Sunday, 4 March 2012

Inflation in the groove; RBA can move

The ever reliable TD-MI Monthly Inflation Gauge* rose 0.1% in February, a touch weaker than what look to have been seasonally large rises of 0.2% in January and 0.5% in December.  Cutting through the volatility in the monthly data, it looks like inflation continues to hover in the lower part of the RBA target band.

In original terms, there is enough to suggest the official March quarter CPI will rise by around 0.8% (there are a few snippets of data that may influence this in March, but it will be close to 0.8%).  In seasonally adjusted terms, this means the CPI will rise by around 0.5% which if delivered, will bring the annual inflation rate down to around 2.0%.  In underlying terms, the CPI will rise by around 0.6% which would bring annual underlying inflation down to 2¼%.

So as you can see, all roads point to on-going low inflation.

With inflation looking to be very well contained, the RBA has plenty of potential downward flexibility with its handle on interest rate settings.  While it clearly should have cut in February (which would have seen about 10 to 15 basis points passed on to consumers), the door will be open for cuts at every meeting for the next few months at least.

Working against rate cuts are the low unemployment rate and the business investment explosion.  A slow but steady return to more normal conditions in financial markets is also at the margin making rate cuts less likely.  And interestingly, it is the unemployment rate, business investment and market conditions that are dominating RBA thinking at the moment. 

The RBA has little regard to the ongoing falls in house prices, the 35 year low in housing credit growth and the chronic weakness in construction.  The Australian dollar doesnt get a lot of weight in the RBAs monetary policy assessment either, even though it is knee-capping many parts of the economy.  Nor is the RBA too bothered by the weakness in retailing as it welcomes the rise in the household saving rate.  The RBA does give a lot of weight to the fiscal settings, but it would probably like to see what the Budget (in 2 months) holds before reacting further to the quite dramatic fiscal contraction that is already in the pipeline. 
The RBA should cut rates but it probably needs one of its top tier issues – unemployment, business investment, market conditions – to buckle before it pulls the trigger. 

* I was a co-creator of the Inflation Gauge with Professor Harding (La Trobe University) and Dr Lei Lei Song (now with the Asia Development Bank). 

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