Enclosed below is by far the best summary of the RBA's inflation problem that I have read so far. The issue, of course, is that the RBA is, in practice, a pure inflation-targeting central bank. It very deliberately and formally redrafted its monetary policy mandate with the Government--via the 1996 'Statement' struck with the Treasurer--to make its 2-3% pa inflation target the RBA's No.1 priority to address confusion about whether it had a dual target.
Put differently, the RBA does not prioritise the maximisation of employment (one part of its original 1959 mandate) precisely because there is an adverse trade-off between inflation and employment in the short-term. That is, you cannot target both at the same time.
To quote the Statement, which has now been executed on four occasions since 1996 by both the Governor of the RBA and the Treasurer:
"Price stability is a crucial precondition for sustained growth in economic activity and employment. Both the Reserve Bank and the Government agree on the importance of low inflation and low inflation expectations. These assist businesses in making sound investment decisions, underpin the creation of jobs, protect the savings of Australians and preserve the value of the currency. In pursuing the goal of medium-term price stability, both the Reserve Bank and the Government agree on the objective of keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle."
The RBA does not, therefore, by its own design have a "dual mandate" like the US Federal Reserve.
In addition to canvassing the risks associated with importing inflation from China, which I have raised many times here, ANZ highlight another point I've mentioned of late: that the deflationary forces we are seeing via the rising AUD are in discretionary--or non-essential--consumer expenditure classes. This means that staples, or the cost of living, is running ahead of measured inflation, which is very, very bad news indeed for inflation expectations. The more worrying thing is that Australian inflation expectations had begun de-coupling from the RBA's 2.5% pa inflation target during the decade or so prior to the GFC, and have surged back to an above-average level since. Unless the RBA grinds inflation back into its 2.5% pa target, the risk is that there will be a more permanent de-coupling going forward, which will eviscerate the effectiveness of an inflation-targeting central bank.
Here is an excerpt from ANZ's excellent note:
"Today's higher than expected result will highly likely force the RBA to upgrade its inflation forecasts. Core inflation would need to average just 0.6% per quarter for the next three quarters to achieve the RBA's previous forecast for core inflation of 2¾% by year-end. We expect such a persistently low quarterly number will be difficult to achieve, with the deflationary impact of the higher AUD likely to be offset by higher oil and other upstream price pressures, higher global inflation (especially from China), a tightening of the local labour market, higher capacity utilisation rates as the mining boom gathers steam and further upward pressure on utilities prices.
The likely upgrade to the RBA's forecasts, for core inflation to now reach 3.0%, the top of the target band, by end-2011 suggests the Bank's tolerance for any further upside surprises on either prices or activity is low. This not only supports our expectation that the Bank will raise its cash rate twice before the end of this year, but also raises the possibility the first rate rise will occur before our current forecast of July.
A pure inflation targeting central bank would most likely need to react to today's number with a May interest rate rise. But the RBA's multi-faceted mandate, which includes the maintenance of full employment, makes monetary policy setting exceedingly tricky in Australia at the moment as it gives possible reasons for a further pause. For forward-looking policy-makers, the issue is what is the policy of least regret? At the May Board meeting, the discussion will be whether a 25bps interest rate rise, to address inflationary pressures towards the end of this year, will overly disrupt the national economy now, when certain sectors are reeling from natural disasters and a multi-decade high in the AUD? In other words, can policy makers afford to wait a couple of months to further assess domestic and global activity?
This is a difficult decision for the RBA Board, which prior to today's number was very comfortable about the stance of monetary policy. While today's number isn't a cause for panic, it will likely cause the RBA to completely re-evaluate their forecasts. Markets are still pricing in a minute chance of a rate rise before H2 and less than 25bps of tightening before year-end. In our view, such market pricing considerably underestimates the risk of interest rate rises in Australia over the next six months.
It will be important to watch commentary from journalists over coming days given that there are no scheduled RBA speeches in which the RBA could flag a surprise hike ahead of next Tuesday's meeting...
Inflation was particularly high for essentials or non-discretionary items in the quarter. While our measure of discretionary prices increased just 0.3% QoQ, prices for non-discretionary items surged 3.2% QoQ. While this partly reflects increases in fuel, fruit and vegetables and deposit & loan facilities, it still raises the risk of an upward shift in inflationary expectations."
