RBA confirms that it is ‘wait and see’ mode

From
  • In a speech by RBA Assistant Governor (Economic) Philip Lowe entitled “Inflation: The Recent Past and the Future”, Mr Lowe has reiterated that the RBA believes underlying inflation will lift only slowly, and over a matter of years rather than months.
  • Philip Lowe didn’t flag any near-term implications for rates, noting: “While conditions are very strong in parts of the economy, other parts are finding things very difficult.”
  • Clearly the RBA remains in ‘wait and see’ mode.

What did the speech cover and what does it all mean?

  • The speech by the Reserve Bank Assistant Governor was entitled “Inflation: The Recent Past and the Future”and indeed that’s what it covered: “First, I will talk in some detail about the distinct cycle in underlying inflation that we have seen in Australia over the past six years or so. After that, I will discuss the lessons that we might take from this cycle, as well as the broader lessons we have learnt from the past two decades of inflation targeting in Australia.”
  • At the outset, Philip Lowe confirmed that underlying inflation was expected to lift very gradually: “As the RBAdiscussed in the latest Statement on Monetary Policy, this decline in underlying inflation looks to have now run its course and a gradual rise is expected over the next couple of years.”
  • This statement is important as a number of analysts had previously interpreted RBA commentary as suggesting a relatively quick upturn in inflation, suggesting that a rate hike was imminent. But Lowe suggests a much more gradual increase for underlying inflation, currently in the lower end of the 2-3 per cent target band.
  • Philip Lowe also discussed the models developed by the RBA to track inflation and their track records. He noted that the “amplitude and timing” of the inflation cycle since 2005 surprised the RBA: “The general picture that one gets from this analysis is that underlying inflation in Australia was slower to pick up than suggested by the historical relationships, but when it did eventually pick up, it did so more quickly, and by a larger amount, than suggested by these relationships.”
  • The RBA has assessed the experience over that period in an attempt to be better understand the weaknesses in the models and to improve future forecasts. He focussed on unit labour costs, housing costs and international factors.
  • While there is a long-run relationship between unit labour costs (basically wages adjusted for productivity) and inflation, the short-term relationship “is not nearly as tight.” In other words, unit labour costs aren’t very useful in short-term forecasting models of inflation.
  • Mr Lowe believes that factors other than wages are more useful in describing inflation since 2005 – such as housing cost inflation.
  • Philip Lowe indicated that changes in home prices, rents and utilities “do help explain the particular dynamics of inflation over the recent cycle.”
  • In this context, it’s worth noting that home prices are now falling while utility prices have been rising, making it difficult to be precise about the influence on housing costs on future inflation outcomes.
  • In terms of international factors, Philip Lowe highlights the similarity of movements in headline inflation rates across the globe. Lowe also examined the influence of the exchange rate. But overall he didn’t find that international factors were overly helpful in explaining the inflation cycle since 2005: “Overall though, these swings in the exchange rate have played only a relatively minor role in explaining the recent cycle in underlying inflation which has been primarily driven by domestic factors.”

 

Implications

  • Philip Lowe concludes that capacity utilisation is the best explanation for the inflation experience since 2005: “So to summarise, an important lesson from this recent experience is that inflation responds to the changing pressures on capacity in the economy. When demand is high relative to the economy’s capacity to produce goods and services, the cost of labour and raw materials tend to rise and firms’ mark-ups tend to increase. Conversely,when demand is low relative to the economy’s capacity to produce goods and services, these pressures ease and inflation tends to fall.”

So where does all this leave monetary policy?

  • The Reserve Bank Assistant Governor is far from clear. There is a boom in mining, but other sectors are finding things very difficult. Low also notes that only a very small proportion of items in the CPI are currently rising more than average. The RBA believes its best contribution is to keep rates low, but there is no short term guidance. The RBA is clearly in wait and see mode.
  • “Looking ahead, as the Bank has discussed recently, the current environment is a particularly challenging one. In the central scenario, we are looking at a significant boom in investment in the resources sector at a time when the overall economy has relatively little spare capacity. While conditions are very strong in parts of the economy, other parts are finding things very difficult because of either the high exchange rate or the ongoing restraint in household spending and borrowing. And to add to the complications, global commodity prices are undergoing a structural shift as hundreds of millions of people in Asia enter the global economy.
  • It is not easy to navigate our way through this difficult environment. The new realities of the global economy have improved Australia’s medium-term prospects. At the same time though, they are causing considerable structural change in the economy which is leading to difficulties in a number of areas. As Australia takes advantage of its new opportunities and manages the process of structural change the task for the RBA is to keep inflation low and stable.”

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