When is inflation not inflation?

A rather rhetorical question for a Friday, to be sure. However, this particular pondering has been brought on by one of WSP’s business partners – John – who has been looking at the Reserve Bank of Australia’s (RBA’s) recent attempts to keep inflation under control. John’s comments are that big chunks of the Consumer Price Index (CPI) changes, have quite clearly been reflecting government policy, and so it can appear that our island is being managed by a multiple personality disorder civic administration. Put more clearly – if government policy increases taxes, resulting in increased costs that then feed into higher cpi figures, isn’t it a little bit crazy to then have interest rates increased in an effort to keep a lid on those price rises?

Here’s the most obvious one for we folks here in the economic miracle that is Perth, Western Australia. According to the Australian newspaper, Perth electricity prices have increased 46% since 2008, while the same article suggests water prices have increased by 29%. The powers-that-be reassure we mere working bees that this is for our own good and for the good of the hive, as they are removing ‘inefficient’ subsidies that weaken our state economy, and 46% price rises (with a further 25% likely in the next year or so) for one of the most fundamental components of modern society’s infrastructure (electricity) will help all and sundry achieve happier and more balanced lifestyles. All cynicism aside, these increases feed directly into the measure for cpi (have a look at this very good article from the Wall Street Journal and its accompanying table) – which in turn, feed into wage negotiations, pension and welfare thresholds and so on, until the eagle eyed Reserve Bank spots price rises outside of its tidy guidelines, leading to increases in the official interest rate. These higher rates feed into higher funding costs for business, which lead to higher return on capital assumptions for businesses wishing to invest in new plant and equipment, which mean that energy generators and wholesalers sitting down with government negotiators have a solid lever to request higher electricity prices… and so the cycle moves on, and on.

There are all sorts of refutations to be made to these statements – such as electricity only making up 2.2% of the cpi basket of goodies in 2010, and the RBA considering many, many more issues that simply electricity or water costs.

However, that ignores the fact that the RBA acts on changes in prices, and small changes in price can lead to surprising outcomes in the basket that is the cpi – just take a moment to remember the infamous ‘banana scare’ a little while back.

So we can now point to an increase in the electricity component of the cpi from 1.6% in 2005 to 2.2% in 2010, and we haven’t even seen the impact from any carbon trading system yet, nor the much vaunted increases in prices due over the next few years as our electricity infrastructure is upgraded and improved to cope with an increasing population. In other words, when the friendly folk at the RBA Monetary Policy team sit down to consider official interest rates, a large chunk of the issues that turn up as changes from the last meeting can usually be pinned on government policy, or the actions of the Policy team themselves. This is no call to action for massive changes to Australia’s financial system but more a statement of the obvious. One that is not really presented to you and i as being a result of the obvious when those official statements come out.

For another example, let’s quickly look at the price of petrol. The Fuelwatch website tells us the average price of unleaded petrol is $1.48 per litre in the Perth metro area. The Australian Bureau of Statistics website points out that an increase in the price of petrol of 10% could result in an increase of 0.5% in the overall cpi. What impact does government policy have on that? Wikipedia suggests that government taxes make up 38c of that cost, leaving a net cost of $1.10 if we were free of that particular set of taxes. Keeping aside an ideal world free of death and taxes, this means that government policy has a strong impact on the cost of fuel, which in turn has a strong impact on cpi and measures of inflation.  Not a big deal necessarily but that may be enough to trigger an interest rate rise. Here’s a scary thought – what if we had the same overall rate of taxes as those driving on the superhighways of the USA? Again using Wikipedia’s fuel tax article as a guide, we can see that there are 3.79 litres to the US gallon, which means that drivers in Perth are paying $5.61 per US gallon for fuel. The overall federal and state taxes paid by US drivers amount to 45.6c per gallon. Bring that back to Australia, and it means our fuel price would be around $1.36 per litre (ignoring currency as an issue). That is, a drop of just over 8%. That could be enough to bring inflation over a period back into RBA preferred guidelines, and hold off an interest rate rise.

This is a Friday, and this is just a musings, so we won’t get too precise about all the ancillary issues surrounding the paragraph on petrol, such as global prices having more impact than government policy etc, etc. That kind of balanced judgement makes an exciting story boring, and remember this is a Friday.

As an aside for those interested in climate change, environmental sustainability and how prices change habits and outcomes – ponder this little gem… The petrol price at the pump for US drivers is around $4 per gallon. That’s around $1.05 per litre.  For we Australian mortals, that would be a windfall bonus but for those in the United States, $4 per gallon is enough to change long term driving habits, and not in a small way.

Did you hear the recent news that for the first time in 20 years, the United States was a net exporter of fuel?! This is amazing stuff. The Financial Times website has a very good article on this momentous event.

Imagine how habits would change if their fuel price were to rise another 40% to reach our levels? Mind you, there’d likely be another Boston Tea Party, except this time it’d be rednecks throwing Molotov cocktails at petrol supertankers…

For those deprived of human interraction or fun weekend activities, the Reserve Bank of Australia presents a far more moderate, balanced and grammatically correct version of monetary policy in their recent statement, which can be located on the RBA website here. A more concise reading of the current cpi figures, and the breakup between various components can be found in this excellent article on the RP Data website.

Inflation is of course far more important to us all currently than i am suggesting with this little Friday posting… The very same price trends that have benefitted Australia hugely over the past few years will eventually turn around to bite us, as the stuff we dig up and sell is processed overseas and sold back to us at a premium – but that is something we will cover in a later, midweek post.