The horns of a dilemma

Yesterday’s CPI number sent the Bullhawks (Carr, Joye, Bloxham) into the stratosphere. The leader of the group, Chris Joye, had the following to say on his blog:

Well, as predicted here more consistently and loudly than pretty much anywhere, Australia officially has a major inflation problem. And I mean “major”.

Underlying or core inflation has been running at more than a 3.5 per cent per annum pace over the last six months. That is more than one percentage point above the RBA’s implied 2.5 per cent per annum target, which just happens to be the highest inflation target in the developed world. (Remember, inflation is a tax on your savings).

As I have unwaveringly forecast–and reiterated only a week ago–we will get at least one to two rate hikes this year (in fact, we should in theory get three).

Forget rate cuts absent a total global meltdown. Anyone suggesting such refuses to accept our inflationary (and full employment) reality.

The currency market gets it, which is one reason why the Aussie dollar is currently trading at a near all-time high of 1.1035 US cents. Only a couple of weeks ago I flagged the risk of a surge in the Aussie dollar as foreign central banks seek to diversify into high-yielding Aussie government bonds.

August or September now loom as a near-certainty for the first RBA cash rate increase. And I reckon we will get another one before the year is out following which the RBA can probably sit pat.

This morning as well, Terry McCrann calls a hike, with this to say:

The inflation tiger is out of the bag and running, before we really get to the actual spending of the resources investment boom which is going to add so much stress to demand for skilled labour, and so wages and inflation.

…In his important speech on Tuesday — it’s important to understand, before he had any knowledge of yesterday’s inflation figures — Stevens argued that softening was achieving the necessary ‘making way’ in the non-resources economy for the resources boom.

But the clear inflation pressure means he can’t assume that will continue. China is pouring a tsunami of money into Australia. We could all too easily see inflation kicking up above 1 per cent a quarter as it did in 2008.

That brings us back to Gillard and Swan and their imposition of old-is-new again rigidities in our labour market and work practices; their pouring of billions into wasted or low-return projects like schools halls and the NBN.

I’m one of those that was taken a little by surprise by the vigor of yesterday’s CPI figure. Most surprising to me was how broad based the price rises were.

Nonetheless, it is still quite possible to mount good arguments as to why enough of the rises were temporary, and that the RBA can afford to wait. The banking charges highlighted by Bill Evans are temporary, the food price rises are clearly flood related and the RBA has said it will look through them. And the rises in at least some of the consumer goods such as clothing, shoes and booze can be seen as choppiness resulting from consumer caution and discounting churn.

Moreover, evidence is quickly mounting that the global economy is slowing quickly. To my mind, it is clear that the eurozone crisis is not resolved and that another, bigger bailout is going to be needed for Italy and Spain. Probably soon.

Also, last night the Federal Reserve Beige Book showed further slowing in the US economy, even without a US debt-ceiling debacle of some sort. And a slew of global companies are reporting a global slowdown is underway.

But. Equally, there is now no doubt that we have come to the witching hour for the RBA.

In September quarter 2008, the bank famously found itself behind the inflationary curve with the CPI jumping to 5%. They are on record saying that they will not allow that to happen again.

The RBA still has a bias to tighten and in its minutes last meeting suggested today’s CPI would figure strongly in its thoughts.

Earlier in the week, Glenn Stevens thumbed his nose at suggestions that consumer weakness means economic weakness and showed confidence in recent European developments. By doing so he paved the way for rate rises if needed.

And now, we have another CPI number running above the target band for the second straight quarter.

All things being equal, the RBA would raise rates Tuesday.

But they aren’t equal. As I wrote after the May rates decision, when bullhawks were demanding immediate hikes, the RBA is managing two adjustments, not one:

So, what the hell is this new paradigm anyway? It can be summed as follows.

As the ratings agencies have made abundantly clear, Australia can no longer prudently expand its offshore debt. That means the banking system cannot grow except through internal funding, which also means the mortgage system will struggle to grow. This much is on the record. I would go further. The RBA is engaged in a grand project of attempting to keep household debt from growing in the hope that through disleveraging(lowered credit growth rates) Australia can grow into its enormous debt and housing bubble. This has a long way to run. Based on GDP to March and March credit aggregates, Australia’s debt to GDP is at 153%, down from 170% in 07/08.

The RBA is also attempting to prevent household debt from growing for the other oft-stated reason, to make room for dramatically expanded resources investment.

In short, the RBA is having to manage two historic economic transformations simultaneously. One of them is potentially enormously deflationary, the other is potentially enormously inflationary. Pulled between these poles, the RBA may continue to lurch from one extreme to the other, at least in its jawboning.

The RBA is caught between unusually large forces. The services economy is very weak, a disorderly slide in house prices is a real concern and, as the commentaries of Mssrs Joye and McCrann show, the major concern for inflation at this stage is that we are early into a commodities boom with limited resources to accommodate it. Especially in labour.

I would say, rather, that the global cycle is in trouble, and that unemployment is a full percentage point above its 2008 low. As well, employment growth is now clearly stalled and the dollar is about to put a whole new batch of manufacturers out of business.

However, there is still one big danger. If I’m Joe Worker and I look around at my shitty stock returns, falling house price and rising food prices, I might I think I need a pay rise, and now.

The danger, then, is that inflation expectations rise and we enter a wage price spiral. To me, that makes the mid August Melbourne Institute Inflation Expectations Survey rather important.

As the Melbourne Institute diagnosed earlier in the week, the RBA is on the horns of a stagflationary “policy dilemma”.

Comments

  1. If I’m Joe Worker and I look around at my shitty stock returns, falling house price and rising food prices, I might I think I need a pay rise, and now.

    Joe Worker may well think that, but unless he’s working in mining, his employer will be unable to pay.

    Margins are crunched to the bone in the domestic economy, and trade-exposed industries are in a tailspin, reeling from the dollar at $1.10.

  2. Joe Worker shouldn’t have borrowed 90% mortgage and expect to go on business class holidays every week!

    Bring on a rate rise.

    • Spot on Jimbo. How can we in a developed nation with pretty good salaries (compared to the rest of the world) have problems with rising cost of utilities and food prices. That 90% mortgage 8 times salary must have something to do with it. It is like buying a $100K BMW and complaining about cost of fuel.

      • The difference is everyone knows the BMW depreciates and needs to be replaced every five or so years. But as real estate doubles in value every 7 years taking on the mega mortgage is the best investment Joe Worker could ever make!

  3. As far as I’m concerned, housing and hence the economy, can tank. I want higher interest rates to offset the ever increasing inflation in things that are important. You guys know that we’ve got massive inflation in the stuff we need, now it’s time for savers to be compensated for this rather than have their wealth eroded away. We chose not to buy into this debt scam, we shouldn’t have to pay the price to support it any longer. Bring on the rate rises now!

  4. H&H agree, and I would expect unions to get noisy about pay rises, but as Lorax says not all sectors will get heard.

  5. It really is a difficult place for the RBA to be and most unfortunate that these two forces are playing out simultaneously. My guess is that the RBA will continue in a holding pattern for a while longer, not because that is what Stevens wants (it isn’t, at heart he wants to raise rates due to inflationary fears) but in an attempt to reassure households for a while longer and to circumvent any freefall in property values – although I don’t see how a small raise would make any substantive difference in affordability for most.

    If inflation gets a head start it can be a difficult beast to tame. And very damaging to those on fixed incomes and savers (and of course indebted households) hence I could see an argument for a small raise now. Who knows – is it possible for the inflationary/deflationary forces to counter the effects of each other?

    Perhaps the we need a little longer in this new normal we are going to have to get accustomed to. There needs to be balanced reporting in the MSM, not a swing from outright bullishness to fearmongering. An overdose gloom is not what is needed right now. We need david type reporting!

    In regard to a wages outbreak – a possibility, although I can only assume as the government is essentially one of ex-union officials and bureaucrats that they have put the hard word on the current bunch not to push on wages at this time. Surely.

    • Who knows – is it possible for the inflationary/deflationary forces to counter the effects of each other?

      They will, in a way. That’s what the two-speed economy is all about.

      The inflation will be contained in the mining regions, where everyone is becoming fabulously wealthy, and rate rises would have no impact anyway.

      The deflation will be concentrated in the non-mining trade exposed sectors, which will be severely punished for daring to produce goods and services in Australia. They will be crucified by the RBA and left to die.

      Mainstream Australia will experience stagflation. Tepid growth at best with inflation leaking out of the mining sector.

    • The interesting proposition and questions we should be asking (and I agree broadly with your thesis Lorax) is how to position your investments, risk and assets depending on where you are in this economy.

      On a contrarian note, what interests me is that the mainstream are still expecting double digit growth from share markets (without working out what part of the share market will have the growth and what will have the deflation) and “subdued”, but WAY above what I consider normal growth rates in housing.

      I hope to write more on this in the weeks ahead.

      • I thought they were the very questions H&H has indeed been asking back since his old H&H days…

      • “what interests me is that the mainstream are still expecting double digit growth from share markets (without working out what part of the share market will have the growth and what will have the deflation) and “subdued”, but WAY above what I consider normal growth rates in housing.”

        Shouldn’t be too difficult in the context of double digit inflation. Back to the 1970’s.

    • “My guess is that the RBA will continue in a holding pattern for a while longer,”

      RBA board members must run the factory I work in because that’s what my managers do when faced with problems – do the same thing and hope that the problem fixes itself.

      It’s been my observation though that problems left untended seem to get significantly worse. Hmmm, maybe the RBA board members take advice from how my wife treats her car, ignore strange noises emanating from the engine or failing that turn up the radio.

      FWIW my wife would ruin the economy for a lot less pay than the current lot. Hell, I’d do it for a laugh but that’d be just me bringing the smack down on debt junkies making them pay in full just before I introduced a gold standard

  6. Does the CPI figure include all of the people that have been buying direct from overseas to pay less money for things?

    This should be included as it reflects the real cost of living in Australia. If the budget conscious consumer who makes rational decisions by buying overseas is removed from statistics, then this will significantly inflate CPI.

      • I always find Bill a very good read. My only complaint is that a few years ago, he used to answer all my questions personally whereas now, he doesn’t really engage with the commentors on his blog.

      • The crowd got bigger Lefty. He can’t respond to everyone. I suspect some questions are not responded to as they’re answered when you think about the post some more or recently covered elsewhere in his blogs/comments.

  7. Why no commentary seems to be mentioning that excluding food and fuel, inflation is perfectly behaved at 0.5% Q/Q after a 0.8% last quarter and 0.1% in the Dec 10 quarter? Core inflation is actually slowing down in 2011 compared to 2010. Rate rises can’t target food and energy prices.

    In the US they seem to understand that very simple concept, but here in Australia, it seems it does not count.

    Core inflation excluding food and fuel was running at 1% Q/Q each quarter in 2008! A big difference.

    The RBA will stay alert in the coming months but this number by itself does not warrant further rate rises.

    • can we live without “food” and “fuel”.

      why not just exclude everything into “no core”.

      then, we don’t have an inflation at all.

      • More rate rises won’t bring down the price of oil nor food. Actually, the increasing price for oil or food is like rate rise in itself and it takes away from discretionary spending.

      • If the rate rises help bring the Australian dollar to USD1.50 as some are predicting, that could bring about a large reduction in the price Australia pays for oil dependent produce, including fuel and food.

      • AUD @ 1.50 implies a lot of USD weakness, so oil prices would probably rise to US$ 150 from US$ 100

      • it is coming down to what is the meaning of “inflation” — more $$$ chasing limited good.

        as long as we can balance it out with “limited $$$ chasing limited good”. economy will balance it out.

        in the short run, it’s in almost everyone’s interests to have more $$$ or cheap rates. but, it is a pain in long run.

        i think it is a critical moment whether RBA could balance it out.

        for US, UK and many other countries, the balance has clearly skewed.

      • Australia is in an open economy. lots of influences are emanating from outside.

        but, given the high AUD, we should already buffered some of those impacts.

        higher fuel price will stay with us over a long period of time.

        someone need to pay for those increasing limited nature resource.

        unless, we have a major technology break through.

  8. Terry McRann:
    “China is pouring a tsunami of money into Australia.”

    Exports to China: $58B
    Imports from China: $39B

    A Nett $19B is hardly a Tsunami into a country with a $1.2T economy.

  9. Employment growth stalling + house prices declining = Joe Worker probably doesn’t have much bargaining power (unless, as someone astutely pointed out, Joe works in mining).

    Also, if inflation at 3.5% means I get 6% on my term deposit, I’ll cop that ‘tax on my savings’, thanks. Time for Joye to accept that low risk premia are a thing of the past.

    • Ben your problem becomes a little different if you look to the future of where inflation is headed. However even at the moment 6%less marginal tax…including medicare levy, flood levy you are left with 3.6% so there is NIL return to savings.In the future, as for much of the last 50 years, your after-tax real return will be negative.
      That’s why we now have all the problems we have with debt in all its forms and denominations.

  10. Rota you missed the point. The tsunami of money is flooding here buying up resources rural land and industry. I’ve no doubt some of it is sitting around in cash one form and another as well.

    Most Chinese are not completely dozey and do not want to be holding USD or its equivalent if they can help it. They want resources.

    Between that and Ben’s infinite money creation the rise of the A$ continues apace and the tsunami of money is virtually destroying nearly everything in its path.

      • Hi Lefty

        As I have always said the solution lies back in time. There is no ‘solution’ now. We are caught in a vice of our own making.
        In order to nudge things in the right direction however we would require higher interest rates i.e. REAL positive after-tax rates to encourage saving. We could then stop selling off our resources and not need to increase our foreign borrowings.
        At the same time this ‘Floating Dollar/feel free to push our currency to whatever level’ with Ben’s free USD has to stop. We need to start controlling the sale of our resources and the flow of speculative money which now dominates our economy. Leigh Harkness has had some input in this regard.

        We have to invest our savings in productive export or import replacement industries. The lower dollar will help with this. We have to stop financing service industries and somehow re-frame the economy so that productive sectors can actually afford those services.

        There are a whole range of issues and measures. None of them are painless that is certain and they ALL tend to make the immediate future a little worse in terms of consumption. Any measure which calls for the end of increasing debt levels will be.

        We need to stop listening to any ‘Magic Pudding’ economics whether peddled by Wayne Swan, Joe hockey, Ken Henry, Glen Stevens or Bill Barnacle et al
        We need a good hard dose of reality!!!!!

    • Different China Fanboy

      Most Chinese are not completely dozey and do not want to be holding USD or its equivalent if they can help it.

      As long as they run trade surpluses they haven’t got a choice. You can’t have one without the other.

      • Fanboy

        They are trying to spend those surpluses on resources to maintain the value of their money and shore up future supplies of materials.
        So countries like us who have chronic Current Account Deficits have to sell those resources.
        China gets rid of their dollars and we get dollars to be able to continue to run the CAD’s

      • Different China Fanboy

        Except that the accumulation of US dollars from trade far — by a long way — outweighs the amount being spent on resources etc. There just isn’t enough shit out there for them to buy with those dollars.

        So as per my comment, as long as those trade surpluses exists, at the scale they exist, you can’t have it both ways.

        This data is out of date but gives you an idea of the scale:

        http://www.wolframalpha.com/input/?i=China+US+dollar+reserves

      • Fanboy thanks
        I am aware of the numbers and scale. I am not talking about it from a Chinese point of view really. I am talking about the effect on the Aus economy. For us it is a massive flood of money that is distorting our economy.

      • So Flawse, if we didn’t have this (all going well, continuing) massive ‘flood of money’ – what then?

        Peak debt has had its run and totally distorted the economy. Everyone, retailers, property agents, etc thought it would never end. It has and the adjustment will occur – good grief we complain to the max – it reflects badly.

    • Fair point flawse. But how big is it in 2010/11?

      “China was the third largest investor in 2009-10 with total proposed investment of
      $16.3 billion. The majority of this proposed investment was in the mineral exploration and development sector, accounting for $12.2 billion and representing 75 per cent of that country’s proposed investment.”

      P33. http://www.firb.gov.au/content/Publications/AnnualReports/2009-2010/_downloads/2009-10_FIRB_AR.pdf

      from
      http://www.firb.gov.au/content/publications.asp?NavID=5

      Still hardly a Tsunami.

  11. The price rises of imported products can be expected to at least continue and actually accelerate.

  12. The garment industry is experiencing a ‘bloodbath’ right now, there is retrenchment everywhere. This opens the way for inflation and unemployment to both go up at the same time. What should the RBA do under such a scenario? That will be when we’ll discover if Glenn Stevens is worth his million dollar plus salary.

  13. Chris Joye is very disappointing. A week ago he was hedging his bets saying that the CPI figures where going to be a turning point one way or the other. So either way he couldn’t loose. Further he was emphatic that there would be a rate rise in June but when it didn’t happen he was somewhat silent and a bit stroppy. Now he’s saying that he has been crowing about interest rates going up. Well we know the truth about that. Economists unfortunately are not great readers or predictors of economic events because they really too heavily on economic statistics. I am an economist but I consider myself a businessman and it is this that allows one to get a better idea about what’s going on.

  14. 3d1K I’m not sure of the point of your question and whether you are tending to agree with me or taking great exception :).
    Remember my time frame on this problem is more than 50 years. As I have always said the answer lies back in time.
    Our economy is so distorted and now so heavily reliant on Foreign Borrowings and foreign Asset sales that, fairly obviously, if you suddenly cut off all the Foreign borrowings and foreign asset sales then there would be widespread dislocation and the downturn experienced by the economy would be most severe with widespread unemployment, stagflation, asset collapse etc
    The fact that this is so should surely set alarm bells ringing for everyone.

    On the other hand if, back in time, when the whole ‘Service Sector’ ‘Foreign borrowings don’t matter’ mantra started, when our CAD problems first started to appear, if we had taken control then, our economy now would be far better balanced, resilient, and debt-free.
    In all likelihood we would have run Current Account Surpluses and actually have a meaningful SWF!

    It’s too large a topic to summarise in a few words but I will say this again. For economists these days the long term is taken to be 10 years or so. The long term for me is 50 years because that is my time studying economics. It’s also the time that obviously things started going badly off the rails for Australia.
    I don’t know maybe the REAL long term is much longer than 50 years but if we could start looking at 50 years that might be a start.