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RBA speech signals likely tolerance of weak growth

RBA Governor's speech signals likely tolerance of weaker growth to cap inflation

RBA Governor Glenn Stevens last night delivered a speech to the Faculty of Economics and Business at the University of Sydney. The speech was entitled The Australian Economy: Then and Now and compared Australia's current economic circumstances with the difficult times in the 1970s, when GDP growth was volatile and inflation persistently high. The Governor later answered questions from an audience of university alumni. The main message from the speech is that the RBA is on hold but, with inflation already well above target, the emergence of sustained evidence that domestic demand is not slowing in line with expectations could trigger another rate hike. Rate cuts any time soon are out of the question.

Indeed, the fact that the Governor chose to compare Australia's current experience to the 1970s is instructive. The Governor referred to the corrosive impact of persistently high inflation in the 1970s and the very high price that had to be paid after policy makers had helped to facilitate high inflation becoming entrenched in corporate pricing decisions and wage negotiations. Clearly, one interpretation is that the RBA does not want a repeat of this painful experience. Inflation currently is running above 4% - more than a full percentage point above the upper band of the 2-3% target range - and RBA officials will remain vigilant to ensure that, this time, inflation expectations remain anchored. For example, while the Governor acknowledged there is little he can do to suppress crude oil prices, he can act to contain second, third, fourth and fifth-round domestic price effects.

There has in recent weeks been a debate over the appropriateness of the RBA's inflation target - even former RBA Governor Bernie Fraser is quoted as saying the target should be higher. Governor Stevens indicated last night that while inflation targeting is imperfect, it is the best system available. He stressed that the inflation target is applied over the medium term and allows room for policy tolerance in regard to inflation, growth and employment. The message here is that the RBA probably can tolerate weaker growth in the near term in order to bring inflation back to target.

The Governor also compared the surge in the terms of trade in the 1970s to the current experience. The bounce in the terms of trade in the 1970s quickly reversed once supply disruptions were cleared. This time, the terms of trade boost is likely to be more sustained - we forecast a 28% rise in the terms of trade this year; the RBA forecasts a 20% rise - partly due to the persistently strong demand for Australian resources from China and India. In fact, the Governor referred to China's surge in demand for commodities as a "once in a century" economic event - the terms of trade boost in the 1970s was supply driven - the current boom is demand driven. The boost to national income from the terms of trade - about 2% per year since 2002 - will place a floor under growth in the slowing economy.

The Governor acknowledged that growth in Australia's economy is slowing (this is abundantly clear from the latest round of economic data), a fact seized upon by financial market participants yearning for signals that the RBA is getting closer to lowering the cash rate. Our view, however, is that a late-cycle rate hike is more likely. While growth in the economy is likely to slow even further in coming months, notwithstanding a likely surge in sales of luxury cars before the July 1 tax hike, the generous personal income tax cuts granted in this week's federal Budget probably will trigger a modest recovery in household spending over the second half of 2008. Similarly, the persistently high terms of trade will further stimulate investment and employment in resources and related sectors.

Also, inflation is unlikely to return to the RBA's target range any time soon. The RBA's forecasts in last week's quarterly statement show inflation staying above target until mid 2010 - our forecasts show a similar profile. With food and energy prices soaring, and the Budget triggering short term price rises for highly-priced cars and private health insurance, the near term risks to inflation are skewed to the upside. Another unexpectedly large CPI print in either late July or late October, therefore, could be sufficient to trigger another rate hike, particularly if domestic demand has not slowed as much as RBA officials expect.


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