Iron Ore, RIO, and the RBA

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It seems to have become common wisdom that Iron Ore’s whizz up to USD170 per tonne means that there is no way the RBA can cut rates at their February meeting.

I think that this is wrong – the broad economy is weak, and if inflation is low (core 0.5%qq or lower), there is scope for further easing. A low inflation print would do two things: it would demonstrate that current inflation pressures are low, and it would confirm that the elevated Q3 result was really more about policy changes than a true inflation surge.

The ‘Iron Ore is Australia’ argument is a bit dim in any case. First of all because Iron Ore is only one source of investment demand – coal and gas remain subdued. Second, because i think that this approach cuts out all the important linkages, and i see change in those linkages.

The link between high commodity prices and inflation is via overall demand in the economy. During both phases of the mining boom, high commodity prices have tended to boost overall demand via higher mining sector investment, and higher corporate tax payments (which were ultimately recycled as higher government spending and consumption boosting tax cuts).

With deficits at all levels of government, it seems unlikely to me that the second channel would operate in the short to medium term. By that, i mean that any boost in mining sector related government revenue is likely to be banked by governments. Of course it is true that this may replace further belt tightening measures, and therefore it is not entirely accurate to say that it has no impact on the balance of risks — but at this point it seems fair to say that this channel is unlikely to boost demand / inflation in the short run.

So if the increase in prices makes a case (by itself) against a rate cut, it must be that we should expect it to boost mining investment. Here’s where Tom and RIO come into it – with so much money written down, my judgement is that RIO (and other major miners) will husband capital, and therefore keep their capex plans unchanged (or perhaps even trim a little).

Of course, BHP and the minnows could still step up — however i don’t see this happening. The iron ore outlook is for oversupply in the medium term, which will put prices well below USD100 per tonne, so i cannot see BHP gearing up. The stuff they trimmed in H2’12 is likely to stay trimmed. In the case of the smaller players, i don’t they have the confidence to re-ramp just yet.

The weird commodity price crash in q3’12 rattled their investors, and i think this will keep most circumspect. The so called ‘iron ore floor’ does not exist, which means that investment in this sector is riskier than many thought. If i am right in this judgement, then investment demand will remain subdued in the medium term (though clearly a sufficiently long period of high prices will repair ‘animal spirits’).

So, while it is clearly the case that a higher iron ore price is better than a low one, i do think that there is CPI number that will get a cut. A 0.5%qq result ought to do the trick.


    1. I think there is an unusually large amount of information in this CPI release – so i am pretty sure that there is a number that is low enough.

  1. I maybe reading wrongly but in terms of fiscal policy it is contractionary. cyclical improvements will not offset this all that much.

    1. That is what i am trying to say – that fiscal policy will remain tight and prevent cyclical improvements in revenue from higher iron ore prices from flowing on into other parts of demand.

  2. I think if we had a NGDP futures market, it would have rallied a bit since November due to better international conditions and notwithstanding the lack of an obvious transmission channel. That, in itself, might increase V and reduce the need for more stimulus. Sumner might say that the Wicksellian rate of interrest has risen. I still think we need one or two more cuts though. Will be interesting to see how the capital city auction markets open up in Feb.

    1. Sure, most forecasts would have risen somewhat — i guess the point i am trying to make is that it is not clear to me that inflation forecasts would have also gone up by much.

  3. off topic but Maate Cochrane has written something sensible and you should add to it.
    see noah smith ( noahopinion).

    It is his latest piece.
    Sorry to lazy to link it

    1. Well, there had long been a tension between The Kouk’s clearly political and bullish tweets about how great the economy was performing – low inflation, 5% UnN, trend growth, low rates, etc – and his more considered but pessimistic articles that highlighted the weaknesses necessitating multiple rate cuts. Now his tweets and articles are at one – everything’s sweet. Just what’s required in an election year. Not saying the turnaround is totally contrived, just a bit.

  4. There was no tension at all.

    He thought rates would fall previously because of tighter fiscal policy.
    Now he thinks O/S growth will obviate this.

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