consistent inflation forecast in its November Statement on Monetary Policy.

This implies a strong chance of further follow-up tightening at the December RBA Board meeting.

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