RBA Rate Rise – “Just in case”

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The RBA has increased interest rates by another 0.25%. Most people won’t notice for a while, as they are still busy enjoying Melbourne Cup luncheons and the like.

It is an interesting move, this one. Obviously, any move of rates is a keenly watched event – much like the 150 year old horse race – as the outcome influences billions of dollars of credit and investment. Why is it interesting? Mainly because the wording that accompanied the announcement suggests that this is a “just in case” rate rise. Something along the lines of “getting in first”. What are the members of the interest rate committee trying to get in first on?

Basically, the statement suggests that inflation is going to rise in coming years. It’s interesting that this requires any action now as opposed to, say, February next year. The notes accompanying the announcement suggest that the Terms of Trade being the best since the ’50’s (obviously reflected in the run-up in shareprices for mining companies recently) and a low level of unemployment all suggest that we will be faced with higher inflation.

Some commentators suggest that this is faulty logic (such as www.RonEconomics.com). Others see it as a correct reaction to bottlenecks in the labour market and a much needed step to stop a wages ‘breakout’.

We don’t normally bother too much with rate rises, as they are covered fairly heavily by mainstream media. This time is a little different because this time, the RBA is taking action now over something that they suggest is being measured over years – and this is why it is interesting.

So, is inflation likely to rise?

Forecasting the future hasn’t really evolved too far from the old reading of the tea-leaves, in that the chances of mainstream analysis correctly forecasting short term rates for the future (for interest settings, currency etc) are less than even. However, there are a few basics that would suggest that the RBA could be worried about a future that isn’t being mentioned (feel free to disagree or chastise me for that one – i even hesitated as i wrote it…). Here are a few:

  • Global interest rates and currency – It can be argued that global interest rates are being set relative to the United States. This sounds a strange argument, as US official rates are nil to 0.25%. However, the US is printing so much money, while leaving rates so low that a lot of that money moves overseas, leading to boosts to economies in other countries. This results in strange moves like governments increasing taxes on foreign investors buying bonds. It results in increased investment into Australia’s commodity markets, resulting in our economy being strained and interest rates being lifted. At some stage all those US borrowings are going to have to be paid back, and interest rates will move to “normal” levels. When that happens, money could very well swing back to the $US, leaving our currency dry and the potential for an inflationary increase in imported goods costs.
  • Global interest rates and funding costs – The Big 4 banks are currently waging a campaign for the populace to accept the need for rate rises outside of RBA movements, owing to the cost of their obtaining funds on the global market. At the moment, that argument is a bit hollow – corporate borrowing costs are the lowest in years (reflected in the strange occurence of a European bank issuing a 100 year bond… ). However, if global rates were to rise then our banks will be forced to pay more for their funding and this will be the case regardless of what our RBA decides to do with short term rates.
  • Chinese exporting inflation – The latest 5-year Grand Plan from China suggests a move to accept higher wages domestically. This can be seen in the 20%+ wage rises granted by some large employers recently. As incomes rise and spare capacity is absorbed, the room for price decreases reduces (especially in the face of increased commodity input prices and increased labour costs through wage rises.. even if from a very low base). The recent and current price deflation of manufactured goods would most likely come to an end at this point. Our tiny Australian market will be competing in the global market with much larger players, and if capacity is restrained then there is little incentive to export to Australia. This may take a very long time to play out but it is hard not to see it as an inevitability.
  • Wage pressures. This is the point raised by the RBA, and the 1970’s record suggests that wage blowouts can have massive impacts on inflationary expectations. However, this is as much an immigration issue as anything else, and is to a large extent politically “fixable” – subject to the usual restraints of public sensibility to a larger intake  of immigrants.
  • Infrastructure – Some reports suggest that Australia will need to spend $600 billion to build, rebuild or maintain our infrastructure to cope with changing demographics. That is a lot of money – Australia’s total output is only ~$1,000 billion. With all the effort in superannuation, that pool of money is still only about ~$1,000 billion. Even if the assumptions are high, there is clearly a lot of money due to be spent in this area. Ports, roads, rail, water, power, gas, communications are predominantly government regulated. However, that won’t stop the need to increase end prices to users to help meet the funding costs. Add to that unknown climate change costs, potential decreases in available oil and gas supplies, extra costs for alternative energy sources and you have the potential for basic services to increase in cost dramatically.

Is this a negative picture of the future? No. It is an attempt to put into words some of the long term worries that policy makers need to keep in mind when setting monetary policy.

But you’ve still got to wonder why these things would suggest a need to increase interest rates right here, right now..? A small increase is highly unlikely to slow down investment into global scale mining ventures. If anything, a higher currency yield is likely to bring more money into the country to obtain exposure to commodity prices (again, feel free to argue the tenuous links being put forward here). Wages may increase in the future but at this stage the private sector wage rises have been lower than public sector wages – so again this is a politically “fixable” area. There have been statements made about offshore workers winning wage rises of $100,000 etc but that is only a very, very small pocket of the total employment picture.

So why is the RBA acting today for something that they don’t see playing out for quite a while yet?

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  2 comments for “RBA Rate Rise – “Just in case”

  1. NEVILLE WARD
    November 2, 2010 at 4:01 pm

    Hi Michael,

    Methinks there is/has developed in Aus a kind of 2 economies.

    One is running fast and high on the back of the Chinese development scene. ( Think Mining) Whilst the other relates and affects the non mining population. The latter experience rising costs whilst those of the mining economy experience boom conditions.

    Perhaps the Reserve is attempting to “steady” the non-boom economy.

    Cheers…NW

  2. November 3, 2010 at 11:49 am

    Hi Neville,
    Yes, there is general agreement that the RBA is trying to deal with the large amount of cash that will flow around the economy with our historic terms of trade. However, you can see the problem here – it’s not really the RBA’s job to do this… it’s the elected government’s role to put in place incentives and disincentives to provide a balanced economy and deal with any bubbles. Of course, the problem we have is that our governments run to either populist or self-interest group lines, with the result that the real issues in the economy aren’t tackled.

    One example we have seen is the ridiculous First Home Owners’ Grant, which simply inflated the price of existing homes, when the idea was supposed to be to increase the supply of housing. There clearly aren’t as many votes associated with new home builders compared to existing home owners.

    The current example is the terms of trade boom. The country’s budget is being balanced in an environment artificially high because of a commodity boom with a limited life span. When that boom stops and national incomes reduce, who’s going to want to accept a pay cut or reduced government services?

    The end result is a RBA Governor forced to act with the bluntest instrument available because the legislators aren’t up to the job.

    The problem with this is that the “token” 0.25% rise won’t stop even a fraction of mining activity but it will definitely hurt an awful lot of other people very much. Small businesses will feel it much more than you would think. It should be remembered that the mining and resource sector is large but still is not the largest part of the real economy. Hitting everyone equally in the way the RBA is acting actually strengthens the mining sector in a relative sense.

    The truly worrying aspect of this move by the RBA is that they may be just as worried about an inflationary future as i am. Taking this step when they don’t need to (keeping the lack of effective political action aside) suggests that some of the issues i raised in the article are possibly going to happen sooner rather than later.

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