Three reasons why the RBA can't overlook signs of higher inflation

All too often, real estate slanted commentary on interest rate decisions follows a line something like: "With dwelling prices in 'X' doing 'Y', then interest rates should fall..."

Which would be all well and good if we had a dwelling price targeting central bank. But we don't. We have an inflation targeting central bank.

The most recent inflation print from the Australian Bureau of Statistics at last showed what some commentators have been fearing of flagging for a while: signs of higher inflation.

In particular, some experts believe that a lower Australian dollar will be reflected in higher prices at the fuel pump, which is clearly bad news for motorists; we might see a petrol price of well above $1.50 per litre through 2014, although that remains to be seen.

The headline consumer price index (CPI) print was 0.8% for the quarter and the 'core' inflation came in at 0.9% for the quarter and 2.6% over the past year.

The Reserve Bank's own chart pack has shown for some time shown a notable split on where the inflation is coming from (non-tradables being items which are not readily exported or important - such as medical services or housing). Note the 'imported' tradables deflation, largely brought about by the rapidly climbing exchange rate at the end of 2011 and in 2012.

While there will no doubt be some discussion about 'looking through' the inflation to allow the economy to grow, there are a few reasons why a subsequent strong inflation print could cause interest rates to be hiked.

The challenge as ever facing the Reserve Bank, is to keep inflation under control while allowing the economy to flourish. Who'd be a central banker?

1) RBA policy

The Reserve Bank has a policy of targeting inflation and keeping CPI to within 2-3% over the medium term as part of its approach to price stability. In fact, here is the RBA's monetary policy in full:

"The Reserve Bank is responsible for Australia's monetary policy. Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.

"In determining monetary policy, the Bank has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3%, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term."

So, in effect, the bank's hands are to some extent tied. If we want a Central Bank which overlooks inflation, then we need a new policy.

Interestingly, Australia's policy of a 2-3% target range of inflation reflects a higher target than our major trading partners. The US Federal Reserve has an inflation target of 2% and so does the Bank of England (not that the BoE has had much success in hitting its target in recent years!).

2) Credibility

I think the key point is credibility. It's all well and good a central bank attempting to imply that "we'll get tough on inflation next time around" but, like the boy who cried wolf, credibility can be quickly lost.

Therefore it is important that announcements are followed up with appropriate future policy. When credibility is lost, monetary policy may no longer have the desired effect and the system breaks down.

Moreover, where businesses don't believe policy announcements are credible, they tend to expect higher inflation and behave accordingly - wage-setting behaviour is adapted, wages tend to rise with inflation to follow, in all likelihood with little or no benefit from increased output.

Despite having 'missed' the inflation target band on occasions since 1993 as the chart below shows, the RBA notes that the inflation target is a medium term average of 2-3%. At times, CPI will inevitably run outside the target band, but broadly speaking markets seem to believe that the Reserve Bank is serious about its inflation target.

As a result of this the Reserve Bank retains some power in its 'jawboning' - comments made in interviews concerning bringing the level of the Australian dollar down, for example, can have an effect while markets believe in the credibility of the central bank and its board.

Of course, one of the challenges for a central bank is that in order to continue to meet a medium term average inflation target of 2-3%, the board needs to look "out of the windscreen" and "not out the window". Not a great analogy, but one that is frequently applied in this case.

3) Human nature

Perhaps a slightly less important point, but although we tend to think of central bankers as aloof, like you and I they are human, and by and large they probably do care about what people think of them.

On any board, it stands to reason that some members will hold more sway than others (particularly the Governor, one would assume), leading some to suggest that central bankers can gain reputations for being 'tough' or 'soft' on inflation (or 'hawkish'/'dovish' as it is sometimes labelled).

This is led some academics to spend (too) much time discussing whether there should be some kind of automated monetary policy system i.e. "If X happens to inflation, then interest rates should be Y". I'm not even sure this is a good idea in theory, but it's certainly a terrible idea in practice.

In reality, economies are complex and human experience must play a part in attributing importance to the various sectors of the economy and the way in which they will interact with one another.

Summary

Of course, housing markets, and particularly dwelling construction, will be one element considered by the Reserve Bank at its meetings in 2014. Further, the financial crisis has shown the central banks would be foolish to turn a blind eye to asset price bubbles in order to concentrate solely on an inflation target.

If you take a read of the Minutes of a Monetary Policy meeting, you will see that a broad range of issues are considered under the broad headings of 'International Economic Conditions', 'Domestic Economic Conditions' and 'Financial Markets'.

An inflation targeting Reserve Bank must consider the current and future trajectory of the inflation rate, and therefore if we have another strong core inflation print on April 23, one would have to assume that the top of the inflation target band would be in danger (the most recent prints are following an upwards trend) and therefore interest rate hikes may follow.

It will be interesting to see how 2014 pans out. Future markets seem torn, and on balance, suggest that perhaps a cash rate stuck at a generational low of 2.50% is the most likely outcome for some time to come yet.

Pete Wargent is the co-founder of AllenWargent property buyers (London, Sydney) and a best-selling author and blogger.

His new book 'Four Green Houses and a Red Hotel' is out now.