A chorus of jerimiahs in the morning newspapers are today calling on the Reserve Bank “to do something” about inflation. By that they mean, lift interest rates. And although we have to assume they all read the Consumer Price Index release from the Australian Bureau of Statistics closely yesterday, it would seem some of their critical thought processes failed them.
One business economist who spotted the problem was Scott Haslem of UBS, while economists at Goldman Sachs JBWere also noticed that there had been a significant tightening in conditions, and that these had shown up in the CPI.
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In his note to clients Haslem argued that there was a circularity in the CPI resulting from last year’s interest rate rises by the RBA and the impact of the credit crunch that forced up interest rates from August September onwards.
He says if you strip out that impact of high rates and tighter market conditions, then the CPI and the RBA’s preferred measures all fall under 3%. The higher finance costs are not responding to demand pressures, but from the price of the supply being raised by the RBA and by the markets.
With tighter financial services adding 0.5% to both headline and core inflation over the past 2 quarters – a reflection of tighter financial conditions – it would seem somewhat odd then, in response, to tighten those conditions further by lifting interest rates.
He says monetary policy is already working: the tightenings from 2007 and the separate tightening of conditions because of the credit crunch is contributing to tighter conditions and reducing demand by reducing spending power by consumers.
The ABS said in yesterday’s release:
…most significant contributors to the increase this quarter were automotive fuel (+7.3%), deposit and loan facilities (+2.7%), house purchase (+1.3%), rents (+1.6%), domestic holiday travel and accommodation (+3.7%) and other financial services (+1.9%).
Meanwhile, Goldman Sachs JBWere didn’t make the same point as Haslem, but they did point out that demand is already being reduced by what is going on in financial markets:
We have argued since late-November that the RBA would subordinate uncomfortably high inflation outcomes to global uncertainties. Underlying inflation at 3.6%yoy in the December quarter is more than just uncomfortable, for an inflation targeting central bank it is painful.
More recently we outlined that the spill over from a recessed US economy to the Australian economy would likely come via falling business and consumer confidence, diminishing wealth effects, higher household savings, tighter financial conditions and weaker profit growth.
In just a fortnight, we have already witnessed sharp declines in equity prices, much tighter financial conditions, defacto interest rate hikes from Australian banks and a sharp drop in consumer confidence.
There is no question that Australian inflation is too high.
…The strongest argument in favour of the RBA waiting and assessing the impact of the recent financial turmoil is that broader financial conditions have tightened by an alarming degree in January and financial market risk aversion is breaching new historical highs.
It’s surprising how many of this morning’s dawn chorus in the papers missed these vital points.
By the way there’s already higher finance costs built into the quarter’s CPI by virtue of the 0.12% to 0.20% rise in mortgage rates from the banks at the start of this month.