Sunday, 15 January 2012

Inflation Is In Check ... Mate

One of my favourite economic indicators, the TD-MI Monthly Inflation Gauge, shows prices rose a quite hefty 0.5% in December, but this follows a fall of 0.1% in November and a total rise of 0.1% over the prior three months.  As you can easily calculate, over the past 6 or 7 months, inflation is rising at an annualised rate of about 1 and a bit per cent even allowing for the up-tick in December.

There is absolutely no doubt that inflation is decelerating to a point where it is likely to remain at or even will fall below the bottom of the RBA target range of 2 to 3%.  The current sub-trend economic growth momentum, the high (over-valued) Australian dollar and slowing wages pressures are likely to be having some impact on prices.  Also forcing inflation lower is the drop in prices in fruit and vegetables as “normal” seasonal conditions return.

Whatever the causes, it does look like the December quarter CPI (due for release on 25 January), could be stunningly low, perhaps even negative.  If the CPI is zero or indeed negative, it will make an interest rate cut all but certain when the RBA Board next meets in February, with discussion likely to be along the lines:

   Should we cut 50 basis points which means consumers get about 30 and the banks 20 knowing of course that the banks will not pass on anywhere near the full RBA move?

   Should we go just the 25 basis points, see just how much is passed on and revisit the issue at the March Board meeting when we can cut again?

   Should we keep rates steady, risking interest rate rises for retail borrowers as banks pass on higher costs, leaving the already over-valued AUD to rise further and risking a sub-trend growth rate for a little longer?

Clearly, the first two items will dominate. 

My guess right now is that the RBA cuts 25 basis points next month and signal it is on a path to further cut rates in the months ahead.  A 50 basis point cut cannot of course be ruled out.  Global conditions are fragile and central banks elsewhere have in place some of the easiest monetary policy ever seen.  Australia is no where near that.  In addition to the low inflation rate, unemployment is edging up, wages growth is slowing, house prices are falling, credit growth is stuck in the mud and the fiscal policy tightening is still working to dampen activity.

As an aside:  Roughly 10 years ago when I was looking how best to created a monthly inflation gauge for Australia with Professor Don Harding and Dr Lei Lei Song, it was thought best to have a timely measure which detected changes in inflation momentum.  We were not too hung up about trying to replicate the ABS CPI (which would require a different methodology), but nonetheless, we have been delighted to see just how accurate the inflation gauge has been in level and year over year terms since it was created.  The gauge was meant to be most useful when there was a clear run of consistently higher or lower inflation readings because there could be some confidence that inflation pressures were also changing in that direction.  Of course, as the ABS note, monthly data are by construction more volatile than quarterly readings, but there is nonetheless a lot of timely information in the monthly inflation gauge we created.

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