We suspect that history will be turned on its head over the next decade or so with Australia and New Zealand experiencing lower inflation rates than some of their peers. It follows that their exchange rates are likely to be weaker than otherwise and that their government bond yields may be lower.
The health of demand will continue to affect inflation, but whether inflation is much higher or much lower over the next decade will mostly depend on the influence of structural forces, such as globalisation and the independence and mandates of the central banks.
At a global level these forces appear consistent with the average inflation rate over the next decade staying close to 2%, but there are likely to be important regional differences. We think that inflation will be highest in the US and lowest in Europe and Japan. In Australia and New Zealand, inflation may gradually drift lower, resulting in it being below 2% on average over the next 15 years. (See our Australia & New Zealand Economics Focus “The new long-term inflation trend”, published on 15th August.)
In particular, we think that a further rise in globalisation will reduce inflation in Australia and New Zealand by more than elsewhere. Both countries are keen to strike new trade deals and both are more susceptible to increased competition from foreign firms. Amazon’s plan to open in Australia next year will raise the share of retail sales that takes place online, which is fairly low at present, and lead to more price wars.
And the central banks in Australia and New Zealand will probably place less weight on their inflation targets and more on the risks to financial stability than others. That means they will keep interest rates higher than otherwise.
Low inflation may be a problem in the next downturn. It means there would be a greater risk of deflation. And the lower neutral interest rate means central banks will run out of ammunition sooner. So at some point in the next decade, Australia and New Zealand may have to turn to quantitative easing.
No small externally-funded economy has done QE. On the surface the notion is absurd. How can you possibly expect to avoid some kind of external crisis if you’re going to actively devalue even as you need to borrow, and your currency is so small that a few hedge funds can push it around?
To me it makes little sense to sustain a high yield spread with the cash rate when you already have macroprudential tools to control credit.
But, perhaps that’s the answer. Sustaining the yield spread while printing money does offer the flexibility of having an easily deployed currency-crushing policy tool.
Having said that, what would Aussie QE buy? If it was government bonds then the risks that our wholesale fuckwit governments misusing it is astronomical. If it is infrastructure then how can we say the RBA is independent any more given that is pure fiscal stimulus? If it is RMBS then the impact would be counter-productive given it would stoke the bubble.
Perhaps it could be currency reserve holders only, as Warwick McKibbin has suggested. That would be small but the implicit threat of devaluation for anyone buying the battler would be big.
Could it happen, though? Australian monetary authorities have proven paralytically slow to innovate new tools. This is a leap of imagination and into the unknown far greater than any yet taken. Aside from anything else, the Aussie dollar is not especially overvalued right now. The terms of trade are still high and the bank has shown zero inclination to get ahead of such measures. It will take much lower terms of trade and probably global crisis to push any QE agenda forward and the Aussie will crater then anyway.
Rather, if the business cycle can last a few more years, and Australian deflation does take a hold (which is a good prospect given debt saturation, hollowing out and mass immigration) then the RBA will simply be forced to cut rates again and to advance macroprudential incrementally forward.
