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, November 23, 2010

Your choice: higher inflation or a higher exchange rate (and higher rates)?

The Treasury's Dr Ken Henry generally tells it like it is. His speeches are harder-hitting than the RBA copy, which are amongst the most anodyne of any central bank in the world. Think. Grey. Cardboard. As a bit of a purist, I nevertheless prefer the analytical density of the RBA missives, which tend to be much more empirical. They also seem a little tighter and professionally packaged. And it is fun decoding central bank speak. It is like learning French at school (the language, that is). Anyhow, in a wide-ranging speech last week, Ken painted a picture of the stark economic alternatives that face the nation:

"The strong rise in Australia’s terms of trade over the past decade could well turn out to be the biggest external shock to our economy in history. Rising terms of trade mean increased aggregate purchasing power and higher aggregate incomes. But not everybody’s income, or purchasing power, gets a boost. The net outcome of the economic adjustments associated with an increase in the terms of trade is what we might call a ‘three speed economy’:

•the mining and mining-related sectors grow strongly;
•other trade-exposed sectors (like many parts of manufacturing) grow more slowly; and
•non-traded sectors grow at a rate somewhere between those two.

In order to balance demand and supply in the non-traded sector, there will be an appreciation of the real exchange rate. That is to say, there has to be an appreciation of the nominal exchange rate and / or a period of time during which our costs of production inflate at a rate that is higher than the average inflation rate of our trading partners.

Putting this another way, the economic adjustment required to balance demand and supply in the non-traded goods sectors necessarily has the effect of making all Australian businesses less internationally competitive. And that loss of competiveness cannot be avoided unless the full income effect of the terms of trade boom is somehow sterilised...

I have been talking about the need for a real appreciation of the exchange rate. Technically, we can choose how much of that comes through the nominal exchange rate, and how much we allow through domestic inflation. In the early 1970s we experienced a large terms of trade shock – somewhere between a quarter and a third the size of the one we are experiencing today. In those days, we had a fixed nominal exchange rate, so the adjustment came through domestic costs and prices. Annual consumer price inflation hit 17½ per cent by the March quarter of 1975 and, ignoring the temporary and technical impact of the introduction of Medicare in 1984, didn’t come back below 5 per cent until the recession of the early 1990s.

That sort of inflation certainly reduced our international competitiveness, spectacularly ‘over-achieving’ what was required to rebalance the economy following the early 1970s terms of trade shock. And that loss of competitiveness did considerable damage. No one wants to pay that price again. And they won’t, because these days we have a floating currency and a strong commitment – underpinned by an independent central bank – to keeping inflation to moderate levels. But what that means is that, on this occasion, most of the loss of competitiveness required to rebalance the macro-economy is coming through an appreciation of the nominal exchange rate; largely explaining why, for example, the Australian dollar is up around its post-float highs against the US dollar."