Another hit and miss: The RBA has an inflation problem

Fri, 26 Apr 2019  |  

This article first appeared on the Yahoo Finance web page at this link: https://au.finance.yahoo.com/news/another-hit-and-miss-the-rba-has-an-inflation-problem-235451380.html 

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Another hit and miss: The RBA has an inflation problem

This is getting embarrassing for the RBA.

It has yet again missed its target for inflation. The March quarter consumer price index confirmed annual headline inflation at 1.3 per cent, while the underlying inflation measure saw inflation running at an equal record low of just 1.4 per cent. Recall, the RBA has as an explicit goal “to keep consumer price inflation between 2 and 3 per cent, on average, over time. The 2 to 3 per cent medium-term goal provides a clearly identifiable performance benchmark over time.”

This target and the approach to setting interest rates has served the Australian economy very well in the 25 years it has been operating. It is probably no coincidence that since the RBA adopted this inflation targeting approach to setting interest rates, Australia has avoided recession.

Alas for the RBA, inflation is falling from a level that is already too low.

For over three years, annual inflation has been below 2 per cent, which is a clear sign the economy has been weak, with firms have no pricing power because demand and spending within the economy has been sluggish. Every economist, except amazingly, those at the RBA, knows that inflation is driven by the speed at which the economy grows. If, for example, the economy is booming, it will be at full employment and wages growth will inevitably be strong. In these circumstances, inflation will be accelerating.

It is a remarkably simple linkage.

Unfortunately, and largely because of the policy failures of the RBA, the Australian economy is dogged by a per capita recession, the unemployment rate is still high at 5 per cent and wages growth is tracking around record lows. In these circumstance, it is no surprise that inflation is low and falling.

For over two and a half years, the RBA has refused to use lower interest rates to underpin a stronger economy or to drive yet lower unemployment and stronger wage increases. It is a strange choice given part of the RBA mandate is to maximise the well-being of all Australians. Perhaps it doesn’t think of the human side of having close to 1.75 million people either unemployed or underemployed. The RBA has been blind-sided by an unhealthy obsession with house prices, a poorly defined concept of ‘financial stability’ and unrelenting forecasts that inflation and wages were just about to pick up.

Meanwhile, the economy has floundered with high interest rates a clear cause. The risk is growing of a very serious disinflationary funk in late 2019 and 2020. That unpleasant scenario can still be avoided, possibly, or at least the effects minimised if finally the RBA cuts interest rates aggressively in the next few months.

It has been clear for some time now, that the RBA should have been addressing the persistent low inflation problem and the slide in the pace of growth with interest rate cuts. Over a year ago, with inflation very low and the housing sector decline well underway, interest rate cuts could have been implemented and the economy now would be materially stronger.

Alas, it failed to act.

In the wake of the shockingly low March quarter inflation result, and if the RBA is serious about meeting its inflation target, it will cut the official cash rate by at least 50 basis points in the next few months. If, when the next one of two inflation readings are released, inflation is still low, the RBA may have to cut rates a further 50 basis points to just 0.5 per cent. It is a simple truism that low and falling interest rates are a sign of weak growth and low inflation, just as high interest rates are associated with strong growth and rising inflation.

The run of economic news so far in 2019 has confirmed a per capita GDP recession and inflation falling to uncomfortably low rates. Even the unemployment rate has stopped falling. It means, quite plainly, the RBA made a serious mistake a year ago when it failed to cut interest rates but it is a mistake it can at least partly recover from with a series of interest rate cuts in the months ahead.

Get set for mortgage rates falling towards 3 per cent and possibly below that level if inflation does not pick up.

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It’s time to end the “strong economy” propaganda

For the last year or so, it has been obvious to anyone with an open mind that the economy is in trouble. Unfortunately, the government and the Reserve Bank not only ignored this growth slump, but they ran a propaganda campaign saying the economy was “strong”, that unemployment would keep falling and wages growth was poised to pick up.

It might have been politics that lead the RBA and Treasury to this view with the recent election swinging on the economic credentials of both major parties. Ahead of the election, the RBA and Treasury were loathe to undermine the government with an honest assessment of the rapidly spreading economic problems.

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An update on my house price bet with Tony Locantro

It is difficult to think of a bigger issue that gets Australians fired up than house prices.Regular readers will know that back in September 2018, I made a bet on house prices with Tony Locantro, a fired-up Investment Manager with Alto Capital in Perth.

Tony wont mind me saying this, but he is what is called an ‘uber bear’ on house prices – he reckons prices are grossly inflated and are overdue to collapse. On the other hand, I reckon there is a cycle and that after the surge up to 2017, house price falls were inevitable, but that the decline would last only a couple of years and would not be too severe.

The bet was framed around a peak-to-trough fall in prices of 35.0 per cent in either Sydney, Melbourne or the 8 capital cities measure used by the Australian Bureau of Statistics. If prices fell by more than 35 per cent at any stage from the peak until the end of 2021, Tony would win, if the fall was less than 35 per cent, I would win.

Simple.

That background is important because the ABS just released the official dwelling price data for the March quarter 2019.

In the quarter, dwelling prices fell 3.0 per cent in the 8 capital cities and dropped 3.9 per cent in Sydney and 3.8 per cent in Melbourne.