Inflation: Dead, buried and in need of resurrecting
Underlying inflation has not been this low – 2.1% through the year – in 13 years. Next quarter, when the 0.8% rise from June 2011 drops out of the annual run rate, it’s likely that underlying inflation will break below the bottom of the RBA target band of 2.0% and there’s a sporting chance it will fall to a record low of 1.8%.
Headline inflation has crashed to 1.6%, below the bottom on the RBA target band and has risen at an annual rate of 0.2% in the last 6 months!
Whichever measure of inflation you wish to use, inflation is massively lower than most forecasts from just 6 or 9 months ago which were skewed towards annual inflation accelerating to 3% or more. In the second half of last year, some market commentators were even suggesting that Australia had a “major inflation problem” and that the RBA was well and truly “behind the interest rate curve”, meaning they expected 2 or 3 rate hikes in quick succession.
The fact that the inflation “problem” could be emerging on the downside and that there have already been 2 rate cuts with 100 basis points more priced in for the next year is a reflection of the all-to-easily dismissed anecdotes from retailers, manufacturing, the tourism and education sectors, housing, construction and basically anyone not attached to the mining sector. Maybe they had a point when they were saying conditions were tough.
What we are seeing now in the inflation data is just how soft the economy has been.
Looking back at the reasons why so many people, including the good folk at the RBA, misread the inflation outlook, a couple of key issues spring to mind:
- Importantly, the level of the Australian dollar has had a more dramatic effect on activity and inflation than was generally assumed.
- The world economic environment remains fragile and is damaging sentiment, confidence and economic activity.
- Interest rates were actually quite restrictive through 2011 and the impact of that restrictive setting is showing up in current data.
- Fiscal policy settings and government demand are having a bigger than assumed dampening effect on activity.
- Falling asset prices in the form of weak stock market prices and falling house prices are poison for the economy.
The inflation result today is so low that it demands that monetary policy move to an accommodative stance as soon as possible. In concert with the fall in the terms of trade and the fall in producer prices, the consumer price data should allow the RBA to get rates lower for the sake of growth, jobs and in doing so, avoid the threat of the Bank missing its inflation target on the down side in the next year or two.
The case for a 50 basis point cut – or more – is compelling. There needs to be some catch up to take account of the low CPI in the December quarter which everyone seems to have forgotten, and the ongoing softer growth momentum in the economy right now.
Whatever amount the RBA cuts next week, it will not be passed on in full. A 25 basis point cut would probably result in about 15 to 20 points being passed on to retail borrowers. In this case, the level of retail rates would be virtually the same at they were at the end of 2011, a time when the RBA and others were still concerned about inflation, wages and were optimistic about improving financial market conditions.
Rates need to be lower than they were at the end of 2011 and the only way to achieve that is for the RBA to cut by 50 basis points (or obviously more), with the cash rate dropping to 3.75% and mortgage rates falling to around 7.0%. The inflation data today and in the last week are low enough to justify such a move.
And there will be more rate cuts after that, given the RBA will have to play catch up and given the world economy and markets remain in a deep funk.