Saturday, January 25, 2014

Australia’s Surprise Bout of Inflation

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While Canada’s central bank grapples with the conundrum of persistent disinflation, the Reserve Bank of Australia (RBA) must now contend with the opposite problem: a surprise rise in inflation.

This week, the Australian Bureau of Statistics reported that inflation, as measured by the consumer price index (CPI), climbed 0.8 percent sequentially during the fourth quarter, while the core CPI, which strips out volatile components such as food and energy, increased by 0.9 percent. According to data aggregated by Bloomberg, economists had expected the aforementioned numbers to rise by 0.4 percent and 0.6 percent, respectively.

On a year-over-year basis, the CPI rose 2.7 percent, while the core CPI rose 2.6 percent, with both figures showing that in the short term at least, inflation is trending toward the higher end of the RBA’s targeted annual range for inflation of 2 percent to 3 percent.

In previous quarters, by contrast, inflation had come in toward the lower end of that range, affording the central bank considerable scope for monetary easing. The RBA has been on a rate-cutting cycle since late 2011, lowering its benchmark cash rate on eight separate occasions until it reached an all-time low of 2.5 percent in August.

One of the key aims of the central bank’s policymaking has been to help force the exchange rate lower. The Australian dollar’s relative strength has been a major headwind for the country’s exporters, and with a decline in mining investment underway, the RBA hopes one of the non-resource sectors will find its footing and drive the economy.

Although the Australian dollar traded above parity with the US dollar for much of 2011 and 2012, it fell sharply last year following the US Federal Reserve’s announcement that it was planning to curtail its extraordinary stimulus. The aussie currently trades near USD0.87, down nearly 21 percent from its high during this cycle.

Although RBA Governor Glenn Stevens would like the currency to trade as low as USD0.85, concerns that the country’s real estate market could be in danger of overheating have thus far precluded the bank from cutting rates again to achieve that end. Instead, Mr. Stevens has resorted to “jawboning,” or talking the currency lower.

But with the sudden jump in inflation, many economists believe that another rate cut is now completely off the table for the remainder of 2014. However, Westpac Chief Economist Bill Evans has an altogether different take. He believes that the latest CPI reading was almost entirely due to the lower exchange rate, particularly in areas such as overseas travel and imported goods, such as audio and visual equipment and fuel. Mr. Evans argues and that this effect likely peaked during the fourth quarter, and that weak domestic demand will contain the currency’s impact on inflation in subsequent quarters.

If the RBA abandons its easing bias, at least temporarily, then the exchange rate could rise modestly and further dampen inflation. And should subsequent data prove that the jump in inflation is indeed transitory, then Mr. Evans believes the RBA could cut rates again as soon as August, assuming the growth in the real economy remains sluggish.

It’s important to note that, among its peers, Westpac seems to be in the minority with this assessment. However, their rationale is well reasoned and merits consideration.

Other economists believe the country’s structural issues are a significant contributor to inflation. For instance, Deutsche Bank Chief Economist Adam Boyton, notes that inflation isn’t solely the product of a lower exchange rate, but that there’s also been a significant rise in “government inflation,” resulting from environmental taxes and higher prices for essential services, among other areas. He says government-induced inflation is running at an average annual rate of 5.7 percent, well in excess of other areas.

Overall, we’d certainly prefer the central bank to have the flexibility to lower rates until the economy rebounds. But even if it doesn’t, rates remain at historic lows, the currency has declined to a more sensible level, and the Australian government is now led by a party that wants to lower taxes in certain areas. Now all we need is a truly resurgent global economy.

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