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Inflation: How low can it go?

(Source: Getty)
(Source: Getty)

The Reserve Bank of Australia’s policy embarrassment continues with the September quarter consumer price index data showing the quarterly underlying inflation at 0.4 per cent, which translates to an annual rise of just 1.4 per cent.

In underlying terms, annual inflation has never been lower.

This locks in 4 straight years where underlying inflation has been below 2 per cent, the bottom of the RBA’s 2 to 3 per cent target.


It locks in 5 years where inflation has been at or below 2.5 per cent, the mid-point of that target.

It locks in just under a decade since inflation was above 3 per cent.

Missing the inflation target so badly for such an extended times says quite plainly that the RBA policy actions were wrong, particularly when other central banks around the world were able to meet their inflation targets with pro-active monetary policy settings.

Until the post-election interest rates cuts which have seen the official cash rate belatedly reduced to 0.75 per cent, the RBA held interest rates at a high level. So high, in fact, that annual economic growth slumped to a decade low under 1.5 per cent, this has seen the unemployment rate remain at or above 5 per cent and wages growth tracked plumbed near record lows.

Sure, the Morrison government’s quest for a budget surplus did not help as spending was cut and tax revenue sucked cash out of the economy, but for month after month, year after year, the RBA felt it better to keep a tight reign on monetary policy as it sought to deflate the growth in household debt and house prices.

The RBA continues to drag out academically pure, but practically misguided, excuses about an unanticipated lift in the workforce participation rate as being a problem; or globalisation as a reason for low inflation.

To a point, this is fair enough.

But these are not new things that just popped up overnight. The RBA and other central banks saw these issues emerge years ago but it was the RBA which failed to fully appreciate the effect they would have on growth, wages and inflation.

When the rest of the industrialised world was cutting interest rates to towards zero or less and some even embarked on quantitative easing, the RBA held rates steady, at a relatively high level.

It is noteworthy that since the RBA resumed the rate cutting cycle in June 2019, there are clear signs that the economy is poised for a stronger year of growth in 2020 and 2021.

Monetary policy works.

To its credit, the RBA had a rethink of policy a few days after the Federal election (is the RBA politically biased?) and it has cut interest rates three times in five months.

There are signs this has worked. Look at house prices, retail spending, capex expectations, the low Aussie dollar and exports, to name a few areas to have benefited for policy stimulus. And the full effect of the interest rate cuts is yet to show up in most data, such are the lags in policy changes.

These lags will mean that the unemployment rate will probably not start to fall until the first half of 2020 which will only then see wage growth move higher and only then, is inflation likely to accelerate from the current record lows.

Inflation is the most lagging of lagging indicators.

Such is the problem with the RBA policy error in recent years – it takes considerable time to turn an economy around and an earlier policy move, when it was obvious the inflation target was being missed, would be yielding benefits now.

That said, the economy appears to be turning and while a further final 25 basis point rate cut might still be needed, the prospects for the inflation rate to reach the mid-point of the RBA target seems limited. Needed are quarterly inflation readings of 0.6 or 0.7 per cent which in turn requires annual GDP growth to exceed 3 per cent and the unemployment rate to track below 4.5 per cent.

That scorecard of economic indicators are possible by late 2020, and would get a helping hand if the Morrison government were to use the mid-year budget update in December to ramp up government spending and/or give some tax relief.

Let’s hope they do it.

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