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Thursday, April 28, 2011

Updated: Why the RBA will hike in next three months

Since the start of 2011, the RBA has accompanied its monthly interest rate decisions with the following bold statement, which I always thought would leave it with egg on its face given the distribution of risks: "The Bank expects that inflation over the year ahead will continue to be consistent with the 2–3 per cent target." The RBA can no longer credibly make this claim.

Before I explain why, note that both the RBA and the markets interpret the RBA's monetary policy mandate as meaning that it has a 2.5% per annum through-the-cycle inflation target, which, as I have noted here many times before, is actually the highest of any central bank in the developed world with the exception of Norway. Also remember that over the last decade or so, the RBA has consistently missed its (already high) 2.5% per annum target, with both core and headline inflation averaging around 3% per annum. This has in turn led to upward drift in long-term consumer inflation expectations, which have averaged 3.5% per annum since 2000.

Based on the RBA's inflation forecasts released in its last Statement on Monetary Policy, the Bank was expecting a 0.6% core inflation result in the first quarter of this year. Instead it got a 0.9% outcome (unrounded 0.85%). Even the most dovish economists believe that this will now force the RBA to upgrade its 2011 calender year forecast for underlying inflation from 2.75% to 3.0%. The key point is that this 3% outcome for core inflation is materially above the 2.5% mid-point implied by the RBA's 2-3% per annum range. In even worse news, the RBA may also need to upgrade its headline inflation forecast, which was already at an above-target 3.0% in 2011.

So it is awfully difficult for the RBA's Board to now claim when it meets on Tuesday next week that "the Bank expects that inflation over the year ahead will continue to be consistent with the 2–3 per cent target" given the long and variable lags associated with monetary policy movements. It will now be projecting significantly above-target underlying inflation at a time when its cash rate setting is only generating lending rates that are "a little above average".

And I have not mentioned anything here about the mounting risks of importing more inflation from an urbanising China, a fully-employed labour market, rapidly increasing wage growth, a much more rigid industrial relations environment, and a mad slowing of population growth (care of the xenophobic debate at the last election, which, as I correctly predicted at the time, is now leading to more acute skills shortages and the need for higher rates).

Some argue that the Australian dollar buys the RBA time. But does it? These same folks maintained that the Aussie dollar's surge over Q4 and Q1 should have given us a benign core inflationary outcome in the first three months of this year. But it did not, and the discounting was not as sharp as many had anticipated. More importantly, the exchange rate is a monetary policy 'circular reference', or a causal result of global interest rate differentials.

The rise in the Aussie has been partly based on the view that the RBA was going to increase rates. If the RBA does not increase rates, the Aussie will face downward pressure.

Another motivator of Aussie appreciation has been central bank diversification away from the USD into commodity currencies, like the AUD and CAD, which I have flagged here before.

But there is a very important constraint on this activity that UBS recently highlighted: when foreign central banks buy the Aussie they need to do so via highly rated and liquid government debt instruments. Australia has a very small government debt market, which is likely to shrink further over time as the Commonwealth seeks to reduce its stock of outstanding obligations. (Foreigners already own nearly three-quarters of all government securities.) In sum, UBS's FX strategists don't think that the Aussie government debt market is large or liquid enough to permit sustained central bank diversification over the long-run.

Yet the major downside risk  for the Aussie is, of course, the US dollar. The recent surge in the Aussie/USD pair has been a USD depreciation story. That is, the USD has been falling against all major currencies. This has has been driven by the maintenance of incredibly low US interest rates in contrast to almost all other central banks.

However, as both core and headline inflation in the US now accelerate, and activity gradually recovers, the Federal Reserve has made it clear that it is stopping QE2 and will start thinking about contracting its balance-sheet. This will represent a normalisation of monetary policy and result in higher US interest rates. Put another way, if you think the US is going to have an inflation challenge going forward, you have to be bearish on the Aussie/USD pair.

In summary, over the next 12-24 months, there are likely to be strong headwinds faced by the Aussie. More significantly, the RBA would be silly to rely on continued appreciation in the AUD as a reason for forestalling monetary policy tightening. The risks here are quite the reverse: a substantial 10-20% depreciation in the Aussie over the next 12-24 months care of rising US yields could produce strong domestic inflationary pressures at just the time that the capex boom is taking off.  And to the extent that the RBA substitutes currency action for interest rate action, this could be self-fulfilling given the exchange-rate is priced off global interest rate differentials.

A word on the market reaction. All economists were caught-out by yesterday's 0.85% core CPI print (nearly 3.4% annualised) with the exception of RBS and ICAP, which both pencilled in 0.8% outcomes. UBS also canvassed upside risks given the producer price index results last week, which I also drew attention to here. Perhaps the most curious response was the attempt by dovish analysts to then rely on the 'year-on-year' inflation numbers. To be clear, that means bizarrely giving as much weight to Australian inflation in March through June 2010 as March through June 2011! Indeed, it means 75% of your inflation result derived from 2010, not 2011. This is clearly flawed, especially when the economy is experiencing a turning point in the inflationary cycle. What matters most is what Glenn Stevens recently described as the ABS's "accurately measured" inflation pulse over the last three months, which is telling us that both headline and core price pressures are running well above the RBA's target.  And cost of living measures, which crucially determine consumer inflation expectations, are even higher again.

Some participants like to ignore the recent increase in consumer inflation expectations, and emphasise investor expectations derived from the government bond market. For what it is worth, these are also very high, with the Australian 10 year rate about 3% per annum. But the key point is that investors don't determine consumer price inflation. Consumers do. We are seeing this same dynamic in the US right now, with 5-10 year consumer inflation expectations surging while investor expectations have remained anchored. The latter is largely irrelevant for monetary policy, despite what some would have us believe. What central bankers should be worried about is consumer expectations feeding into cost of living views and then wage claims. Prioritising bond market break-even rates over consumer beliefs is a total furphy.

As a final comment, why wouldn't the RBA wait for the second quarter inflation results? Simply because they cannot afford to. If the Q2 numbers print high again, which is where the risks lie, the RBA will be confronting a situation whereby core and headline inflation have been running materially above target for half a year at the beginning of a cyclical recovery. They will be forced again to revise up all their inflation projections (damaging for their credibility), and will be reacting to a serious, six month old inflation problem in the third quarter. Given the RBA's spotty track-record over the last 10 years, and fluid inflation expectations, this is just not a tenable situation for a credible inflation-targeting central bank. So the RBA needs to take out insurance today, via one hike prior to the Q2 CPI, against the risk that it is once again behind the curve.