It would be a wild exaggeration to say that Australia has an inflation problem, but the March quarter CPI highlighted the fact that the strength of the domestic economy is spilling over into a somewhat uncomfortable acceleration in the inflation rate.
While the March quarter inflation rates came in under market expectations (which says more about those expectations than it does about the actual hard data), inflation is moving higher.
Whether it is the annual headline inflation rate – which has risen from a low of 1.2 per cent in the June quarter 2012 to 2.9 per cent now – or the underlying inflation rate – which has risen from a low of 1.9 per cent to 2.7 per cent now – the RBA can no longer sit on a record low cash rate of 2.5 per cent and be confident that a further acceleration in the inflation rate wont happen.
Left unchecked, there is more chance the inflation rate will exceed 3.5 per cent than it will drop below 2.5 per cent in the year ahead. This suggests the RBA is playing a very dangerous game in its refusal to contemplate even a moderate winding back of the current monetary policy stimulus that has been in place for a year.
What could be worrisome about the recent upward momentum in the inflation rate is that it has occurred with wages growth near historical allows. This means we are not seeing cost-push inflation (the old wage/inflation ‘spiral’) but demand-pull inflation, which results from demand running ahead of capacity.
One only needs to look at the strong growth in retail spending, the record high level of new house building and the massive $1 trillion boost to wealth over the last two years from rising house and stock market prices to see why firms are able to get away with price increases to eager consumers.
While it is early days with the turn in labour market conditions, any upshift in wages growth would, according to RBA orthodoxy, only add to inflation pressures.
With the economy showing no sign of losing momentum, it seems obvious that interest rates need to move towards a neutral rate around 3.5 per cent. The RBA should still be taking out the proverbial insurance against an inflation breakout later this year and into 2015 by hiking the cash rate by 25 basis points rates very soon as it starts along the path back to, say, 3.5 per cent for the cash rate.
The fall-away in mining investment is being swamped by stronger growth elsewhere. The transition is occurring and the threat to economic growth from a tight budget seems very low risk given the countervailing boost to government spending on infrastructure, paid parental leave, defence and a raft of other Coalition favourites.
The next RBA Board meeting is 13 days away. The RBA should be hiking interest rates but its body language now makes that unlikely. Inflation is getting uncomfortable, the RBA knows it, but obviously wants to see the inflation pressure build further before acting.
