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Wednesday, July 21, 2010

Is the RBA's inflation model broken? So asks NAB...

Hardly a comforting question for an inflation-targeting central bank. A central bank that likes to think of itself as best-of-breed. This comes back to credibility, as I have belaboured here for weeks now. Having NAB accuse you of consistently "under-clubbing" prices is liable to give the RBA much pause, if only from an expectations/perceptions perspective. Reiterating my observation the other day that the Phillips Curve is back in the popular vernacular, NAB produced the following analysis this AM:

"While we’re on inflation models, evidence does suggest that the RBA’s models aren’t working well as their forecasts have consistently under-clubbed inflation during the commodity boom era – I would hastily add that so have the NAB’s own econometric models/equations. Perhaps in reaction to this, a couple of weeks ago the RBA released a discussion paper titled “Modelling Inflation in Australia”.

There is way too much complicated maths and econometrics in this paper for most of us, but the conclusion was thankfully simple and elegant. The model they found that explained underlying inflation best was a simple Phillips Curve augmented with import prices. The unemployment rate captures domestic inflation pressures and import prices capture the effects of global price pressures and movements in the exchange rate.

Basically, this is a more sophisticated version of the chart I’ve had in many of my notes recently – and which I show again below - which shows rather intuitively that there is an inverse relationship between the unemployment rate and inflation. As the unemployment rate falls, inflation tends to rise. And as my simple chart highlights, when the unemployment rate falls below 5% some asymmetry enters the relationship and this economy becomes very inflationary.

Looking ahead, at NAB we are going to replicate what the RBA found in their paper and rig-up their inflation model. I’m fairly sure that we’ll find is that an unemployment rate now at 5.1%, and still seemingly falling, is a big inflation warning for the RBA.

Of course, a potential offset to this is the import price term. If global prices are falling, or the $A exchange is rising, then that would placate the RBA. Despite the many negative headlines out of the US and Europe, broader evidence is completely contrary to this idea.

While its true there are disinflationary forces in Europe and the US, inflation in Asia and emerging economies has been rising quite sharply to leave overall Global inflation edging higher in recent quarters. The chart below from the IMF’s recent World Economic Outlook captures this split world accurately. On the $A exchange rate, while the AUD TWI is high in long-term sense, it has been broadly unchanged over the past nine months and is in fact a bit lower than when the RBA made their last public forecast in early May. All up, a 5.1% unemployment rate, in an OK world, looks threateningly inflationary to me, and I suspect the RBA.

Next weeks Q2 CPI

This brings us to next Wednesday’s Q2 underlying inflation result. What is the RBA’s flinching level? Helpfully, they have given us a fairly precise marker to judge next Wednesday’s CPI outcome, with the Minutes saying that staff saw “the underlying inflation rate of inflation continuing to moderate in year-ended terms, to be below 3% for the first time in three years.”

Averaging the RBA’s two measures, underlying inflation was +0.8% qoq and 3.05% yoy in March 2010. Dropping out of the calculation will be the Q2 2009 result, which averaged +0.85% qoq. So unambiguously a +0.7% or less outcome next week would be a moderation in inflation, with the year-ended number dropping below 3% and the quarterly outturn being less than Q1’s +0.8%. This would make for a fairly comfortable on hold at the August 3 meeting.

A +0.8% qoq increase would be a poor outcome. The year-ended underlying rate would still be around 3% and the qoq% rate another high +0.8%. I expect this would make for a vigorous debate in the Board. It would appear that the RBA’s models are again under-clubbing inflation pressures, but balancing this is global uncertainty. Surely entering the debate (but probably not the Minutes) would also be that there is a Federal Election a few weeks later. While it is true the RBA hiked immediately ahead of the 2007 Federal Election, arguably the case for a hike then was more clear-cut. All up, a +08% outcome would make for a very uncomfortable on-hold.

A +0.9% or more increase would be an extremely poor inflation outcome and too hard for the RBA to ignore. Their models would have seriously under-estimated inflation pressures. Moreover, the year-ended rate would be rising again having never even got to below 3%. With a good expansion under-way, a reasonable forecast would see the underlying inflation rate at 3½% and rising a year from now. So despite the global uncertainty, and despite the Federal Election, the inflation targeting RBA would be almost compelled to tighten on August 3.

All up, it might seem too simplistic but for mine the August 3 RBA decision is reduced to +0.7% or less they hold, +0.8% a very uncomfortable hold, +0.9% or more they hike. NAB economists expect underlying inflation to print +0.6%/2.8%, hence our call for on hold on August 3."