FYI | Oct 25 2006
One person who’s walking around with a cheeky smile on his face today is BIS Shrapnel economist Frank Gelber. Regular readers of my weekly editorial may remember Gelber has been among the more hawkish economists in Australia over the past few years.
Until recently this meant there was quite a large gap between Gelber’s repeated calls for higher interest rates in Australia and the Reserve Bank board who kept their finger off the trigger since December 2005.
This year, however, both views have converged and it was most of the other economists’ turn to catch up with the new reality.
Until a few weeks ago, half of the country’s leading economists did not think interest rates would rise beyond 6% in Australia. Today a little less than half of them are pondering whether another hike will be needed in early 2007 to take interest rates to 6.50%, especially after today’s surprisingly high consumer price figure for the September quarter.
This makes the November hike a near fait accompli.
Frank Gelber’s “victory”, if I can use the word in this context, no doubt tastes double sweet as the surprise did not come from oil or property rents but from fruit, again vindicating Gelber’s view that future inflation would stem from tradeables instead of non-tradeables.
The key to understanding the current inflationary pressures in Australia, Gelber explained earlier this year, is to make a split between tradeables and non-tradeables. Both are exactly what you are now thinking of and each component more or less represents half of the country’s Consumer Price Index measure.
Tradeables are (mainly) goods that are freely traded and thus subject to foreign competition. Non-tradeables are mainly services and responsible for a CPI contribution of up to 4% nowadays. Luckily that was for a prolonged time offset by price falls on the side of the tradeables (Chinese production, cheaper imports because of a stronger Aussie dollar).
As the inflationary pressures from the side of the non-tradeables is unlikely to abate, the danger was always present that a little bit of inflation on the side of the tradeables would cause serious havoc on the inflation front. A critic could argue Dame Fortuna has been on Gelber’s side with hurricanes and drought pushing up prices for fruit, but I am certain Gelber would respond this is merely a side-issue. Inflation is not about bananas!
It is his assessment that more than anything else it has been the strong Aussie currency that has kept inflation in check over the past few years. If the general anticipation is correct that prices for metals and other commodities will be trending lower from now on, and that the Australian currency will therefore weaken as well over the next two years or so, this should logically lead to the conclusion that the currency will no longer play an inflationary mitigating role.
And we haven’t even talked about the real problems in Australia yet.
To understand where the Australian economy is today we must go back to the last recession of the early nineties, says Gelber. Nobody likes recessions, but the fact of the matter is they do take care of matters in a very efficient way. Australia experienced what Gelber describes as a “substantial investment boom” throughout the eighties. The result was the country was building up excess capacity and employing all its labour. All that came crashing down with the recession.
After that, both capacity and labour were very cheap (both had become abundant). The effects have lasted for the past sixteen years. During that period Australia has effectively experienced an “unconstrained economy”. Happy days. But everyone can see that as the economy grows year after year after year that this story cannot last forever.
Enter capacity constraints and shortages of skilled and experienced labour. The results are twofold: a strong investment cycle led by resources companies to alleviate capacity constraints and… inflationary pressures because skilled labour is now scarce while productivity growth is running low (when things are going well companies don’t really see the need to invest in labour saving techniques).
So are interest rates going up further from here? Oh yes, Gelber predicted a few months ago already. The main question is at what stage are interest rates high enough to crush the demand for additional labour? (The only way to alleviate the labour problem is by slowing economic growth is his argument and many economists would agree).
Gelber predicted earlier this year it would probably require an extra 50 basis points or, in other words, an official cash rate of 6.50%. This brings him now at par with the likes of Westpac economist Anthony Thompson who stated today: “[because of] the apparent continuing strong labour market, we have to give a very solid probability to the risk of a February hike”.
This, in a nutshell, is inflation 101 in Australia today.
It goes without saying the above scenario will have implications for consumer discretionary spending and the recovery in the housing sector.
Economists at Macquarie pointed out today that if Australian interest rates move up again in November, 2006, this would represent “the most aggressive period of tightening during the current [RBA] extended tightening campaign”.
On Macquarie’s calculations, if interest rates rise by 75 basis points, disposable income growth is cut by one full percentage point (1%).
This is important because household disposable income rose by 6.2% over the year to June. Another rate raise will thus shave off around 1ppt from this while the surge in prices of nondiscretionary items (such as food, education and petrol) suggests the basic cost of living in Australia has risen by close to 6%, says Macquarie.
In other words, many Australian households with a mortgage are likely to end up worse off than they were a year ago. Not so happy days.
Does this mean the Australian economy will come crashing down as happened in New Zealand?
No, says Gelber (and almost every other economist in the country). That’s because most investment projects, especially those in the minerals sector, are pretty much locked in for the next two years. That’ll support economic growth while households and housing will be licking their wounds.
Don’t forget that 2007 is an election year and given past experiences Howard and Costello are likely to grab into the government household jar again.
So this is it then, no room for alternative scenarios anymore?
An often used expression of wisdom by trading guru Dennis Gartman is that the fastest horse does not always win the race, but if one has to take a bet upfront surely that is the most logical choice to make.
Till next week!
Your happy I don’t have a mortgage myself editor,
Rudi Filapek-Vandyck
(As always supported by the Fabulous Terry, Chris and Greg)
