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Thursday, May 5, 2011

Happy days: no rate hikes priced for 2011; Aussie dollar falling like a stone

Despite Australia’s first quarter core and headline inflation numbers printing at stunning 3.4 per cent and 6.4 per cent annualised rates last week, following on from the ABS’s estimate of producer prices expanding by a stonking 4.8 per cent annualised rate, the interest rate futures markets are still not fully pricing in a single rate hike in 2011. That is to say, financial markets are not certain we will see the RBA move until 2012. The foreign exchange market has tracked in lock-step, with the Aussie dollar shaving nearly three US cents from its recent high of over 1.10 to plunge back to a low of 1.073 in overnight trade. The Aussie dollar continues to fall as I write this, and could well slip back to 1.06 US cents. This firmly reinforces the thesis I outlined earlier this week that it would be mad for the RBA to rely on the exchange rate--as many argue they should--as a secondary monetary policy tool.

Or, put differently, to take the view that it does not need to lift interest rates today because the exchange rate is doing the work for it. Of course, since the Aussie equities market has consistently underperformed (as we predicted) since its 50 per cent crash in November 2007, and a small number of export sectors, such as tourism and education, are being hurt by the currency, there is the 'appearance' of vast swathes of economic discontent. This is naturally contradicted by our 4.9 per cent unemployment rate. I also have little doubt that the five businessmen that sit on the RBA's Board, which lend it an inherently 'dovish' tilt, would be feeling the pinch via their public company responsibilities and direct equities exposures. Surely things must be tough if the sharemarket is getting smashed...

In summary, many billions of dollars of capital, and the world's smartest investors, have collectively concluded that Australia's central bank is not overly worried about core inflation running 100 basis points above its official 2.5 per cent per annum target (ie, the mid point of its mandated 2-3 per cent range), and headline (and cost of living) inflation rising higher again.

Based on all the feedback the RBA has supplied to investors this year, and the formal Statement released by the Board on Tuesday this week, the smart money has inferred that Glenn Stevens basically thinks everything is 'you beaut' down under.

The prevailing consensus is that notwithstanding the RBA’s currently ‘mildly restrictive’ monetary policy and evidence of scorching core and headline inflation pressures emerging (the annualised rates I quote above are consistent with US conventions), this RBA Governor will wait at least until the second and third quarter inflation results come out. He is in no rush. You can just hear investors imagining a dry Australian drawl from Glenn Stevens: "no dramas, mate."

Never mind that if the April through June core inflation figures once again print way above target, the RBA will have ignored one of the highest core inflation rates in the OECD for over half a year, just like it did in 2006-07.

Never mind that if inflation starts also building in the US, and US interest rates begin to rise off their all time historical lows, there will likely be very significant downward pressure on the Australian exchange rate, which will then start acting as a source of domestic inflation, rather than disinflation, in its own right at the same time as the economy is exhausting all its spare capacity

Never mind that the labour market is already fully employed at the start of the biggest private investment boom in Australia’s history, and that many of our major trading partners—China, India and South Korea—have inflation problems they are beginning to export to us.

One gets the sense that the attitude of investors is partly driven by the fact that the RBA has overshot both its core inflation and headline 2.5 per cent target by about 20 per cent per annum for the last decade.

Indeed, one of the largest fixed income investors in the world recently argued that the RBA's target was not, in fact, 2.5 per cent per annum, and that long-term Australian core inflation equal to 3.0 per cent would, in theory, be consistent with its mandate. I beg to disagree. That would mean that Australia's central bank is comfortable tolerating inflation at least 50 per cent higher than almost other developed world central banks. The RBA itself has made clear that its aim is to keep inflation at 2.5 per cent per annum. The wider 2-3 per cent range simply gives the RBA room to move over the course of the business cycle.

The behavior of financial markets and the RBA’s long-term performance starts to lend a lot of credence to the expectations of Australian consumers, which, as I have illustrated here many times before, have drifted up over the last 20 years to the point where they are now averaging around 3.5 per cent per annum. The man on the street is basically saying that they don’t believe the RBA will keep inflation at 2.5 per cent per annum over the long-run. And they have been right thus far.

It is also consistent with the break-even inflation rates bond market investors impute to Australia, which are among the highest in the world at 3.08 per cent per annum.

I have recently argued that in order to actually get the RBA to hit a 2.5 per cent inflation target we might have to consider reducing its otherwise high goal back in line with other central banks to, say, 2.0 per cent per annum. At the very least, this would mean that regularly delivering 3.0 per cent core inflation would look a helluva lot worse. That is, it would have a sharper disciplining influence on Australia's central bank.

If for some reason I am wrong, and there is a case to accept past outcomes, and use them as a guide for the future, as both investors and consumers are presently doing, let’s just bite the bullet and raise the RBA’s inflation target to 3.0 per cent per annum, and not try to pretend otherwise.

If the collective intelligence of financial markets is right, and the RBA does not raise rates in 2011, then the credibility of the RBA’s current inflation target will, I believe, be very much open to question. The next 12 months thus loom large as a true test of our central bank’s independence and commitment to price stability.