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RBA board faces a number of dilemmas today

By Henry Thornton - posted Tuesday, 1 June 2010


The Reserve Bank board, meeting today, faces a number of dilemmas. Uncertainties are likely to mean the board will keep interest rates unchanged but there is a powerful underlying reason to keep raising rates.

It will not be evident for a year or so whether or not decisions this year (both rate hikes so far and decisions to be made today and in coming months) are correct.

That is always the case but now the currents in global and domestic economies are especially difficult to interpret. The underlying threat is inflation.

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Internationally, equity markets have corrected downward but with days of wild optimism amid the general gloom, meaning volatility is high.

The potential failure of Greece to honour its debts has created uncertainty about the future of the euro-zone economic grouping and the European Monetary Union.

The weak nations of southern Europe would benefit from currency depreciation but remain locked into the EMU straitjacket.

A breakdown of the currency in the EMU is feared because money flows from nations such as Greece and other highly indebted euro-zone nations would put many banks at risk of default.

This is the first dilemma the RBA board will face today.

It is not, of course, a matter for any decision by the board, but rather a question of what is likely to happen and what different outcomes might mean for the global recovery.

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The second global dilemma concerns the state of the Chinese and US economies.

Recent talks have elicited hope that China may abandon its close link with the US dollar.

Ideally, of course, China would float its currency and buttress its planned move from export-led growth to a more balanced situation with the help of a stronger currency.

At the same time, depreciation of the US dollar would strengthen US exports, especially if the US used a less consumerist approach to economic strategy.

But the US budget has deficits "as far as the eye can see" and US cash-interest rates are close to zero, hardly a scenario to encourage hard work and high saving.

China has been attempting to slow its runaway growth while the US has been showing signs of a double-dip recession.

Along with fears of a euro-zone debt crisis, the net result has been fears of a renewed global slowdown and this has increased uncertainty (raising market volatility) and produced renewed net falls in global share prices.

How these complex currents and cross currents play out provides the second major dilemma facing the RBA board today.

Domestically the uncertainties are real, too.

Like the global economy, Australia has a two-speed economy and as deputy-governor Ric Battellino has said, two speed for Australia usually means "fast" and "very fast".

The second leg of the present great resource boom is clearly under way, but if the world has another down-dip there will be some check to the optimism of miners and the many contractors working in the mining industry.

And there is a home-grown reason for the mining boom to slow: the "great big new mining tax".

The more hysterical commentators have spoken of a "capital strike" by the mining industry and it seems clear a good number of projects are on hold until this unexpected obstacle is dealt with.

Retail sales are said to be weak and there are many good discounts about.

Other things equal, this is a good thing, but if exports begin to slow and business investment is revised down, the gloss will come off Australia's so far excellent post-crash economic performance.

Under the Labor government's industrial relations rollback, it is now more difficult to sack non-performing workers, already providing a depressive influence on jobs growth.

If reports of a major attempt to reverse what is a widespread move for workers to become independent contractors are true, there will be a hiring strike to match the potential capital strike.

Slowing activity on top of these actual or potential government-induced drag on employment would lead to the labour market quickly deteriorating.

Now we come to the item of most direct importance to the RBA board: inflation indicators.

As already noted, share-price inflation has been reduced to deflation by various global concerns and house-price inflation in Australia has exceeded that in China, where "bubble" is the usual description.

As we have argued previously, house-price inflation is not entirely the fault of the RBA, but it is a factor in interest-rate decisions.

This month, one might make the case that house-price inflation is roughly offset by share-price deflation, certainly that is the tendency. The unambiguous case for continued interest-rate increases is that goods-and-services inflation has exceeded the general expectation and the forecasts of RBA staff. This in turn is due to activity growing faster than predicted and the board has to decide whether or not the new deflationary forces are sufficient to offset inflation in excess of previous forecasts.

Only yesterday we learned that in the 12 months to May, the TD Securities-Melbourne Institute Monthly Goods and Services Inflation measure rose by 3.7 per cent, the fastest pace since October 2008, smashing through the upper limit of the RBA's 2 per cent to 3 per cent inflation target range.

This measure of inflation is well above the target band even if the effect of the "one-off" tobacco tax is excluded.

The dilemma for the board is whether prospective slowing due to adverse recent events is sufficient to offset recent momentum in an inflationary direction.

The news in the past month is mostly grim and this will generate much debate at this month's meeting of the board.

Australia's cash rate is now close to the neutral zone, and market rates may be a bit above neutral, given increased margins.

I expect there will be an "on balance" decision to hold rates where they are.

In the analysis, the board would be wise to maintain the current bias to tightening.

If Europe survives the present crisis, if US jobs begin again to rise, if China manufactures a slowdown of activity to a "modest" 10 per cent annual rate and if the Rudd government makes peace with the mining industry, soon there will be a strong case for further anti-inflationary policy tightening.

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First published in The Australian on June 1, 2010 and on Henry Thornton's blog.



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About the Author

Henry Thornton (1760-1815) was a banker, M.P., Philanthropist, and a leading figure in the influential group of Evangelicals that was known as the Clapham set. His column is provided by the writers at www.henrythornton.com.

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