The author has been described by News Ltd as an "iconoclast", "Svengali", a pollie's "economist muse", and "pungently accurate". Fairfax says he is a "Renaissance man" and "one of Australia’s most respected analysts." Stephen Koukoulas concludes that he is "85% right", and "would make a great Opposition leader." Terry McCrann claims the author thinks "‘nuance’ is a trendy village in the south of France", but can be "scintillating" when he thinks "clearly". The ACTU reckons he’s "an enigma wrapped in a Bloomberg terminal, wrapped in some apparently well-honed abs."

Tuesday, January 25, 2011

What today's inflation numbers mean for mums and dads: A dummies guide

So Australia’s December 2010 quarter inflation numbers are reported at 11.30am today. What does this really mean for mums and dads? And what is inflation?

Inflation is a measure of changes in the prices (ie, cost) of consumer goods and services. The stuff you and I buy. Rapidly rising inflation is generally considered to be a bad thing. Why? Because if the cost of the goods and services we buy is increasing at a faster rate than the money we have in the bank, we suffer a dilution in our purchasing power. Furthermore, if we are worried about future inflation rates, which we think might be highly variable, we might be reluctant to save money, and hence could unwittingly contract the pool of cash available for investment (since banks lend out the money we save to fund investments).

This is to be distinguished from asset price inflation (eg, increases in the value of shares, houses, etc), which, all other things being equal, improves our wealth and purchasing power assuming we own the assets in question.

Economists tend to prefer a low and predictable rate of inflation, since this mitigates the abovementioned problems, and also gives the unelected folks who run much of the economy--known as ‘central bankers’ employed by the Reserve Bank of Australia, which is a taxpayer-owned bank--an opportunity to manage the price of credit (ie, interest rates), so that we can keep inflation low and stable. In fact, they have been mandated by our elected officials--ie, politicians--to try and keep headline inflation between 2-3 per cent per annum, on average, through the economic cycle.

Okay, we have the definitional stuff dealt with. What do today’s numbers mean for the man on the street? Well, first you need to pay attention to what are known as the ‘core’ measures of inflation. There are two main ones: the ‘trimmed mean’ and the ‘weighted median’. These fancy terms simply remove the influence of so-called outliers. It is exactly like mowing your lawn. The height of the blade on your mower determines the maximum acceptable length of the grass on your lawn. These two core measures of inflation have the same effect: they set the maximum acceptable price movements in a quarter. Most economists then average these two numbers together to get an overall picture of ‘core’ inflation.

For what it is worth, here is my dummies guide to what the RBA is likely to do depending on what happens at 11.30am this morning.

1. Core inflation averages 0.6 per cent or less in the quarter (good news): Interest rates will not increase until May or June, and then it will depend on the March quarter inflation results, and what is happening with unemployment.

2. Core inflation averages 0.7 per cent (not so good news): Same as above, although there is probably a 10-20 per cent chance the RBA lifts interest rates in March or April if the unemployment rate keeps falling strongly below its present 5.0 per cent level.

3. Core inflation hits 0.8 per cent or higher (bad news given if we annualise this number core inflation is running above the RBA's target 2-3 per cent band): What happens here will depend partly on the integrity of the numbers. For example, do all the core measures line up nicely? Are there any other anomalous explanations for this result? If not, and if the unemployment rate stays flat or falls in February, I would venture that we have a greater-than-50 per cent probability of getting an interest rate hike in March, and almost certainly will get one in the months thereafter if they don’t go in March.

What will be driving Australian inflation? Three key things. First, internal shocks, like the Queensland floods, that have destroyed our ability to produce things, and therefore reduced their supply. Second, external shocks, like inflation in China, that will drive up the cost of the goods we import (assuming the currency does not appreciate further). Finally, perhaps the most significant long-term driver of inflation will be what are known as ‘capacity constraints’. This mainly means labour shortages. We simply do not have enough skilled workers in Australia, and when the demand for workers exceeds their supply, wages tend to rise. This in turn pushes up the cost of producing the goods and services we consume.

Of course, if you are a net saver (ie, you have more cash than debt), rising interest rates can be a good thing: you will earn more money on your cash at the bank, all else equal. If you are a net debtor with a variable rate home loan, on the other hand, higher rates are not such an enjoyable experience.

So here’s to hoping that core inflation prints at 0.7 per cent or less today.