The Reserve Bank of Australia board gathers today after a five-week lay-off. We hope that its members have pondered its dilemma.
The things it says it worries about - namely, leading indicators of goods and services price inflation - have edged higher, building the pipeline of future inflation rate increases. But most activity measures - employment apart - are weak.
The list of adverse indicators of future inflation is swelling alarmingly.
- Productivity growth collapsed in the year to the March quarter, with real GDP up only 1.9 per cent while employment rose by 3 per cent;
- Wages increases are beginning to pick up, with some indicators running now at 4.4 per cent a year and edging higher;
- Non-tradables consumer prices increased by 3.7 per cent over the year to the first quarter - an increase from the long-hoped-for slowdown in the December quarter;
- The GDP deflator rose by 3.7 per cent in the year to the March quarter;
- The prospect of tradables prices continuing to fall, and so containing the pace of increase of average prices, is disappearing as the Australian dollar weakens;
- The hope for early relief from high oil prices is gradually being downplayed. Spot prices have increased again and futures prices remain disappointingly firm; and
- Also boosting inflation - though also hopefully only temporarily - is drought on the eastern seaboard.
It seems clear to us - and should be to the RBA board - that the 2-3 per cent inflation target is going to be exceeded in the next few months for a sustained period that could run beyond the bank's two-year forecast horizon. What is the board to do?
Bear in mind what it has done. It had governor Ian Macfarlane talk and act tough in February and March, only to be howled down - first by public opinion and later, in May, by the Treasury Secretary. Since the last meeting of the board, the governor put out a monetary policy statement that retained a bias to tighten. The market has decided this is only a Clayton's bias and, in fact, has priced out any interest rate rises in future and has marked down the value of the currency even in the face of a further rise in the terms of trade.
The exchange rate has anyway been lagging the rise in the terms of trade. Monetary policy has therefore been eased significantly.
The statement warned, however, that the top side of the inflation target was to be hit as soon as the June quarter, and core inflation was to rise to the top of the target by late next year with no hint of any slowdown before the end of the forecast period.
Until the RBA is willing to stand its ground and act to bring inflation back down, we expect the board will opt to keep its profile low.
How does it do this? By not changing interest rates.
If pressed it will have the governor emphasise, on its behalf, that the target is only "an average over the cycle" of indeterminate duration and that temporary excesses ("deviations") - even of a period of two years or more - are permitted. Flexibility is to be put on a pedestal.
Furthermore, the governor is likely to argue that the fall in long bond yields to historically low levels confirms that longer-term inflation expectations are contained, even though this is more due to overseas influences than any judgment about the quality of domestic economic management.
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