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Friday, October 21, 2011

The great inflation debate...

At precisely 11.30am next Wednesday you should be able to work out whether the RBA will give borrowers an interest rate break at its November board meeting.

Why? Because that is when the ABS releases the all-important third-quarter inflation data, which tracks movements in “headline” and “underlying” consumer prices between June and September 2011.

The official headline number will not have much influence on the RBA board's decision since the bank believes that it has been biased by the see-sawing associated with various flood-affected prices.

This is one reason why the official figures have been so high over the last six months, expanding by 1.6% in the first quarter and by another 0.9% in the second quarter. What the RBA will be focusing on is the average of its underlying or “core” inflation estimates that strip out both rapidly rising and rapidly falling prices.

The two top guys at the RBA have both publicly commented this year that setting monetary policy – that is, the process by which the RBA, which is an independent, taxpayer-owned, central bank to our private banks, changes its "target cash rate" in order to influence the actual interest rates we receive on our savings and pay on our loans – has been the most difficult they can recall since the early 1990s.

That particular period is an important marker since it denotes the time when the RBA adopted a new policy approach called "inflation-targeting". In brief, the RBA decided that the smartest thing it could do was to try and influence the interest rates prevailing in markets in order to keep the change in the price of consumer goods and services between 2% and 3% per annum as frequently as possible (or, in the jargon, "through the cycle").

This 2% to 3% per annum inflation target, which is a little higher than the bands adopted by most other developed countries, was selected by the RBA simply because it was the rate at which consumer price inflation settled following the painful 1991 recession. While most 20- and 30-somethings will have forgotten, unemployment peaked at around 11% in 1991 in part because the RBA had lifted borrowing rates to an incredible 17%.

The 2% to 3% per annum band has been kept deliberately wide by the RBA’s boffins since they don't believe, frankly, that they can accurately forecast inflation to a single decimal place, nor, therefore, hope to be held to such an exact goal. This explains why the head of the RBA, Glenn Stevens, refers to the RBA’s objective as keeping the rate at which consumer goods and services prices rise to “two point something”.

The RBA's job has been particularly difficult this year because it had projected elevated inflation over 2011, 2012, and 2013, which, it understandably assumed, would necessitate higher rates.

These forecasts appeared uncannily accurate when the ABS released its official inflation data for the first and second quarters. Specifically, the RBA's preferred core inflation benchmarks averaged about 0.85% for the first six months of the year. This is considered well above the RBA's "acceptable rate", and would ordinarily have led to reflexive hikes.

While it came very close to pulling the rate trigger as recently as August – the decision not do so incidentally cost arbitrageurs billions of dollars – the RBA exercised the option to wait. Why? Well, there were three main reasons.

First, the devastating floods caused a major 0.9% real contraction in economic growth over the first three months of the year. The RBA did not think it would be politically smart to lift rates during this period.

Incidentally, even with the floods reportedly lopping 0.5% off growth in the final quarter of 2010, GDP still managed to print at (an upwardly revised) 0.8% – or 3.2% annualised – which gives you a sense for the strength of the economy. Following the June quarter data, we know that domestic demand in the first half of 2011 has been running at a very healthy 5% per annum pace.

The floods were then followed by an unprecedented sequence of crises, from the earthquakes in New Zealand to the Japanese tsunami-cum-nuclear catastrophe (no small deal for Australia's second-biggest trading partner and the world's third-largest economy), then the adverse oil price shock invoked by a series of Middle Eastern revolutions, and, finally, the European and US sovereign debt crises. It is hard to conceive of more going wrong in any half-year period absent the outbreak of a global war.

Finally, there was the Australian dollar, which soared to what would have, until recently, seemed like unimaginable levels. The RBA's research implies that an increase in the value of our exchange rate pulls down the cost of imported goods and depresses activity in export and import-competing industries. All told, this helps to attenuate inflation.

So there were certainly credible reasons for the RBA to think very hard about its 2011 decisions. After the experience of 2007-08 when Australia's underlying inflation rate surged to 4% to 5% per annum, the RBA was keen to avoid a repeat of this episode. One quarter of bad data amidst the aforementioned headwinds was, to be sure, forgettable. But the even stronger second-quarter numbers appeared to make hikes a certainty.

Since wages and a host of other things are "indexed" to the official inflation numbers, the ABS gets the willies if anyone starts talking about "revisions" to its data (check out this press release scolding such talk). Formally, there are never revisions: the official numbers are the raw headline estimates, and they never change. Yet since these are affected by modifications to tax rates and once-off shocks like the floods, the RBA, and its financial market acolytes, get to mostly ignore them. They concentrate on the "cleaner" core measures of price changes discussed above.

While the ABS happily released its shocking core inflation numbers just before the RBA's August board meeting, what nobody in the public domain knew – save possibly two well-informed journalists at Fairfax – was that the ABS would subsequently publish substantial revisions to these numbers one to two months later.

These controversial "revisions" came in two forms. The first was a change to the way in which the ABS "smooths" the inflation data to manage clearly identifiable "seasonality". The ABS used to only smooth 20 of the 90 consumer price categories. It has now increased this to 64 classes of goods and services. This increased the historical rate of inflation a touch, but, more significantly, materially cut the (already smoothed) second quarter "core" inflation proxies from 0.9% to just 0.6%.

This really changes everything. Rather than a demonstrably accelerating rate of underlying inflation over 2010 and the first half of 2011, we have just one stand-out result in the first quarter after the ABS’s rehashed numbers.

The second revision was a change to the weightings that each of the consumer goods and services categories get in the overall make-up of the CPI. These weightings are adjusted every six years, and, according to the RBA, the new weights reported by the ABS (combined with an additional change to the way in which financial services inflation is calculated) further lower the underlying rate of inflation over the last year. These numbers might sound small, but they all add up.

The net effect of the revisions is that the underlying pace of inflation over the year to June 2011 fell from the RBA’s original estimate of about 2.75% to somewhere between 2.25% and 2.5%. To be clear, that is in the bottom half of the RBA's target band and has big consequences for the way in which we think about inflation.

Given the RBA's public statements following the original publication of the ABS’s second quarter inflation results, which characterised core inflation as "troubling", "broad-based", and, more importantly, caused the RBA to lift its underlying inflation forecast from 2.75% over 2011 to an unpalatably high 3%, it is unlikely that the bank fully understood the impact of these adjustments before they were released.

While it is not constructive to waste much time debating this point, we know, as a matter of record, that prior to the two revisions, the RBA had upgraded its official inflation projections, canvassed raising rates at its August board meeting, and made numerous remarks to the effect that it was worried by the data it was seeing, fingering, in particular, a rise in the cost of workers (or “unit labour costs”) as a culprit.

After the ABS revisions, the RBA has decidedly changed its tune, and argued that there is evidence to suggest that inflation might not be as strong as they had first thought.

For an institution that is paranoid about its credibility, this insinuates that there was, for some reason, a disconnect between the ABS and the RBA on the subject of the revisions.

This itself is no surprise given the two organisations have had a frosty relationship, with the ABS for years refusing to publish the RBA's preferred measures of underlying inflation. (This, as an aside, led investors into an analytical “arms race” after the release of the ABS's official inflation data to see who could first work out what the RBA's measures would actually be.)

Another wrinkle layered on top of all this is, I suspect, that the RBA would not be opposed to "normalising" the level of interest rates in view of its new information. If the third-quarter inflation numbers print on the very low side, they will hammer the final nail in the coffin of the current inflation debate. There will be no evidence that price pressures are accelerating. With a still high currency, this will then denude the rationale for holding the cost of money at the RBA's "mildly restrictive" level (assuming that the RBA is able to revise down all of its currently-elevated inflation forecasts out to 2013).

By bringing the price of money back to what the RBA considers to be a "neutral" level, it can signal to the community that it is not going to unnecessarily punish it on the basis of a misguided pursuit of inflation-fighting zealotry. In doing so, it builds up more goodwill with the public that can be expended when the RBA has a real inflation battle to fight.

A genuinely low core inflation print next Wednesday of equal to or less than 0.6% might give the RBA sufficient ammunition to justify a pleasant Melbourne Cup Day present. It is hard to know what the bank would do if the core numbers come out at between 0.6% and 0.8%. One can be more confident that a core print of 0.8% or higher would significantly reduce any chance of interest rate accommodation, at least for the time being. Of course, all of this is subject to the usual condition that “bad stuff” can, and does, happen.