Boy, I don't envy the RBA right now. The Fed has announced a 2% core inflation target over the medium term, consistent with most other central banks. Core inflation in Australia is currently running at 2.6% per annum with nontrivial upside risks. If you listen to Terry McCrann, the RBA is "almost certain" to cut rates in February because it is not worried about inflation and wants to protect the major banks' net interest margins. Apparently the RBA wants to also cut rates because of the high Australian dollar. Ironic given the currency is where it has been for 12 months, and was previously regarded as an important brake on inflation. This is not a matter of opinion: the only reason core inflation has stayed at 2.6% per annum is because of our imported and tradables deflation. Also ironic because the RBA has previously argued that you cannot control currencies with policy. So then we go to David Bassanese, who has published a truly terrific article on the RBA's dilemma over at the AFR. In fact, I think its probably the best article I have ever read of his. In conflict with McCrann, Bassanese posits:
"Sadly for interest rate watchers, the underlying consumer price inflation results for the December quarter were not low enough to make a rate cut by the RBA next month a done deal...
[T]he case for a third consecutive interest rate cut is to date far from strong – and certainly not as high as the 80 per cent probability priced in by financial markets ahead of this week’s CPI release.
After all, if anything, economic risks in Europe have been gradually receding since the RBA last cut interest rates in early December. European bond yields are down, and equity prices are up. Greece is still killing itself trying to stay in the euro zone.
The Chinese and US economies, moreover, are holding up well. Locally, business and consumer confidence have recovered from their slumps in August last year – which in turn followed the sharp fall in world equity markets. Local confidence is far from buoyant, but at worst it’s probably only a little below average."
The really interesting aspect of Bass's analysis is his parsing of the inflation data:
"Low inflation owes thanks in large part to the strength of the Australian dollar, which is holding down import costs. Indeed, in trade-weighted terms, the $A is up by more than 40 per cent in the past three years.
Domestically generated inflation – especially in the services sector – is far from benign...
Indeed, it’s worth noting that despite the apparent softness in the economy, annual service sector inflation has accelerated in recent quarters, and ended the year at a relatively uncomfortable 4.4 per cent. Annual inflation in those sectors relatively sheltered from international competition (the non-tradable sector) has also accelerated, ending the year at 3.9 per cent.
It’s just as well that annual inflation in both the goods and tradable sectors is running at a relatively low 2 per cent, or else inflation would not be so benign.
All up, Australia appears to have an intractable service sector inflation problem, which likely reflects the underlying strength in the labour market, poor labour productivity growth and a lack of effective price competition – especially in the utilities, health and education sectors. This is being masked by weak import prices, which also won’t be so benign once the already high Australian dollar stops rising.
Against this background, it strikes me that there’s only so much insurance the RBA can take out against a European-led implosion in the global economy. While most forecasters – most recently the World Bank and the International Monetary – concede there are large downside risks to the global economy, the fact remains that so far at least the worst-case scenario has not been borne out."
