Inflation clouds rates outlook

October 29, 2012, 12:29 pm David Taylor Yahoo!7

The Reserve Bank needs ammunition. It needs to have the capacity to significantly reduce borrowing costs in the event of an economic shock.

I think it seems like a pretty sweet gig – attend one board meeting a month to set the official cash rate target and promptly update your resume to include, “Reserve Bank Board Member”.

The reality though is that for many being a member of the board is the icing on the cake for an already outstanding career.

The role also looks a lot harder than it is. Not only do you have to agree on one interest rate setting that will fit the entire economy, but you have to be prepared to answer the critics if the economic picture deteriorates. It’s not as easy as it looks, and recently it’s become a whole lot more difficult.

Despite the media’s obsession with following the interest rate guessing game, there is a science to it. The Reserve Bank has a very clear charter to follow.

Among the objectives for the bank to achieve are currency stability, full employment, and the general improvement of the welfare of the people of Australia. In recent times the bank has focused on keeping inflation in a band of between 2 and 3 per cent to help it achieve those goals.

The bank uses these criteria to essentially steer the economy onto a path of sustainable economic growth.

Given all of that, you’d have to say the bank is doing quite well.

Just look at the statistics: unemployment is under 5.5 per cent, inflation is inside the target band and the high Australian dollar is putting the brakes on a one-in-a-generation mining boom (and yes a mining boom that is now ending). The problem is that, the statistics mentioned above, are static. They don’t necessarily reflect what’s around the corner. That is what policy makers are starting to question.

The problem as I see it is that there are just too many downside risks at the moment. Put another way, things look like they could deteriorate. Every measure of the economy could go in the wrong direction from here.

Rather than getting bogged down in a comprehensive economic analysis, I want to propose just one problem and a solution to that problem.

The reality is that the Australian economy has been in cruise control for the past decade. The Howard government did not spend enough money boosting the infrastructure of the resources sector and the current government has allowed the mining boom to do all the economic hard work for the economy.

It's left Australia’s productive capacity wanting. That doesn’t mean Australians are lazy – far from it.

It means we’ve missed opportunities in recent years to work out how to work more effectively. It’s led to a rise in the type of inflation that should scare the pants off the RBA – cost-push inflation.

It’s one of those jargon words you here in year 11 economics and don’t give a second thought.

Unfortunately, though, it’s a cancer on the economy.

The other type of inflation which I would argue is more benign is demand-pull inflation. That’s the kind of inflation you see when demand in the economy is high. Consumers are out there buying goods and services and prices are rising to meet the demand. The RBA has this type of inflation in its sights.

Cost-push inflation, on the other hand, occurs when the inputs to the economy (like production costs) start to rise.

It also includes things like insurance premiums and the carbon tax. Not surprisingly, cost pressures in the economy start to rise when the economic engine becomes less efficient.

Now this wouldn’t be such a problem if there was a plan to manage it, but there isn’t.

The Reserve Bank has the power to influence the price of money – and more broadly demand - in the economy, but it’s the government that has control over the costs of things like healthcare and the amount of tax consumers are businesses pay.

Right now the inflation ‘problem’ in the economy is not immediately solvable by the Reserve Bank. That leaves it to the Federal Government but it has insisted on sticking to its promise of achieving a surplus budget – a budget that has the capacity to raise the cost of living for Australia’s middle class and produce further price pressures in the economy.

So what happens next?

Well that’s actually the $64 million question. The Reserve Bank indicated in its latest board minutes that it was concerned about the deteriorating global economic backdrop and the effect that might have on the resources sector, and ultimately the labour market.

If there is a major international macroeconomic shock in the near term, Australia will need to respond.

However if the Reserve Bank can’t move because inflation (a type of inflation it has little control over no less) is preventing it from lowering interest rates, policy makers will find themselves caught out.

The Reserve Bank needs ammunition. It needs to have the capacity to significantly reduce borrowing costs in the event of an economic shock. Failing that, the government needs to be able to step in – either by lifting spending, or removing impediments to spending in the economy – that means reducing the cost of living.

Final thought

When the consumer price index (CPI) was released last week (underlying inflation at 2.5 per cent), the Australian dollar rose. Currency markets generally reflect the thinking of traders and that thinking suggested there was less of a chance of an interest rate cut on Melbourne Cup Day.

The more evidence we see that cost pressures are rising in the economy, the more the Reserve Bank will be squeezed out the economic management picture just a the time it can least afford it. That isn’t something any on us can afford.

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