British House of Lords inquiry into the Bank of England’s performance is a confusing array of contrary notions
On November 27, 2023, the Economic Affairs Committee of the British House of Lords completed…
The Tweets have started already demanding an interest rate rise in May at the next RBA Board meeting. Bankers, media commentators who just are conduits for the bankers – all with vested interests. Today’s data release from the Australian Bureau of Statistics – Consumer Price Index, Australia (April 27, 2022) – has fuelled their mania. Inflation in the March-quarter 2022 rose to 2.1 per cent (5.1 per cent for the 12 months) on the back of rising automotive fuel costs (uncompetitive cartel and deliberate government petrol tax policies), global supply chain disruptions (pandemic) and material shortages (supply chain and bushfires). As long as these influences are present, inflation will remain at elevated levels. But with wage pressures absent, it is hard to make a case that the rising inflation is now entrenched. Certainly, the long-term expectations measures would not suggest that. I cannot see why the RBA will hike rates in May. More evidence of wage pressures would be needed one suspects.
The summary Consumer Price Index results for the March-quarter 2022 are as follows:
The ABS Media Release notes that:
Continued shortages of building supplies and labour, heightened freight costs and ongoing strong demand contributed to price rises for newly built dwellings. Fewer grant payments made this quarter from the Federal Government’s HomeBuilder program and similar state-based housing construction programs also contributed to the rise …
The CPI’s automotive fuel series reached a record level for the third consecutive quarter, with fuel price rises seen across all three months of the March quarter.
The rise in tertiary education reflected the continuing impact of updated student contribution bands and fees, introduced last year.
Short assessment: The inflation is being driven by a relatively narrow set of circumstances related to the supply disruptions from the global pandemic and shortages of timber due to the massive bushfires in late 2019/early 2020 which burned down lots of forests and created a shortage in timber.
The OPEC cartel is pushing oil prices up.
And significantly, cost pressures from explicit government decisions (fewer grants, user pays in higher education, etc) have pushed prices up.
It is hard to see this as an entrenched episode independent of the pandemic supply issues and possibly the Ukraine War.
It is also hard to see how interest rate rises will reduce these pressures (see below).
Update: Here is a graphic image of the ships queuing outside the largest port in the world – Shanghai – as a result of the Covid lockdown there. This is a supply constraint and nothing to do with fiscal deficits, central bank bond purchases etc (thanks to Marine Traffic). The red dots are tankers and the green dots are cargo vessels.
The headline inflation rate increased by 2.1 per cent in the March-quarter 2022 and 5.1 per cent over the 12 months, up from the annual rate of 3.7 per cent recorded last quarter. But the rise is transitory (mostly an adjustment in fuel prices as transport resumes and building materials).
Many commentators are claiming there is an upward trend in inflation but once we take out these transitory factors, the trend at best is modest.
The following graph shows the quarterly inflation rate since the March-quarter 2005.
To put that into historical perspective, here is the series since the March-quarter 1970. We are nowhere near the inflationary pressures that followed the OPEC price rises in 1973.
The next graph shows the annual headline inflation rate since the first-quarter 2002. The black line is a simple regression trend line depicting the general tendency. The shaded area is the RBA’s so-called targetting range (but read below for an interpretation).
The trend inflation rate over this long period is downwards.
The following bar chart compares the contributions to the quarterly change in the CPI for the March-quarter 2022 (blue bars) compared to the December-quarter 2021 (green bars).
Note that Utilities is a sub-group of Housing.
This quarter it is petrol, housing and food driving the inflation.
None of these influences have much to do with the state of the economy – oil prices are cartel driven and the housing rises are due to shortages of inputs arising from supply disruptions and bushfires.
The ABS notes that food price rises – “reflecting high transport, fertiliser, packaging and ingredient costs, as well as COVID-related disruptions and herd restocking due to favourable weather.”
The next graph provides shows the contributions in points to the annual inflation rate by the various components.
The following graph shows four measures of expected inflation expectations produced by the RBA – Inflation Expectations – G3 – from the March-quarter 2005 to the March-quarter 2021.
The four measures are:
1. Market economists’ inflation expectations – 1-year ahead.
2. Market economists’ inflation expectations – 2-year ahead – so what they think inflation will be in 2 years time.
3. Break-even 10-year inflation rate – The average annual inflation rate implied by the difference between 10-year nominal bond yield and 10-year inflation indexed bond yield. This is a measure of the market sentiment to inflation risk.
4. Union officials’ inflation expectations – 2-year ahead.
Notwithstanding the systematic errors in the forecasts, the price expectations (as measured by these series) have risen over the last year, which is hardly surprising.
But they are hardly going ‘through the roof’.
The most reliable measure – the Break-even 10-year inflation rate – rose from 2.3 per cent (below the lower bound of the RBA targetting range) to 2.5 per cent (within the range).
This measure is a good indicator of long-term inflation expectations.
That supports the notion that this is not yet an endemic inflationary episode.
What does this all mean for monetary policy?
There is some modest rise in expected inflation but the most reliable long-term indicator is well within the RBA range.
The private banking economists that are continually wheeled out in the media to comment on prospective interest obviously talk up interest rate rises because their organisations benefit, which poses the question as to why they are used in this way and held out as independent authorities.
But, in my view (with no vested interests), the inflation trends provide no basis for any expectation that the RBA will hike interest rates in the coming month.
The RBA has consistently said they will not increase rates until wage pressures are pushing inflation up.
Wage pressures are not evident as yet (next data on May 18, 2022).
There are some obvious and predictable increases in cost pressures due to the economy trying to deal with the pandemic, which is being exacerbated by anti-competitive behaviour in world oil markets.
Some government policy changes have pushed the March-quarter inflation rate up.
None of that represents any major structural bias towards persistently higher inflation rates.
The RBA uses a range of measures to ascertain whether they believe there are persistent inflation threats.
Please read my blog post – Australian inflation trending down – lower oil prices and subdued economy – for a detailed discussion about the use of the headline rate of inflation and other analytical inflation measures.
The Consumer Price Index (CPI) is designed to reflect a broad basket of goods and services (the ‘regimen’) which are representative of the cost of living. You can learn more about the CPI regimen HERE.
The RBA’s formal inflation targeting rule aims to keep annual inflation rate (measured by the consumer price index) between 2 and 3 per cent over the medium term.
The RBA also does not rely on the ‘headline’ inflation rate. Instead, they use two measures of underlying inflation which attempt to net out the most volatile price movements.
To understand the difference between the headline rate and other non-volatile measures of inflation, you might like to read the March 2010 RBA Bulletin which contains an interesting article – Measures of Underlying Inflation. That article explains the different inflation measures the RBA considers and the logic behind them.
The concept of underlying inflation is an attempt to separate the trend (“the persistent component of inflation) from the short-term fluctuations in prices. The main source of short-term ‘noise’ comes from “fluctuations in commodity markets and agricultural conditions, policy changes, or seasonal or infrequent price resetting”.
The RBA uses several different measures of underlying inflation which are generally categorised as ‘exclusion-based measures’ and ‘trimmed-mean measures’.
So, you can exclude “a particular set of volatile items – namely fruit, vegetables and automotive fuel” to get a better picture of the “persistent inflation pressures in the economy”. The main weaknesses with this method is that there can be “large temporary movements in components of the CPI that are not excluded” and volatile components can still be trending up (as in energy prices) or down.
The alternative trimmed-mean measures are popular among central bankers.
The authors say:
The trimmed-mean rate of inflation is defined as the average rate of inflation after “trimming” away a certain percentage of the distribution of price changes at both ends of that distribution. These measures are calculated by ordering the seasonally adjusted price changes for all CPI components in any period from lowest to highest, trimming away those that lie at the two outer edges of the distribution of price changes for that period, and then calculating an average inflation rate from the remaining set of price changes.
So you get some measure of central tendency not by exclusion but by giving lower weighting to volatile elements. Two trimmed measures are used by the RBA: (a) “the 15 per cent trimmed mean (which trims away the 15 per cent of items with both the smallest and largest price changes)”; and (b) “the weighted median (which is the price change at the 50th percentile by weight of the distribution of price changes)”.
Please read my blog post – Australian inflation trending down – lower oil prices and subdued economy (January 29, 2015) – for a more detailed discussion.
So what has been happening with these different measures?
The following graph shows the three main inflation series published by the ABS since the March-quarter 2009 – the annual percentage change in the All items CPI (blue line); the annual changes in the weighted median (green line) and the trimmed mean (red line).
The RBAs inflation targetting band is 2 to 3 per cent (shaded area). The data is seasonally-adjusted.
The three measures are all currently below the RBA’s targetting range:
1. CPI measure of inflation rose by 5.1 per cent (up from 3.7 per cent last quarter).
2. The RBAs preferred measures – the Trimmed Mean was 3.7 per cent and the Weighted Median was 3.2 – moved outside the the RBAs targetting range for the first time since December 2009.
How to we assess these results?
1. The economy is starting to adjust to the hard supply constraints imposed by the pandemic.
2. Inflationary expectations are relatively contained, especially the most reliable indicator of long-term inflationary expectations.
3. The RBA has consistently said they will not increase rates until there is signs of wage pressures driving the show.
4. The RBA knows that with no wage pressures evidence, increasing interest rate rises will do nothing to grow forests more quickly to ease the timber shortage nor send a signal to OPEC to stop profit gouging. They also know that rate rises will do nothing to make ships deliver goods more quickly.
5. They know that if rising rates do anything they will worsen cost pressures on firms.
6. I don’t think they will hike rates in May.
The inflation rate in Australia is following world trends upwards, although it is still below the US levels.
The major sources of price increases are temporary – adjustments back to pre-pandemic levels, anti-competitive cartel behaviour and the War in Ukraine.
In Australia’s case, these influences are supplemented by shortages of building materials due to bushfires and soon the major floods (which will also impact on the food supply).
That is enough for today!
(c) Copyright 2022 William Mitchell. All Rights Reserved.