The Reserve Bank now sees slowing domestic economic growth and the slowing world economy as risks of the same weighting to our current high inflation rate.

As a result, Australia remains on track for a cut in official interest rates next month after the Reserve Bank issued its third Monetary Policy Statement of the year, signalling that it is now more concerned about the slump in economic growth and its impact on a slowing local economy.

For the first time this year, the central bank says it is now committed to “sustainable economic growth” as well as the medium term inflation target of 2%-3%. That was after warning in the two previous quarterly statements of the need to either tighten monetary policy, or maintain it to make sure inflation slows.

Sustainable economic growth and price stability are the two main policy objectives of the RBA, but since February controlling soaring inflation has been its main one via two interest rates to add to the two in November and August 2007. On top of that we had 0.50% or more in rate rises from the bank, plus higher oil prices, all of which have combined to trigger a rapid slowdown in domestic demand.

It is quite a significant signal to the market and is a clear sign the RBA sees the rapidity of the slowdown in domestic economic activity is doing its work and will slow inflation from next year onwards. That’s even though it admits inflation will rise in the September and December quarters, where it could hit the 5% level.

CPI inflation is expected to be higher in the short run, at around 5 per cent in the December quarter, reflecting the effects of higher petrol prices and the recent correction to estimates of financial services inflation, before declining thereafter. Excluding financial services and the effect of the child care tax rebate, underlying inflation would peak at 4¼ per cent while CPI inflation would peak at 4¾ per cent.

An estimate of 5% inflation from the RBA would normally see markets pricing in another rate rise and pushing the Aussie dollar higher towards parity with the US currency. But not now. The sharp drop in private credit in recent months — as well as retail sales, consumer confidence, home loans and building approvals — is why the bank is signalling madly that a rate cut is coming. And I’d be punting on a drop of 0.50% or one of 0.25% next month and another in October because of something else the RBA said. The bank seems to be more worried about what a further downturn in the world economy would do to Australia, more worried than the impact of the higher inflation rate.

Any further deterioration in the outlook for global growth would represent a significant downside risk to the domestic activity profile, particularly if it led to a marked slowing in growth in China and India.

This could lead to a significant deterioration in the outlook for the Australian economy and commodity markets, which could lead to further moderation in inflation over time as growth of domestic incomes and spending eased and oil prices fell.

In addition, the ongoing turmoil in capital markets could exacerbate the slowing in domestic growth by further reducing the availability of credit to households and businesses.

That’s the first time the central bank has been so explicit on the dangers from the very volatile world economy and credit markets and it appears to be setting up a pre-emptive rate cut or two (as Mr Stevens has suggested in the past it has done with rate rises) to give the economy room to handle any worsening in the global economy.

While many economists had expected big changes to its forecasts, there was very little. Like the May statement, the bank still thinks inflation will fall to 2.75% by the end of 2010 with economic growth running around the same rate, as well as non-farm growth.

The bank repeated the new mantra contained in last week’s statement from Governor Glenn Stevens that: “On the assumption that the subdued demand conditions are likely to continue, scope to move to a less restrictive monetary policy stance in the period ahead is increasing.” It continued:

While inflation is likely to remain high in the short term, the Board judged at its August meeting that demand was slowing to an extent that could be expected to bring about a significant reduction in inflation over time. On this basis the Board decided that the existing monetary policy setting was appropriate for the time being

The evidence to date is that a significant moderation in demand is now occurring, and it is looking more likely that demand will remain subdued, and economic growth will be fairly slow, in the period ahead.

The Board will continue to monitor developments and make adjustments as required in order to promote sustainable growth consistent with the medium-term inflation target of 2–3 per cent.

That last statement was added to the main statement in the document for the first time this year and sends a signal that the bank now is juggling “sustainable economic growth” as well as inflation in some time. This is what it said at the end of the May statement:

The Board will continue to monitor developments, and will make adjustments to policy as needed to ensure that inflation returns over time to the medium-term target. months.

In fact it’s a complete switch in policy from May’s concentration solely on inflation.

Peter Fray

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