The Reserve Bank board meets today, and our task is to provide advice that will help its members make up their minds.
We infer that there are at least two views among the staff of the Reserve. The natural, conservative, view is to do nothing if at all possible — very likely the view of Governor Glenn Stevens. Then there is the view of Chief Economist Malcolm Edey, who recently spoke in more radical terms — Henry’s translation “let’s make sure inflation is properly under control”.
Henry guesses that Deputy Governor Ric Battellino is a hawk. This is his natural bent, and conforms to the traditional role for the Deputy Governor, especially one whose age makes it likely he will never be Governor. He will emphasise the continued strong growth of credit on top of other bullish local economic data.
The rising cost of oil will be used both by hawks and doves — the hawks because price rises will increase oil price inflation and at some stage this will spill into other prices (including wages) and the doves because higher fuel prices will dampen household and business spending. And they will make the case that this is equivalent in its effects to monetary tightening.
Is the rising Aussie dollar a reason for holding back on interest rate hikes? In the 1980s, RBA Governor RA Johnston argued that a rising exchange rate was effectively a “tightening of monetary conditions”. This led the Reserve to go easy on monetary policy at some vital times, and this in turn led to an overheated boom, rising inflation, eventual large interest rate hikes and then the “recession we had to have”.
For this reason, the Reserve nowadays tries not to be deflected by the state of the currency. But this matter is not just based on memories of burnt fingers. Consider this graph.
If a strong dollar reduced CPI inflation one would expect a negative correlation. A rising dollar certainly helps contain inflation, but there is a lot of research that says this effect is small and hard to detect. There is no obvious negative correlation between CPI inflation and the value of the Aussie dollar. Instead there is a lagged positive correlation. This suggests that the main causation runs from inflation to the currency. This is because high inflation makes the RBA raise interest rates and this (ceteris paribus) puts the currency up, and vice versa.
We have disposed of the two main arguments of the doves. The Reserve should raise cash rates tomorrow by 25 basis points. This would be a case of better late than never. If they do not, inflationary pressures will continue to build in the Australian economy.
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