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."

Saturday, July 30, 2011

The explain-away-inflation fiasco (blame it on "deposit and loan charges")....

Folks like my good mate Peter Martin have argued this week that even underlying inflation is not such a big worry because it has been distorted by a variable known as "deposit and loan charges", which has risen robustly and will be excised from the standard core inflation measures next quarter.

These claims are wrong for two reasons. First, as I have explained before, deposit and loan charges have almost no impact on the "weighted median" inflation measure (which is simply the 50th percentile inflation rate and not affected by outliers like the trimmed mean can be). Second, RBS's Kieran Davies and Felicity Emmett have shown that even if you exclude this variable from the trimmed mean (or "average" core inflation)--which is a questionable decision--underlying inflation over the last half year is still running above the top of the RBA's target 2-3% per annum band.

This is especially disturbing given the RBA was not forecasting above-target core inflation until 2013, and even then assumed that they had had the deflationary benefit of a further two interest rate increases, and an elevated currency! In their report, RBS find:

"Excluding [the deposit and loan charges] series lifts quarterly underlying inflation slightly last year and reduces it slightly this year, although the annual inflation rate is basically unchanged (the model’s fit is also improved). This means that the currency may have had slightly less impact last year than first thought...[But] recent higher still above the 2-3% target band on an annualised basis, whereas the RBA did not have inflation exceeding the band until 2013."

The thing is, this deposit and loan charge series is meant to reflect the cost of financial services charged to consumers. And when you stand back and think about it, the huge widening in bank margins post-GFC makes increases in this series explicable. For example, banks added on an extra 20 basis points to the last RBA cash rate change in November 2010. The deposit and loan charge series also captures other non-interest fees. According to the ABS, these costs have been rising during Q1 and Q2, which seems to make practical sense. That is, the cost of getting a home loan, and the fees and charges we get slugged with by banks, have been on the increase. Since financial services are such an important component of consumer spending, it is not clear why these are going to be excluded from the CPI. Surely there are "measurement solutions" that would help remedy the methodological volatility that has plagued the series thus far? It was, after all, the RBA that first proposed introducing this into the CPI in 2005.

The key point, however, is that even if we ignore the higher cost of financial services in Australia, core inflation is still running above the RBA's target band 3 years before it was supposed to. RBS's chart below makes this clear (focus on the black line, which is core inflation excluding deposit and loan charges):