In the long run, the only thing that monetary policy can do is set the price level. Pretty much every economist agrees with this if we make the time horizon long enough — so it’s natural that after the high Q3 inflation print some will argue against further easing of monetary policy.
I regard this as a reasonable argument, and if the labour market was tight and demand conditions were firm, i’d probably be making it myself, however i think that the right thing to do is to be confident and cut the official cash rate by 25bps to 3% at the November RBA meeting.
My initial impression was that ex policy induced supply shocks that core inflation was ~0.5%q/q. The publication of the PPI and trade prices, following the Q3 CPI report, makes this judgement a little less speculative.
Headline final goods PPI was a modest +0.6%q/q in Q3 (mkt +1%q/q), to take PPI to 1.1%y/y. Intermediate PPI was 0.1%q/q (1.5%y/y) and preliminary goods PPI was -0.2%q/q (1.2%y/y). So current inflation looks to have been weak, and if anything there’s disinflation in the pipeline.
Consumer goods are what the RBA targets however — that ‘pipeline’ also looks empty. Due to a decline in import prices (the AUD appreciated modestly) consumer goods PPI was a +0.8%q/q (-70bps to 1.0%y/y). Domestic Consumer goods PPI was +1.2%q/q (-70bps to 0.8%y/y) despite this being where the carbon tax boosted utilities sector is located; imported consumer goods PPI was -3.4%q/q (-0.5%y/y), larger than the 2.2% gain the the AUD TWI (2.9% AUDUSD).
All this seems consistent with there being generally low consumer price inflation pressure in Q3, and also generally low inflation risk over the medium term.
Most models show that it takes a few years for falling import prices to fully work their way through the system, so the very low consumer goods PPI import prices in Q3 suggest low inflation risk over the next year or so.
The trade prices series is important because it allows us to pin down the terms of trade. Import prices fell by 2.4%q/q and export prices fell by 6.4%, meaning that the terms of trade probably fell by about 4%q/q in Q3. This takes the decline in the terms of trade, from the peak a year ago to ~14%. This is only a few ppts shy of the decline in the GFC (where the AUD crash protected us from a much larger drop in the USD price of our exports).
This terms of trade decline continues — despite what you might think given the bluster about the spot price of iron ore in the Chinese port of Tianjin. While Iron Ore is an import export, it’s not the only export, and we don’t only deliver it to the Tianjin spot market. Coal is also important, and due to it’s price tanking the RBA’s export price index shows that SDR export prices were -3.5%m/m in October — a rise in the price of Iron Ore exports offset some the decline, but not all of it.
In AUD terms, the price decline was 2.2%m/m (the September price decline was also revised down to -2.2% in SDR terms, and +0.1%m/m in AUD terms, from -1.3%m/m and +0.9% respectively).
Finally, it’s worth noting that it’s not the export price per-se that matters. Central Banks care about export prices because they worry that high profits are a leading indicator of higher inflation (via higher investment demand). We have seen ongoing project cancellations despite the Iron Ore price bounce — so it seems that BHP for one is not buying into the hype. Additionally, Australian Coal mines have been closed.
So on the inflation side, i see weak pipeline (PPI) price pressures, a falling terms of trade, and an ongoing decline in the price of our exports — these factors have historically presaged weak (and weakening) underlying inflation pressures.
The supply shock from policy might be something you’d worry about — due to second round inflation — if the labour market was tight … but it’s not. The unemployment rate is rising, job advertising is very weak (and weakening), and hours worked per employee suggest ample spare capacity even at current levels of employment. Thus, it seems unlikely that the cost of living increases due to government policy changes will lead to second-round inflation.
Finally, the data this past week has put paid to another argument against lower rates — that they are goosing house prices. The October RPdata house price estimate was for a broad based 1%m/m NSA decline in house prices, spread across markets except Perth and Darwin. This index has been volatile, and i think the most accurate thing we can say is that prices are probably stable.
The weakness of housing credit and low level of housing finance applications suggests that whatever strength there is in the housing market is narrow. Owner occupier housing credit was a meek 0.3%m/m in September (a new low of 4.5%y/y), and investor credit for housing was 0.4%m/m (up from the low of 3.2%y/y in 2009).
With prices probably flat (it’s implausible to argue that they are falling at >; 10%y/y, after rising at a slightly faster pace the prior month), and credit weak, it’s tough take arguments that asset price inflation is a reason not to ease monetary policy.
Reliable house price growth is a pre-condition for the residential investment lift that the Treasury and RBA are looking for to keep us out of recession when the mining investment boom turns down in 2013. It’s a pre-condition, as builders and financiers are reluctant to hold risky inventory of properties if prices are falling — which makes them reluctant to invest.
With unemployment rising, inflation low, export prices declining, and the housing market remaining weak, there is both scope to ease policy and a need to do so. Add in a fiscal contraction that is going to crunch even harder in 2013, and it’s plain to see the case for a few more cuts.
I expect that the RBA will make a further adjustment to policy at their 6 November meeting, taking the cash rate down to 3%, and signalling that’s it for the moment. They will probably try and take a break for a while in H1’13 — to gauge how quickly the mining investment boom is likely to tail off, and how housing and residential investment is responding to easier policy.