Sustained high inflation a danger
Alan Wood, Economics editor May 10, 2008
THE Australian economy is a powder keg of rising prices, rising inflation expectations and accelerating wage demands. And there is a real risk Tuesday's budget will put a match to it.
This isn't a message the Reserve Bank headlines in its latest Statement on Monetary Policy, but all the elements are there in its analysis of the forces at work in the economy.
What is more likely to catch the headlines are its latest forecasts for economic growth, which are certainly dramatic enough. They show real non-farm GDP growth plunging from 4 per cent in the year to the December quarter of last year (the most recent figure we have) to 1.75 per cent in the December-half of this year.
But I think this should be seen as the path the central bank would like to see the economy follow rather than the one it is yet convinced it will follow.
And even with these forecasts, with growth only picking up to 2.5 per cent in 2009 and not much more in 2010, inflation runs at 4.5 per cent (4 per cent underlying rate) in the six months to December this year and then only declines gradually to 2.75 per cent in the half year to December 2010.
This means that inflation will remain at dangerously elevated levels for the next two years, presenting the Reserve Bank with a serious policy challenge: how does it keep inflation expectations under control for such a long period?
It is inflation expectations that really matter, because once they start to rise it becomes much harder and much more painful -- politically, in terms of jobs, profits and growth, and socially as unemployment rises -- to get inflation back under control.
Inflation expectations are starting to rise. The RBA's survey of market economists shows that their expectations of inflation in the year to June 2009 have risen from 2.6 per cent last November to 3 per cent this month. More worrying, the expectations of union officials have jumped form 3 per cent to 4 per cent over the same period. The various wage measures cited by the bank, such as the wage price index, show wage rises stepping up to match rising inflation.
The RBA comments that wage rises in the private sector, at 4.3 per cent, are rising at the fastest rate of growth in the monetary statement's 10-year history.
Equally worrying, these are averages and many workers are seeing their wages falling behind inflation, causing growing union agitation for bigger wage rises. In both the private and public sectors, there have been recent settlements of 5 per cent.
If the RBA is to avoid further interest rate rises, it has to convince the corporate sector and wage earners that despite high inflation running on for an extended period, it will bring it back under control. Its forecasts of a sharp slowing in economic growth, its implied squeeze on consumer spending and a rise in unemployment are aimed at doing this.
The message of the forecasts is that this is no time to be seeking higher wages.
But as the RBA concedes, with Australia's terms of trade set to record their biggest one-year jump since the China boom began, at more than 20 per cent, it is difficult to know what the net balance will be between the forces of expansion and contraction operating on the Australian economy.
We are told that: "On balance, the board's assessment is that a period of below-trend growth in the Australian economy is now in prospect. If sustained, this will mean a gradual easing in capacity pressures, which in turn can be expected to have a restraining influence on inflation over time."
Yet while we are told the available economic data for 2008 suggests a significant moderation in domestic spending is now occurring, the evidence cited is less than convincing.
For example, we are told that after strong growth last year, the volume of retail sales is estimated to have fallen "slightly" in the March quarter.
Similarly, while surveys in the business sector point to a noticeable fall in confidence, trading conditions are reported to have softened only "moderately".
As for the labour market, the RBA says indicators have remained strong, with employment continuing to expand in the March quarter and unemployment remaining close to record lows.
This doesn't sound like a central bank convinced it has done enough to bring inflation under control and anchor inflation expectations. And remember, its growth forecasts are just that -- forecasts.
Have a look at the two tables, the first showing the RBA's latest forecasts for growth and inflation and, the second, its forecasts in May last year. A year ago, the RBA didn't publish detailed forecasts for non-farm growth, but it did tell us in the text of its monetary policy statement that it expected it to run on at 3.25-3.5 per cent.
Growth was stronger than that in 2007, as the first table shows. But its latest forecasts mark a substantial cut in its growth expectations going forward.
On the other hand, it is now distinctly less optimistic about inflation.
None of this is surprising, since it has put up interest rates a full percentage point since then, there has been a global credit meltdown, rising food and oil prices and so on. But it is a salutary reminder of the margin for error in any set of economic forecasts.
We should see its latest forecast as what it wants to achieve, and assume it will do whatever is necessary to do so if there isn't further evidence of clearly contracting domestic spending or wages growth continues to rise.
Attention now swings to next Tuesday's budget. Treasurer Wayne Swan assures us that the RBA's Glenn Stevens "will be quite happy with the (fiscal) settings we announce".
Despite the tough talk, I think there is a good chance he won't be. To have a significant influence on interest rates and inflation, the budget surplus will need to be genuine -- no fudges -- and in the range of $25-30 billion for 2008-09, and it doesn't sound like it will be.
This raises the danger of a financial market backlash once the budget's details are absorbed, if the reality falls short of the expectations of blood-on-the-floor decision-making built up by Kevin Rudd and Swan.
Source: http://www.theaustralian.news.com.au/story/0,25197,23672511-643,00.html
