February, 2013

Australian Inflation: Behind The Headlines

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Australian Inflation: Behind The Headlines

Headline inflation in Australia is currently sitting comfortably within the Reserve Bank of Australia’s (RBA) target range of 2-3%. Which on the surface should be reassuring to investors and savers in the Australian economy.Australian Inflation - Behind The Headlines1

However if we separate the headline inflation number between domestic and imported inflation, it reveals that whilst imported inflation (tradeables) is  actually negative, domestic inflation (non-tradeables) is well above the RBA’s target range (see below). One part of this equation can be explained by the high value of the Australian dollar.

Australian Inflation - Behind The Headlines2

By making imports cheaper and causing the negative value in the tradeables component of inflation, the high AUD is helping to ease inflationary pressure in Australia. The below chart demonstrates how the AUD is currently at unusually high levels against the USD.

Australian Inflation - Behind The Headlines3

Whilst the high currency rate is working to make the price of imported goods cheaper, the price of domestic goods is increasing at a rate well outside the target RBA range.

Australian Inflation - Behind The Headlines4Here we see a steep rise in the consumer price index (CPI) for utilities (items such as electricity and water) rent, education and health services.  With both sides of Australian politics being very quick to grab headlines with comments about cost of living pressures, Australian families are in fact facing sharp increases in the daily cost of household items purchased domestically.

Whilst the headline rate is currently within the RBA’s desired 2-3% range this is only because the high domestic rate of inflation is being offset by the negative imported rate. With such a critical reliance on the high AUD to maintain low overall inflation it is worth exploring the drivers of the currently high exchange rate.

Why is the AUD so high?

So why is the Australian dollar so high?  Is it commodity prices, high interest rates or is the AUD now seen as a ‘safe haven’ currency?

The AUD has traditionally been viewed as a commodities based currency so the current “commodities boom”, and the resultant high prices Australian companies have been able to obtain for natural resource exports have driven up the value of the AUD. Since 2011 there has been a sharp decrease in the prices Australia is able to sell its commodities for. The value of the AUD historically correlates with commodity prices however the USD/AUD exchange appears to have decoupled from that relationship around that time.

Australian Inflation - Behind The Headlines5

Since the global financial crisis (GFC) the RBA has maintained relatively high official interest rates which has helped to bolster the AUD as international funds acquired AUD to access to those higher rates. More recently the RBA has dropped interest rates to record lows to boost the Australian economy. At the recent February RBA meeting governor Glen Stevens said “the current outlook for inflation would afford scope to ease policy further, should that be necessary to support demand”.  Australia therefore looks set to lose some of the capital inflow that has resulted from our comparably high interest rates. The below chart shows the convergence of the Australian 90 day bank bill swap rates with the rest of world.

Australian Inflation - Behind The Headlines6

Finally, since the triggers for the GFC since 2008, Australia has enjoyed a much higher economic growth rate than its OECD peers.  In addition, the Australian banking sector has continued profit growth, and expansion of capital bases, whilst at the same time appearing to have avoided write off issues that have plagued banking sectors in other parts of the world.  These factors, combined with relatively low levels of government debt, have all contributed to recently developing Australia’s reputation as a safe haven currency in the context of current global economic settings. Foreign capital inflows seeking this safe haven have therefore pushed up the value of the AUD.  These factors are now however beginning to turn in the wrong direction.  Australia’s economic growth rate is decreasing, trending towards to rates of OECD counterparts.  RBA Governor Glen Stevens announced on the 8th February that economic growth for Australia is expected to be 2.5% in 2013, this compares to the US Federal Reserve estimates of 2.3-3% GDP growth for the US.  In other announcements the RBA has decreased rates, and left scope open for further reductions.

With the commodities boom drawing to an end, interest rates on their way down and economic growth rates decreasing, the factors responsible for holding up the value of the Australian dollar look set to disappear over 2013.

Conclusion

Whilst headline inflation in Australian currently remains within the RBA’s target band of 2-3%, this is only a result of higher domestic inflation being offset by negative imported inflation caused by an unusually high AUD exchange rate.  The high exchange rate has in turn been caused by factors such as the commodities boom, high official interest rates and the development of a ‘safe haven’ mentality, however those factors are now turning in the opposite direction.

Any reduction in the AUD will drive up the cost of imported goods and therefore sharply increase headline inflation. Such a rise could be very damaging to the Australian economy, as growth rates remain low, and would certainly limit the RBA’s capacity to use interest rates to bolster the fragile domestic economy. Australian media, households and businesses are always very keen to focus on the arguments for cutting interest rates, however those parties would do well to focus on measures to control domestic price rises, including wage pressures, to give the RBA room to move in that direction.  In our view, there is very limited scope for further rate reductions whilst domestic inflation remains at such high levels.