Vital signs. Zero inflation means the Reserve Bank should cut rates as soon as it can, on Tuesday week



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The last time inflation was zero the Reserve Bank cut rates twice. It’ll get the chance on May 7.
Shutterstock

Richard Holden, UNSW

What do US pizza executive Herman Cain, US conservative commentator Stephen Moore, US Chief Justice Earl Warren, and Australia’s Reserve Bank governor Philip Lowe have in common?

More than you might think.

The immediate issue for Lowe is Wednesday’s inflation figures released by the Bureau of Statistics. Inflation for the first quarter of 2019 came in at 0.0%. Zero. Nada.

Taken together, the sum of consumer prices moved not at all between the last quarter of 2019 and the first quarter of 2019. The annual increase (all of it in the last three quarters of last year) was 1.3%.

However you cut the numbers, inflation is now incredibly low. The Reserve Bank’s measures of so-called underlying inflation (that mute the effects of sharp movements in things such as the prices of fruit and vegetables) are at the same level they were in 2016 when the Reserve Bank cut rates twice – in May and then August.

The Reserve Bank must cut

It has to do it again. The market expects it and is pricing in a cut.

Trading on the Australian Securities Exchange implies that 67% of those wagering real money expect the Reserve Bank to cut its cash rate from its present record low of 1.5% to another uncharted low of 1.25% when it next meets to consider rates on Tuesday May 7, a fortnight before the election.

A day earlier, before the release of Wednesday’s shockingly low inflation figure, only 13% expected a cut on Tuesday week.


ASX Target Rate Tracker

Three days after the Reserve Bank meeting, and just one week before the election, Lowe is due to release his quarterly report on the state of the economy and his stance on interest rates. He’ll find it easier to write if he justifies a cut.

Not only is inflation far lower than he is his aiming for, but economic growth has plummeted to levels that imply annual growth of closer to 1% than the present 2.3%
or his forecast of 3% by December. Strong house price growth, that would have once been a reason for caution about cutting rates, is no longer a consideration.

A broad cross-section of market economists expect a cut on Tuesday week.

Westpac’s Bill Evans has long predicted 50 basis points of cuts this year, and on Wednesday ANZ economists Hayden Dimes and David Plank said

The downward surprise to core inflation in the first quarter leaves the RBA with little choice but to cut the cash rate by 25 points at its May meeting, with another basis points likely to follow in August

The Reserve Bank’s inflation target of 2-3% has become a joke. Inflation has rarely even entered that range the entire time Lowe has been governor.

Lowe keeps hoping for lower unemployment to spark wages growth, but despite unemployment being consistently at or near its long term low of 5%, nothing much has happened, for almost a decade.

Most observers think that unemployment would need to be much lower – closer to 4% than 5% – for wages to take off.

Politics makes it urgent

Then factor in the election. Labor is odds-on to win. If it does, then there is a chance of fairly radical industrial relations reform. Think about the wish list of Australian Council of Trade Unions Secretary Sally McManus. That seems unlikely to me because of Labor’s extremely sensible economic team, but it’s possible.

Whether it happens or not, until the industrial relations landscape becomes clear businesses are unlikely to do a lot of hiring. Why hire a bunch of folks if you don’t know what you might have to end up paying them or how easy it will be to let them go or change what they do?

That uncertainty is likely to put more downward pressure on wages than whatever upward pressure comes from Labor heavying the Fair Work Commission into reversing its recent penalty-rates decision.

The Bank is losing credibility

All this suggests that the Reserve Bank has waited far too long for wages to tick up of their own accord.

We’ve had recent lessons from the US about the importance of credibility in central banking.

Donald Trump’s nomination of pizza executive Herman Cain to the board of the US Federal Reserve has been withdrawn after sexual harassment allegations, his nomination of Stephen Moore is in doubt after a series of derogatory public remarks he made about women.

They have political problems. Their nominations are in trouble because they are, to put it bluntly, grossly unqualified to govern the Federal Reserve.

The Reserve Bank’s problem is obviously different. It enjoys an impeccable reputation. But repeatedly seeming to ignore inflation numbers (and its own targets for inflation) is putting that reputation at risk.

Having resolve is important. The Reserve Bank isn’t supposed to just do exactly what the market expects or wants it to do.

But getting way out of whack with informed public sentiment without offering good reasons for doing so is very dangerous.

US Chief Justice Earl Warren – the great liberal reformer who desegregated education, ensured the right to a lawyer in criminal cases, and established the principle of one person one vote – was famously mindful of the Court not getting too far ahead of public opinion.

In Brown v Board of Education, which ruled racially segregated education unlawful, Warren worked hard to ensure a unanimous opinion of the Court. That opinion required desegregation “with all deliberate speed” – a phrase that was justly criticised as allowing desegregation to proceed far too slowly, but ensured that the court wasn’t too far out ahead of the Southern states and allowed them to adapt rather than defy it.

The Reserve Bank’s problem is not getting too far ahead of public opinion, it is lagging too far behind.

The consequences can be similar, though. If the public and the markets lose faith in the Bank as an institution – if it seems radically out of touch – then it will lose its ability to persuade and it will risk forced change from the outside.

Forced change is a possibility. Each new government strikes a new agreement with the Reserve Bank governor setting out what it expects of him.

The present one specifies “inflation between 2% and 3%, on average, over time”. If it can be seen that the governor has paid scant regard to the agreement, the new one might make the target more binding, or replace it with a different target.

Treasurer and Reserve Bank Governor, Statement on the Conduct of Monetary Policy, September 19, 2016.
Reserve Bank of Australia

It’s time to stop waiting

Governor Lowe waiting for wages to tick up without any underlying factor to cause it to happen is like Waiting for Godot. And it’s getting absurd.

He needs a better narrative than “something will turn up”, and he needs to cut rates. Not with all deliberate speed, but fast.The Conversation

Richard Holden, Professor of Economics, UNSW

This article is republished from The Conversation under a Creative Commons license. Read the original article.

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Vital Signs. Yet another year of steady rates. What’s the point of the RBA inflation target?



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Economists expect the cash rate to remain steady for yet another year even though inflation is on the floor.
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Richard Holden, UNSW

The Reserve Bank kicks off its first meeting for the year next Tuesday facing the same dilemma it did throughout last year.

It hasn’t got easier.

The bank has a very public, fairly clear objective: to keep inflation between 2% and 3%. But it keeps missing it. Over and over and over again, and on the downside.

As the following chart shows, inflation has been below the bank’s target band for nearly all of the past four years.



During his decade in office, the previous governor Glenn Stephens achieved an average inflation rate of 2.46% – almost bang in the centre of the target band.

During his subsequent two and half years in the job, Philip Lowe has averaged just 1.87%. At no point during Lowe’s term of office has the average fallen within the target band. The rate for December, released on Wednesday, was 1.8%.

Next Wednesday Lowe will make an unusual address to the National Press Club, during which he will outline his thoughts about the year ahead.

It is a year which The Conversation’s forecasting panel predicted will be free of interest rate adjustments, making it a record 40 months without a rate move – Lowe’s entire term in office.



The RBA has more than one target

Although the inflation target is an important part of the Reserve Bank’s mandate, it is also asked to focus on other things. Among them are GDP growth, employment, and (probably less explicitly) the Australian dollar and house prices.

And therein lies the problem. Unless the rate moves needed to meet all those objectives point in the same direction, the bank needs to make trade-offs, or sideline one or more of its objectives.

A classic principle of economics is that a policy-maker needs one instrument (or policy tool) for each objective. It is called the Tinbergen Rule, after the 1969 Nobel Laureate.

The bank has four or five objectives, but really only one tool – the cash rate, stuck at 1.5% since Lowe took the job.

Throw in the ability to partially shape market expectations through speeches by Lowe and Deputy Governor Guy Debelle (so-called “open mouth” operations), and maybe it has two.

Since Lowe took office, the casualty of this imbalance between instruments and objectives has been the inflation target. And it’s unlikely to change for some time.

So why is inflation so low?

Australia is not alone. Advanced economies around the world have had several years of low wages growth, low productivity growth, and low inflation. Populations are ageing, less keen on spending, and have a glut of excess savings.

Add to this the fact that technology and international trade have made a whole range of goods probably permanently cheaper and it’s hard to find inflationary pressure.




Read more:
Vital Signs: inflation misses again, so where does the RBA go next?


Potentially making things worse in Australia is the decline in house prices in Sydney and Melbourne eating into consumer confidence and with it, spending. With well over half of the economy coming from private spending, already soft consumer spending could be hit further.

So far, RBA Governor Philip Lowe has been doing an admirable impression of Mr Micawber, in the Charles Dickens novel David Copperfield. When it comes to inflation, he is hoping “something will turn up”. But it hasn’t, even with historically low levels of unemployment.

Worse still, it doesn’t even seem to really be ticking up in the United States, despite the lowest year-end unemployment rate since 1969.

And why does it target inflation?

The bank targets inflation in order to maintain credibility.

The high levels of inflation in the 1970s and ‘80s – despite quite high levels of unemployment – led to the realisation that expectations had a lot to do with it.

Put simply, if people believe prices are going to rise sharply they will demand steep wage rises, which will cause prices to rise sharply. It becomes a “wage-price spiral”.

Macroeconomists and central bankers realised that a credible commitment to keep inflation low would remove the need for the large wage rises, cutting off the spiral before it got going.

The bank describes the rationale for its inflation target this way:

The Governor and the Treasurer have agreed that the appropriate target for monetary policy in Australia is to achieve an inflation rate of 2–3%, on average, over time. This is a rate of inflation sufficiently low that it does not materially distort economic decisions in the community. Seeking to achieve this rate, on average, provides discipline for monetary policy decision-making, and serves as an anchor for private-sector inflation expectations.

That’s been the logic for the past 25 years. We have certainly done away with inflationary spirals. We are in the age of secular stagnation, with an excess of savings chasing too little spending. A world where, since the turn of this century, robust growth has only really been possible when accompanied with financial bubbles–first in dot-coms, then in housing.

So what’s a central banker to do?

There is an active debate among central bankers and leading macroeconomists about whether to abandon the inflation targeting framework.

Luminaries like former US Treasury Secretary Larry Summers argue that inflation targets are, to borrow from Hamlet, “more honour’d in the breach than the observance”.

Right now Lowe faces a real dilemma. If he doesn’t cut rates, the inflation target will become more and more of a joke. It will add to pressure on him to articulate a new monetary policy framework for a new secular-stagnation era.

If he does, he risks re-inflating the housing bubble, boosting already sky-high household debt, and giving himself even less wiggle room if a recession hits.

On Tuesday he’ll leave the cash rate at 1.50%. And on the first Tuesday of the next month, and the the next, and the one after that…

But I think he’ll begin serious internal discussions about a new monetary policy framework, and the mechanics of getting into (and out of) a massive bond-buying program (otherwise known as quantitative easing or printing money) if needed to ward off the next recession should the cash rate remain or get so low he can’t cut it further.

He might have already started. He might drop further hints on Wednesday.




Read more:
No surplus, no share market growth, no lift in wage growth. Economic survey points to bleaker times post-election


The Conversation


Richard Holden, Professor of Economics, UNSW

This article is republished from The Conversation under a Creative Commons license. Read the original article.

Vital Signs: inflation misses again, so where does the RBA go next?


Richard Holden, UNSW

Vital Signs is a regular economic wrap from UNSW economics professor Richard Holden (@profholden). Vital Signs aims to contextualise weekly economic events and cut through the noise of the data affecting global economies.


The disturbing trend of persistently low inflation continues, as Wednesday’s data release shows.

Headline inflation was 2.1% for the last 12 months. But the more relevant “underlying” rate came in at 1.9%. This is even below the 2.0% the RBA forecast in May.

Given that the RBA’s target band for inflation is 2-3%, and that inflation has barely touched the bottom of that band over a protracted period, there are implications for monetary policy.

But, before we get to that, the obvious question to ask is: why is inflation so low?




Read more:
Vital Signs: booming jobs numbers, but dig deeper and it’s not all rosy


One strand of thinking involves the “Philips Curve”. This basically says that low unemployment pushes up wages growth and hence inflation.

We could get into a long discussion of whether the current 5.4% unemployment rate is “low”. And whether the effective rate really is 5.4% given anecdotal evidence about “underemployment”, the impact of recent decisions on penalty rates and minimum wage rises, and the robot revolution as a backdrop to the whole labour market.

But we don’t need to go there. There is barely any evidence of the Philips Curve in the data over the past quarter century, so let’s just reject that theory and move on.

Plausible factors keeping a lid on inflation

  1. Technology. The information technology and internet revolution has made lots of things much cheaper. Take music. Gone are the days of paying A$20-plus for a CD with maybe 16 songs on it. Streaming services like Apple Music and Spotify give access to literally millions of songs for a small monthly fee.

  2. China. The rise of Chinese manufacturing has led to everything from kids’ toys to cell phones being produced vastly more cheaply than if those things were manufactured with higher-cost labour.

  3. Globalisation and trade. The world has become radically more connected, and so have company supply chains. This not only allows access to lower-cost manufacturing but also leads to better specialisation through the principle of comparative advantage. This means that high-labour-cost countries like Australia can specialise in other components of goods and services, get better at producing those components, and reduce overall costs further.

  4. Wages. Wage growth has been subdued for a long time now. Since labour costs are an important component of many goods and services, this has served to tame inflation. One potential reason for low wage growth is that automation sits as a background threat to human labour. If labour costs get too high then processes get automated, which serves to keep wages in check.

  5. Leverage and consumer spending. A final factor is that given how heavily indebted Australian households are –largely through mortgage debt – they simply don’t have a lot of discretionary income. This limits consumer spending and makes price rises in the retail sector less likely.

These factors don’t look likely to change any time soon – with the possible exception of trade due to the Trump trade war. But even if that escalates dramatically it will shrink economic activity, further depressing prices.




Read more:
Explainer: why some economists think the RBA should drop its inflation target


So we have long-run, persistently low inflation. Is that a problem?

The major concern is that it could turn into deflation, although that doesn’t look terribly likely right now.

If, however, there was another significant economic downturn then deflation is a very real prospect. That would raise the spectre of Japan’s experience of the 1990s where deflation caused people to hoard money, severely contracting economic activity.

But for now the real impact of low inflation is on the RBA.

Faced with inflation below its target band for an extended period, the standard response would be to cut interest rates. The RBA is clearly worried about doing this.

One reason is housing prices – the RBA is worried about further fuelling the bubble.

With housing prices easing, this may become less of a concern, although household debt levels remain extremely high. Not encouraging households to become further indebted seems like a reasonable concern.

A second reason the RBA may be nervous about cutting rates is that it doesn’t have very far to go with the cash rate at 1.50%. If there is another major economic downturn then the RBA wants to have some firepower left to respond.

If short-term rates were already near zero then the only tools available to the central bank would be non-standard measures such as quantitative easing. That would be uncharted territory for the RBA, which seems reticent to explore that territory.

So, as with economic growth and wage rises, the RBA response seems to involve crossing as many fingers and toes as possible and to publicly proclaim that things are looking good, but may take a while.

The ConversationWe will get a better look into how that strategy is going when wage price index figures are released mid-August.

Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

This article was originally published on The Conversation. Read the original article.

Vital Signs: how inflation in China and the US could affect Australia


Richard Holden, UNSW

Vital Signs is a regular economic wrap from UNSW economics professor and Harvard PhD Richard Holden (@profholden). Vital Signs aims to contextualise weekly economic events and cut through the noise of the data affecting global economies.

This week: How the economies of China and the United States will affect what happens in our own.


Business conditions in Australia have been strong enough to see a surge in company tax revenue that led Treasurer Scott Morrison to outline cuts to personal income taxes over the next seven years in Tuesday’s federal budget.

Those same robust business conditions were reflected in the National Australia Bank Business Conditions Index which was up sharply in April to 21 points (up 6 points from the previous month). This puts it at the highest level in twenty years.

NAB chief economist Alan Oster said of the figures:

The record high in the April survey simply reinforces what has been evident since the middle of last year, that business activity in Australia is robust…I see the business survey as indicative as why the government appears to be rolling in corporate tax revenue.

In the United States, the Job Openings and Labor Turnover Survey in March showed a surge of job openings – up 472,000 to 6.55 million. That was the highest reading on record. It also showed more workers voluntarily leaving jobs. This is generally regarded as strong sign of worker confidence and is indicative of looming wage inflation.

The US Producer Price Index rose just 0.1% in April according to the Bureau of Labor Statistics, much lower than estimates of 0.3%, the level of growth in March. This put the index up 2.6% over the last 12 months, down from 3.0%.

This eased concerns about rising inflation that have been a major focus of discussions about interest rates at the Federal Open Market Committee at recent meetings. That could make the Fed less likely to raise rates quickly, though the tightening path still seems likely.

All eyes will be on the May 10, inflation statistics release to see if there is less heat than the Fed has seemed to fear, especially with unemployment now running at 3.9%.

Adding to this, China’s Producer Price Index dropped by 0.2% from February, putting the annual rate at 3.1%, the weakest level since October 2016.

Economists were looking for an annual increase of 3.2%, down from 3.7% in February. Because China is such a significant global exporter, the lower Producer Price Index should ease any inflationary pressures in other countries. In other words, China is exporting less inflation.

China’s Consumer Price Index actually fell 1.1% last month, putting the annual rate at positive 2.1%. Last month’s figures in part reflect the timing of Chinese New Year, so one shouldn’t read too much into them. On the other hand, any softening of the Chinese economy is a big deal for Australian exporters and our economy generally.

The coming months overseas will be very revealing. We will get a better handle on whether there are genuine inflationary pressures in the US – or whether perhaps there is a new normal. That will affect short-term interest rates, but also says something about where those rates are likely to move back to in the cycle.

We will also get a better fix on the Chinese economy, at least in terms of growth numbers. What still remains opaque is the health of China’s financial sector. That remains a significant concern.

Both the US and China will factor heavily into two key things in Australia. The first is, of course, the RBA’s interest rate decisions later this year. The second is the key number in the federal budget – the 3.0% real GDP growth assumption that underpins the forecast return to surplus and the rationale for the personal income tax plan.

The ConversationAt least for the next few months, what happens overseas will be more important for the Australian economy than domestic factors per se.

Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

This article was originally published on The Conversation. Read the original article.

Vital Signs: weak inflation means interest rates aren’t rising anytime soon


Richard Holden, UNSW

Vital Signs is a weekly economic wrap from UNSW economics professor and Harvard PhD Richard Holden (@profholden). Vital Signs aims to contextualise weekly economic events and cut through the noise of the data affecting global economies.

This week: changes to how inflation is calculated, stagnant housing credit, and the US Federal Reserve keeps interest rates on hold


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It’s not often there are news stories anticipating Australian Bureau of Statistics data a week before it comes out. But Wednesday’s Consumer Price Index was an exception. The data showed a 0.6% rise in the Consumer Price Index for the December quarter, bringing the annual rate up to 1.9% (from 1.8% in the 12 months to September).

This is still below the Reserve Bank of Australia’s target range of 2-3%, but it’s edging closer. Kind of. It was still below what was forecasted.

One reason why market participants follow the Consumer Price Index so closely is the impact it has on the RBA in setting the official cash rate. For the RBA to start raising interest rates would require it to be pretty confident that the disinflationary pressures in the Australian economy have abated.

That still seems unclear, which is why it is a near certainty they will leave the cash rate unchanged at the next board meeting on Tuesday.

Two changes to how the Consumer Price Index is calculated were also introduced. Firstly, the weights that different categories of expenditure receive were tweaked, as they are periodically. This is to make sure that the goods in the “basket” reflect what households are actually spending their money on.

In the new calculation, items like childcare (now 1.35%) and education (now 4.27%) get a larger weighting.

A less routine and more interesting change was to use scanner data from retailers at point-of-sale in calculating the Consumer Price Index. This was spearheaded by the work of my UNSW School of Economics colleague Professor Kevin Fox, who was quoted by the ABS:

I strongly support the ABS decision to implement new CPI methods for the treatment of transactions data… These new methods will enhance the accuracy of the Australian CPI, provide additional analytics and better inform policy formulation.

Scanner data has been used in the Australian CPI since 2014, and makes up about one quarter of the expenditure basket. There were some issues, however, in how that data was incorporated. Roughly speaking (for technical details see the ABS report), the changes involve using all the products available (rather than a sample) and weighting products by their economic importance. A bonus for the cash-strapped ABS is that, as they put it

The use of multilateral methods will require fewer resources in the medium term.

Using more data, and using it better is definitely a good idea. And in the long run it will give us more informative, and reliable inflation figures.




Read more:
Vital Signs: five economic red flags to watch for in 2018


Reserve Bank of Australia data released Wednesday showed fairly steady credit growth compared to previous months. Housing credit grew at 6.3% for the year to December, as in 2016. Of course, one doesn’t want this to be too high given concerns about property bubbles, not too low given the importance of the housing market to the broader economy.

Meanwhile, in the US, this week marked the final board meeting of outgoing Federal Reserve Chair Janet Yellen. As expected, they left official interest rates unchanged at 1.25-1.50%, issuing this statement.

The Fed continues to be heavily focused on inflation, much like the RBA. The Federal Open Market Committee statement made that point, stating:

Inflation on a 12‑month basis is expected to move up this year and to stabilise around the Committee’s 2% objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.

This is best read as a sign that another rate rise at the March meeting is likely, unless material new information arrives in the interim.

The ConversationOne of the significant economic stories of 2018 seems likely to be the divergence between US and Australian interest rates, what it means for the Australian dollar, and what it means for capital flows to Australia. At the moment, it seems the Fed will steadily raise US interest rates this year, while the RBA will be stuck with hard choices and may be reticent to begin a tightening cycle.

Richard Holden, Professor of Economics and PLuS Alliance Fellow, UNSW

This article was originally published on The Conversation. Read the original article.