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Sound the inflation alarm: Interest rates need to rise

·4-min read
Australian 50 Dollar banknotes being printed
Inflation looks to be settling around 3 per cent in headline terms, but with clear upside momentum in underlying terms. (Source: Getty)

For the first time in more than a decade, inflation is rising and it‘s testing the upper half of the Reserve Band of Australia’s 2 to 3 per cent target band.

It is increasingly obvious that the current official cash rate of 0.1 per cent, which was set when the coronavirus was inflicting intense disruption on the economy, is no longer appropriate for the prevailing economic circumstances.

The late 2021 economic rebound and now, building inflation pressures, are proof of that.

In November, the Melbourne Institute Monthly Inflation Gauge (MIMIG) rose 0.3 per cent following increases of 0.2 per cent in October and 0.3 per cent in September.

These are solid increases in inflation. In the year to November, the MIMIG rose 3.1 per cent, locking in seven months in a row where it had been at or above 2.5 per cent.

In November, the main price changes were for private motoring (+1.3 per cent) and new dwellings (+1.2 per cent).

These increases were partially offset by price falls for holiday, travel & accommodation (-5.9 per cent) and alcoholic beverages (-0.5 per cent).

Filling a void

The MIMIG is a vitally important economic release, filling the void left by the Australian Bureau of Statistics (ABS), which only publishes the Consumer Price Index inflation data quarterly and, even then, it does so with a considerable lag.

The ABS December quarter CPI will not be released until 27 January, 2022.

The Monthly Inflation Gauge uses the broad methodology employed by the ABS when it compiles the CPI. The long-run history shows how close the two series are in tracking annual changes in inflation.

The November figures incorporate around three quarters of the data that will go into the December-quarter CPI, which will be a critical data release that the Reserve Bank of Australia (RBA) and financial markets will not see for at least eight long weeks.

The chart below, from IFM Investors chief economist Alex Joiner, shows the history of the gauge in annual percentage-change terms plotted against the ABS headline CPI.

A graph showing the divergence between ABS quarterly headline inflation data and the Melbourne Institute Monthly Inflation Gauge data.
(Source: Provided)

While there are occasional divergences in the inflation rate measured in each series, the MIMIG reveals turning points in inflation momentum and, just as importantly, the same broad intensity of inflation pressures as the ABS CPI.

Which brings us back to the November data.

It is clear that Australia is now a fully paid-up member of the global club that is seeing inflation rates rise.

RBA must change tack

Inflation in Australia looks to be settling around 3 per cent in headline terms, but with clear momentum to the upside in underlying terms.

If this broad trend continues in the next few months and underlying inflation hits the top of the target band, the market pricing for a series of interest rate hikes starting around the middle of 2022 will be robustly based, and the RBA will need to change its calls on where it is seeing the economy through the course of the next 12-24 months.

It should be clear that interest rates above 0.1 per cent are inappropriate in an economy where inflation is persistently near 3 per cent.

In other words, a 0.1 per cent cash rate was quite rightly set for an economic disaster and that disaster has passed.

While some economists worry about the fact that the ABS does not produce a monthly CPI, the accuracy and timeliness of the MIMIG should allay all of those concerns.

Via the Melbourne Institute, Australia has a timely and reliable indicator of inflation on a monthly basis.

The RBA and markets would be wise to pay close attention to it, particularly when the results it shows are materially different to its view on where the inflation rate is going.

Right now is one of these times.

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