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Friday, September 17, 2010

RBA on the inflation warpath

If I can say so, I don’t think I have ever done a better job predicting anything than yesterday's article on the speech by the RBA’s Dr Phil Lowe. Every single one of my expectations came to pass.

In short, this is an RBA that thinks it will have to lift the cash rate by a sizeable margin in the not too distant future. I am guessing we could see up to four hikes over the course of this cycle. And I would be stunned if the RBA did not start to tighten the screws this year.

The calculus is pretty simple. The cash rate is currently neutral. The unemployment rate of 5.1 per cent is near the RBA’s minimum acceptable level, which is believed to be about 4.75 per cent (beyond that we get wage-price spirals).

Based on the last quarter’s growth, the Australian economy is currently expanding at a much higher-than-trend rate. Even if the third quarter is softer, which is entirely possible, the RBA is projecting that over the next few years Australia will expand at very high rates that exhaust all spare capacity. The problem is that we are starting this period of high growth with little extant capacity, as demonstrated by the unemployment statistics. Perhaps most importantly, the RBA has recently emphasised that changes to its target cash rate today only have their full effect in 1-2 years’ time.

The current data is largely irrelevant because it is backward looking. And we already have more than enough empirical evidence to suggest that there is a very reasonable probability the Australian economy will hit the RBA’s targets.

On this basis, a neutral cash rate is too low. The RBA will also want to do everything possible to cauterise the risk of consumers reverting back to their bad old ways, and having to deal with synchronous household and resources booms, which would be an inflationary disaster. A couple of hikes before Christmas might be the perfect tonic to keep consumers in their box.

Turning to Lowe’s very hawkish speech, he told us that Australia’s medium term economic prospects “look brighter than they did a decade ago”. This is a remarkable statement given the extraordinary optimism that prevailed prior to the GFC.

He highlighted a point I have made here previously: while our informational (ie, news) and financial markets are still highly correlated with events in the US and Europe, our economic destinies lie with China and India. The markets don’t seem to get this yet. Specifically, he commented, “With this constant flow of information about the North Atlantic, it is sometimes easy to forget just how profound – and important to Australia – are the structural changes taking place in Asia.”

He spent a great deal of timing emphasising, as I anticipated, “the twin processes of urbanisation and industrialisation” in 'Chindia'. In fact, he used almost exactly the same words I have employed here before, describing China’s urbanisation as the biggest mass migration of people in human history. Here it is worth quoting him in full:

“While there have been a couple of historical examples of other countries urbanising as quickly, the sheer number of people migrating to urban centres is unprecedented in human history – over the past 30 years, nearly 400 million Chinese citizens (almost 20 times the population of Australia) have moved to cities. As a result, there are now around 170 Chinese cities with more than a million residents, compared with only around 35 in Europe.”

Lowe reinforced another argument I have made in these pages: that China’s urbanisation is not remotely close to complete, contrary to what the bears would have you believe, commenting “the urbanisation process still has quite a long way to run, with another 300 to 400 million people expected to move from the country to the city over the next 20 years.”

Critically for Australia, Dr Lowe canvassed the prospect of India, which is far less progressed along its industrialisation path, eventually becoming a second China with consequently higher export demand for Australia’s iron ore and coal resources, and even our agricultural products given the correlation between development and protein intake.

As I forecast, Lowe made a big deal of the fact that Australia’s much closer ties with Chindia will inevitably lead to more volatile output growth depending on the vagaries of these economies. And China could hardly be described as an open, predictable democracy. Anything could happen. In Lowe’s more measured words, “It would be unrealistic to assume that the growth paths in these countries will be without bumps, perhaps large ones. And these bumps will have an impact upon Australia.”

Most gratifying was Lowe’s digression completely off his chosen topic of the risks and rewards of Asia, to warn against Australian households not living up to the RBA’s ambitious thinking around a ‘new normal’ in consumer conservatism, which I foretold yesterday.

Lowe explained why this conservatism was warranted: higher risk aversion about the future implies a lower willingness to spend and leverage up today. More specifically, “restraint now provides some insurance against the possibility that things do not work out as well as expected.”

As I have argued here before, I really don’t see how the lay Aussie consumer has been seared by the GFC. They had a blip in unemployment, a tiny nudge in default rates, but otherwise saw their disposable incomes rocket through the roof as interest rates fell to their lowest levels in around 40 years and the Commonwealth lavished them with cash gifts and tax cuts. The risk, I believe, is the opposite of that which the RBA portends. The risk is that Australian households are overcome with hubris: if that was the worst crisis in 75 years, as so many politicians told us, the chances are they think they’re bullet proof. The risk is, therefore, that they return to their profligate ways and the RBA has no choice but to crush them with interest rates.

And as I expected, Lowe brought out the big monetary policy stick, with his final parting words: “[G]iven that there is currently a relatively limited amount of spare capacity in the economy, the risk of upwards pressure on inflation would be increased if investment and consumption were both to increase very strongly over the next few years.”

That is code for, Don’t say I didn’t warn you: spend too much today kiddies, and we are going to give you an almighty whack tomorrow. And if you don’t believe me, consider where the RBA had positioned monetary policy when it thought that the GFC would fizzle out in mid 2008: a 7.25 per cent cash rate and 9.6 per cent mortgage rates. The message is that we all need to pull our horns in.