what next on rates? you decide

Hold on to your house keys, mortgage holders; the Reserve Bank’s monthly board meetings are about to get interesting again. After six months of leaving interest rates comfortably on hold, the Reserve Bank board will meet on Tuesday with a fresh dilemma on its hands.

This week’s inflation report confirms inflation has turned a corner. After falling as low as 2.2 per cent last year, underlying growth in consumer prices picked up to 2.25 per cent over the year to March. This marks the first increase in the annual rate of growth in underlying prices since the September quarter of 2008 when the collapse of the US investment firm Lehman Brothers plunged the global financial crisis into a dangerous new phase.

Based on these numbers, the Reserve’s most recent forecasts – prepared in February – that underlying inflation would clock in at just 2.25 per cent over the year to June now appear too low. This is particularly so given cyclone-related price rises for fruits and vegetables are likely to spill over into this quarter’s inflation reading too.

The Reserve Bank will release fresh forecasts in its next Statement on Monetary Policy, which is due to be released next Friday. Either way, it appears the annual headline rate of inflation, now running at 3.3 per cent, is set for an extended period above the Reserve’s comfort zone of 2 to 3 per cent.

Which will all make for an interesting discussion around the board table at the Reserve’s Martin Place headquarters on Tuesday. The time for tea and biscuits is over.
But the Reserve has been well aware that the time would come when further interest rate rises would be needed.

The surge in mining export income on the back of high global commodity prices has created a domestic tinderbox for inflation. A good deal of this income is being reinvested by mining and mining-related companies in new equipment, projects and employees. Some has also found its way through to households, where some has been spent, but much has been saved. Clearly, more money chasing a relatively constant supply of capital and labour spells inflation trouble.

Which is not to suggest that Australia has an inflation problem. But it is the potential to develop an inflation problem, and quickly, that worries the Reserve. Now is exactly the time it needs to be watching like a hawk for emerging signs of inflation pressure.

But just as the need for accurate, timely information on the true state of the economy becomes crucial, two of the main economic indicators – national accounts and inflation – are effectively off line due to the interference created by the impact of summer flooding and cyclone Yasi.

The inflation figures show how volatility in the numbers makes interpreting underlying trends more difficult. The next set of figures on economic growth is likely to prove just as troublesome, most likely showing the economy contracted in the first three months of the year, mainly due to lost coal export revenue from flooding.

Fortunately, the Reserve still has some time up its sleeve to assess these trends, thanks to the higher Aussie dollar working to cool inflation and the fact interest rates are already at a little above their historic average.

But even on its current forecasts, without any upward revision next week, the Reserve sees inflation on an upward trajectory, hitting 3 per cent in underlying terms by the end of next year. That in itself is justification for one or two interest rate rises this year. This week’s inflation reading brings forward the day when the board will be forced to lift interest rates again.

“Which will be when, exactly?” I hear you ask. Forecasting the precise timing of interest rate moves is a mug’s game. But (here I go) a move at Tuesday’s board meeting seems unlikely. After that, several reports due for release will be influential in the Reserve’s thinking.

Due to a quirk of timing in June, in which the first Tuesday of the month (the usual board meeting day) falls after the first Wednesday of the month (the usual release date for quarterly national accounts), the Reserve will have access to the March quarter economic growth figures just before its monthly meeting. The Reserve will look through the temporary loss in production in the March quarter but will look for signs that activity is rebounding faster than expected. It will also be in a position by then to assess, through its liaison with industry, how fast the economy is rebounding in the following quarter.

Higher still on the Reserve’s radar next month will be reports due
on wages, jobs and retail spending. This week’s inflation surprise means the bank will have a reduced tolerance for any signs workers are increasing their wage claims as compensation for the rising cost of living or any signs that consumer caution at the till is waning.

You see, what happens next on interest rates really depends on you and me.
The Reserve’s greatest concern is that amid high headline inflation, workers will lose their confidence in its ability to keep inflation at an average of 2.5 per cent over time. They might start to demand higher wages as a result, feeding a wages and inflation spiral.

Similarly, the Reserve will be wondering for how much longer consumers will keep a lid on their spending even as incomes rise.

If households show any signs they are spending more or mounting higher wage claims, you can bet the Reserve’s interest rate response will be swifter or larger than current market predictions of just one interest rate rise in the next 12 months.

SMH, Interest rate rests on households, April 29, 2011

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This entry was posted in Housing, Inflation, Interest Rates, Reserve Bank. Bookmark the permalink.

One Response to what next on rates? you decide

  1. Magpie says:

    I think economists and journalists would gain a fresh perspective on these subjects by reading:

    James K. Galbraith, Olivier G. Giovannoni, and Ann J. Russo (2007) “The Fed’s Real Reaction Function: Monetary Policy, Inflation, Unemployment, Inequality – and Presidential Politics”

    Abstract:
    “Using a VAR model of the American economy from 1984 to 2003, we find that, contrary to official claims, the FEDERAL RESERVE DOES NOT TARGET INFLATION OR REACT TO ‘INFLATION SIGNALS.’ Rather, the Fed reacts to the very ‘real’ signal sent by unemployment, in a way that suggests that A BASELESS FEAR OF FULL EMPLOYMENT IS A PRINCIPAL FORCE BEHIND MONETARY POLICY. Tests of variations in the workings of a Taylor Rule, using dummy variable regressions, on data going back to 1969 suggest that after 1983 the Federal Reserve largely ceased reacting to inflation or high unemployment, but continued to react when unemployment fell ‘too low.’ Further, we find that MONETARY POLICY (MEASURED BY THE YIELD CURVE) HAS SIGNIFICANT CAUSAL IMPACT ON PAY INEQUALITY – A DOMAIN WHERE THE FED REFUSES RESPONSIBILITY. Finally, we test whether Federal Reserve policy has exhibited a pattern of partisan bias in presidential election years, with results that suggest the presence of such bias, after controlling for the effects of inflation and unemployment.” (Added emphasis)

    http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1006822

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