Australia | Oct 22 2008
By Greg Peel
Yesterday’s purchasing price index (PPI) gave economists a bit of a heads up with regards to today’s all important consumer price index (CPI) number, given it was surprisingly high. Economists have always assumed the third quarter CPI number would be a high one anyway, given the “look-back” nature of the measurement and that fact we were all still very concerned about high oil prices until rather recently. Similarly will were still basking in the glow of bulk commodity prices that could never go down again.
But the world changed in October and we have since had both a 100 basis point rate cut from the Reserve bank and the announcement of a stimulus package from the government. In isolation both seem ludicrous ahead of what the RBA had already warned would probably be a CPI number that would hit 5%.
The third quarter figure did hit 5%, but it still came as a surprise given economist consensus had the quarterly number rising only 1.0% for a 4.8% annual figure, but instead the rise was 1.2%. The core reading was also a concern, rising 1.3% to 4.7% annual. Apart from petrol, the costs of food, rent and financial services were major contributors.
When the RBA made its first 25 basis point rate cut back in September, it flagged that inflation would likely peak in third quarter and ease back into the 2-3% target range by sometime in 2010. When the world fell apart in October, the RBA was able to justify what can only be considered a globally coordinated emergency rate cut by reiterating its “peak” assumption but suggesting inflation could now quickly move back into the comfort zone by 2009.
To that end, economists do not believe today’s overly strong CPI will prevent the RBA from cutting again next month and continuing to cut in the future. However, the risk is that inflation starts to create what economists call a “feedback loop”.
The reason central banks learned that inflation was the most important element to control, even at the expense of economic growth, is that if left unchecked inflation can enter a dangerous and uncontrollable spiral. It all comes down to “inflation expectations” – something the RBA monitors closely.
Put simply, a widget retailer must buy widgets from a wholesaler and stack the widget shelves. There is a lag between when the widgets are bought and on sold to consumers by the retailer. There is also a lag from the time the widget wholesaler buys the raw materials needed to make widgets. If the wholesaler experiences high inflation (or even just reads high inflation numbers in the paper) he will worry that the next load of raw material costs will be higher, effectively meaning his current widget wholesale price will be too low to make a profit on. The widget retailer will also fear a price rise from the wholesaler. The retailer won’t wait and will immediately put his prices up in order to cover the cost of the next delivery. The wholesaler won’t wait and will increase the price to the retailer. So it will go on with one price rise affecting a belief that another will soon be coming. Inflation will thus feed itself.
And this is where the “feedback loop” comes in. Central banks around the globe are cutting rates making borrowing costs cheaper. But at the same time lingering high inflation is threatening to keep prices higher, even if only because of “expectations”. A slowing economy should slow inflation, but under the feedback loop scenario there is a risk that inflation does not slow at all, or a least that it takes a lot longer to slow.
Australian economists now therefore believe the RBA will need to pace its easing policy carefully. Most still believe we will get a 50bps cut next month although some now suggest only 25. Most still believe we will get another 100bps in total sooner rather than later but some now believe only 75. Generally economists believe, in light of today’s CPI, that the RBA’s easing program will either be longer in duration, or shallower in depth, or both.
Global credit markets are indeed easing, which is why all the big banks have been able to catch up to almost the full100bps cash rate reduction this last week with their mortgage rate reductions. The banks are also anticipating further rate cuts, which provides them with a bit more bravado on the competition front. The risk is now that this CPI figure will crimp that bravado a bit, all around, and that the pain will tend to linger a little longer.
It’s a difficult task for the RBA as it balances on the high wire between a hard economic landing and continuing high inflation – the stagflation disaster.