FYI | Jul 02 2008
By Greg Peel
Perhaps the most notable element of the Reserve Bank of Australia’s latest monetary policy statement was that the central bank recognised high energy prices as both an influence on high inflation, and a restraint on economic growth. There have been two distinct camps forming recently among Australian economists – those who believe commodity inflation is just so strong the RBA will have to hike at least once, if not twice, and those who believe the economy and business confidence are falling so fast that the RBA will soon need to cut at least once, if not twice, before the end of 2008. The RBA’s statement, and unchanged cash rate, tended to quash the first camp but not exactly endorse the second.
Whatever economists may think however, the RBA is braced for a high, oil-driven second quarter CPI. Given the bank sees high oil prices as a restraint, it will not necessarily fear that CPI. A similar view was taken by the US Federal Reserve when it left rates changed at the end of last month. Yes – inflation is a problem, but the Fed is still banking on a slowing economy eventually bringing that inflation level down.
Economists at Morgan Stanley in the US believe that despite a lack of action by the Fed, the market should not take that as a given the central bank will not raise the cash rate. Every Fed statement concludes with the line “The Committee will…act as needed to promote sustainable economic growth and price stability”. If that price stability appears under threat because high inflation is lingering, then the Fed will raise without hesitation, Morgan Stanley suggests.
The question thus is: How efficacious is the argument that slowing economic growth must slow inflation?
Morgan Stanley notes there’s every reason not to fear high inflation in the US in particular. While the CPI is running at 4%, headline inflation as measured by personal consumption expenditures slowed to 3.1% in May, down 0.5% from six months ago. Core inflation is low at just over 2% and has also retreated. One quarter of the CPI is a measure of “owner-equivalent rent”, which assumes an equivalent price of rent against a house value. As housing values are crashing, so too is there downward pressure on the CPI.
At the same time, income growth has begun to slow but productivity remains high. Both are disinflationary. Lower income growth means lesser spending power, and high productivity means more goods are being produced for the same number of man-hours, thus reducing the value of those goods. “Slack” in the economy is also increasing given capacity utilisation is falling and unemployment is rising. Such slack means there’s room for more growth without pushing up prices and wages.
Nevertheless, there are plenty of bad signs along with the good. Apart from the immediate commodity price influences, inflation expectations are now at a 13-year high. If producers expect inflation to remain high, they will put up the price of their inventory so as not to get caught out on rising input costs. Expectations are very self-fulfilling. And with a falling US dollar, import prices have risen.
However a more worrying development, according to Morgan Stanley, is the rise of inflation abroad. The economists can count 50 economies around the globe where inflation is now tracking above 10%. The bulk of these are the dollar-peggers, particularly in the developing world, who have combined lax monetary policy with a falling US dollar, and where citizens spend a much greater proportion of their income on staples such as food and energy. There is a flow-back effect here, because many of these countries rely on exporting goods to the US, and hence US import prices are rising.
Nevertheless, such changes in prices are relative and not absolute, notes Morgan Stanley. On that basis high inflation should indeed be transitory. However:
“The problem now is that it likely will take central bank action and some time to rein in inflation in many parts of the world, and not every central bank is working hard to do it”.
The risk is thus that whatever the Fed is trying to control with its monetary policy domestically, its actions or lack thereof may be scuppered by relativities and the inaction of developing economies. It is now, after all, a “globalised” world. On that basis, Morgan Stanley suggests there is every chance the Fed will be forced to hike its cash rate, even if the economic growth outlook in the US is dire.
There is also every likelihood that the European Central Bank will raise its own cash rate on Thursday (later today), thus bringing more pressure to bear on the US dollar. So convinced is the global currency market that this will happen, attention has now turned to whether the ECB’s accompanying rhetoric will be persistently hawkish or whether one rise might be it for now. On this basis a 25 basis point rise and an accompanying “that’ll probably do” statement could even see the US dollar rally.
However, there is one very significant difference between the Fed and the ECB. The Fed has a dual mandate of promoting both “sustainable economic growth” and “price stability” (the latter meaning inflation). Yet the ECB has only a single mandate – to control inflation. It is not up to the ECB to focus on European economic growth. Those in Europe hoping the ECB will not be too aggressive given a weakening economy may thus be rather disappointed. One presumes the ECB would only refrain from raising the cash rate if it thought, as the Fed does, that weakening economic growth will bring down inflation by itself. When the Fed was madly slashing its cash rate to save the US economy, the ECB did nothing. Why? Because inflation still loomed as a threat.
Whatever happens, Morgan Stanley is warning its clients that there is more upside risk to global interest rates at present than there is downside risk.
