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Tuesday, July 27, 2010

Inflation outcome could swing election

Tomorrow’s inflation numbers could have a profound impact on the 2010 election outcome. If the RBA hikes to 4.75 per cent, it would lift the headline mortgage rate to 7.7 per cent (assuming no bank top-ups), which is above the long-term average since the mid 1990s. This would in turn undermine the government’s current momentum and lend much weight to the opposition’s cost of living arguments. If, on the other hand, the RBA pauses at its so-called ‘neutral cash rate’ for the third month running, the opposition’s claims that the fiscal stimulus was unnecessary and is simply working to force the RBA’s hand will look very weak.

There is a strong consensus amongst market economists that the ‘core measures’ of inflation will print at somewhere between 0.7 and 0.9 per cent for the June quarter. This would mean that inflation is running at between 2.8 and 3.6 per cent per annum. On that basis, one should expect a decent chance of a hike. There are, however, two underappreciated riders to this conclusion. First, the RBA is forecasting a much lower inflation outcome of just 0.55 per cent. Second, new research published by UBS yesterday firmly reinforces the RBA’s view, and argues that there is a much higher probability of a low inflation result than market participants expect.

Recall that the RBA has a formally agreed mandate with the Treasurer to keep inflation within a 2-3 per cent per annum ‘target’ band through-the-cycle. Yet for three of Glenn Stevens’ four year term as Governor, the RBA’s two preferred inflation benchmarks—the so-called ‘trimmed mean’ and the ‘weighted median’—have been running above the 3 per cent upper bound. Put bluntly, Australia has had a persistent inflation problem.

Given the recent stabilisation in Europe via a combination of surprisingly strong economic data and the purportedly positive ‘stress test’ results, the RBA is likely to employ a very simple decision-rule for its next meeting (ie, uncomplicated by the external sector).

If the preferred core measures of inflation come in at 0.7 per cent or less, the RBA will almost certainly remain on hold. If they print at 0.8 per cent or higher, we will get a hike. Economists and the markets have a slightly different perspective. They think that a 0.8 per cent result will make a hike a 50:50 bet, while 0.9 per cent or more locks in a rate increase.

But this logic looks faulty to me. First, the RBA set a precedent only a few months ago in May by raising rates when inflation printed at 0.8 per cent. Second, this outcome would indicate that price pressures are not subsiding, as the RBA has explicitly forecast. This would further demonstrate that the RBA has again ‘under-club’ its inflation projections, as NAB’s Peter Jolly has put it.

Thirdly, a 0.8 per result tell us that inflation is currently running at 3.2 per cent per annum, which is above the RBA’s target range. This would be especially disturbing for the RBA since we are coming out of a modest downturn when the economy is supposed to have spare capacity. A high inflation print would suggest otherwise and portend much deeper price stability problems down the track.

Finally, the RBA raised rates in the middle of the last election campaign, and would run the risk of serious politicisation and brand damage if it ignored all of the preceding evidence and tendered some nebulous arguments as to why it should remain on hold despite a high number.

There is, however, some good news for the government. In a research report published yesterday, UBS’s Matt Johnson concludes that the market may have got it wrong. In particular, his analysis shows that there is a seemingly high 67 per cent chance that tomorrow’s numbers will come in it at less than the consensus forecast of 0.8 per cent.

Johnson notes that the RBA’s average forecast error in recent times has been a positive 0.15 per cent per quarter (ie, it has consistently underestimated inflation), although this has been declining over time. One simple exercise is to add the RBA’s June quarter forecast to its historic error, which gives you a 0.7 per cent result. If this comes to pass, rates will be on hold.

Johnson’s second interesting conclusion is that the ‘breadth’ or dispersion of high inflation across the economy has been declining since the end of the financial crisis. This is important because the greater the breadth, the more likely the two core estimates of inflation will print higher. If, on the other hand, the sources of price pressure are limited, they will likely be excluded from the RBA’s core measures.

One thing we know with certainty is this. Julia Gillard will be closely monitoring her blackberry at 11.30am tomorrow and hoping that Matt Johnson and the RBA are right. Her opponent will be similarly fixated on the wires, but praying they have got it wrong.