Despite the RBA’s efforts to kill the beast in the June RBA meeting minutes (see this post), the “lower AUD means the RBA should not cut” beast is stirring.
This time it’s in my mate Chris Joye’s weekend AFR column (I always like reading Chris, but we’ve been at odds on inflation for the last five years).
Here’s an extract from Chris’s note:
My final message is to expect a new debate to emerge about how the RBA should respond to a revival in inflation. We are already seeing the first pre-emptive demands for the RBA to “look through” imported or “tradeables” inflation fuelled by a falling exchange rate.
These arguments will doubtless come from the same folk who clamoured for the RBA to ease policy on the back of the tradeables deflation our ascending exchange rate delivered. You’ve got to love the inconsistencies: an appreciating dollar means rate cuts, but we don’t need increases on the way down.
Chris has been warning about this ‘risk’ for some time. That warning has been falling on deaf ears for about the same amount of time. It’s been falling on deaf ears for good reasons: we ought always to ignore shifts in relative prices that are due to appropriate macro adjustments.
The question of if we ought to care about the first round effects of a level adjustment in the AUD really boils down to a view about the labour market. If workers are able to negotiate an increase in their nominal wages to compensate for the decrease in their real wage (due to the higher price of imported consumption goods) then the RBA ought to worry about the falling AUD. This would be the case if the labour market was tight.
If, on the other hand, the labour market is slack, workers are likely to simply accept the real wage cut. This seems likely to be the present case: and if i’m right about that, if follows that the central bank should not worry about the import price shock.
In a note on the falling AUD, the Age’s Peter Martin quotes Treasury Secretary Parkinson and his Deputy David Gruen, saying basically the same thing:
As the Australian dollar slid below 95 US cents for the first time in 30 months on Thursday Dr Parkinson told a Senate hearing the Bank should “look through” the inflation consequences of the sliding dollar and continue to keep interest rates low or cut them further even as the falling dollar pushed up prices.
“I wouldn’t wish to speak on the governor’s behalf and as a board member it is always a slightly difficult situation,” he said.
“But they could basically keep interest rates at a particular point, or they could lower them further, and just accept that inflation went out of the band for a period. Then, you know, they could try and stop the second round effects.”
He was backed up by his deputy David Gruen who said the Reserve Bank’s “flexible” target meant it could allow inflation to climb above the top of the 2 to 3 per cent target band so long as it did not spark a wage-price spiral. Inflation is at present 2.5 per cent. A sudden increase in rates in order to contain inflation as the dollar fell could harm the economy and prevent the dollar from falling further. It has slid from 102 US cents to 94.6 US cents in the past five weeks.
We ran this debate in the 1990s, when the TWI dropped 15% following the Asian Financial Crisis. Despite all sort of howls from the MCI crew about how the lower AUD was boosting demand, the RBA cut their policy rate by 125bps between 1997 and 1999. The RBNZ raised rates, and subsequently dumped the MCI as an operational target.
In my view, the present adjustment is a similar shock: the AUD is (appropriately) weakening due to the terms of trade drop. The labour market is weak, so the probability of a core inflation problem is small: it follows that monetary policy should seek to encourage this adjustment.