Manufacturing News

Inflation/interest rates to remain high: analyst

The days of low interest rates are over. Inflation is a long, not a short, game says economic forecaster and industry analyst, BIS Shrapnel, forecasts inflation will remain above three per cent for the rest of 2008, through 2009 and into 2010.

However, while the Reserve Bank of Australia’s (RBA) tightening of the cash rate should be sufficient to bring it back to three per cent by 2010, BIS Shrapnel believes the days of low interest rates are over and the RBA will continue to struggle to control inflation for the next decade.

BIS Shrapnel’s Long Term Forecasts, February 2008 Update states inflation will continue to be an issue and the RBA will be forced to increase interest rates rate to arrest growth.

“The RBA is on a mission to bring inflation back within its two-to-three per cent target range,” said BIS Shrapnel senior economist and chief forecaster, Richard Robinson.

“Aided by the world-wide credit squeeze, the RBA has been steadily tightening the noose on consumers in order to make room for an investment boom it can’t actually influence.

“Monetary policy is being employed in an environment of strong demand, capacity constraints and labour shortages,” said Robinson.

“The strength of employment and the boost from successive income tax cuts is making the Bank’s job harder, as these factors are helping to cushion household incomes.

Demand won’t fall away, but given the indebtedness of the household sector it is inevitable that we will see consumer spending slow.” T

he impact of RBA policies on the business sector has been slightly different. The mining and infrastructure booms are largely immune to interest rate rises, according to BIS Shrapnel.

Further, overall strong corporate profitability and comparatively low debt levels means the business sector is less sensitive than the household sector to moves in the official cash rate.

Despite this, Robinson warns business investment has been growing strongly for a number of years and this growth is not sustainable — there is not enough demand to maintain the momentum.

“The upshot is that the RBA will be successful in reigning in the economy in the short-term,” said Robinson.

“It won’t stop until it is. The moderation in investment and spending will in turn slow demand for labour and take pressure off wages.

“The problem is that it will only be a temporary measure because in the absence of a recession, we won’t see a blow-out in the unemployment rate — our modeling suggests it won’t reach six per cent in this cycle. Consequently, it won’t take long for labour markets to tighten-up once again.”

While business investment is nearing its peak, according to BIS Shrapnel, residential construction is waiting in the wings as the next driver of growth.

“The upswing in dwelling construction has been held-back by rising interest rates, but once the current tightening cycle peaks and slowing non-dwelling construction provides room for a come-back, we expect a long-overdue strong round of residential construction to start later this decade.”

Australia’s main inflationary concern remains the lack of slack in the labour market, which will be compounded by the ageing population.

“Investing in education is one way to alleviate the problem of skills shortages, but we have been slow to react to the shortfall and the benefits of current training initiatives won’t become apparent for some years,” said Robinson.

Measures to boost labour supply including increasing participation, encouraging people to delay retirement and immigration policies will also provide an extra buffer, as will measures to enhance labour productivity, according to BIS Shrapnel.

However, while ever the Australian economy is near full employment, the potential for a wage-cost push in inflation will remain a threat.

Robinson says wages growth has not been the trigger of inflationary pressures in the current tightening phase as labour market reforms and institutionalised setting of wages have dampened growth.

The low world inflation environment and the high Australian dollar have also been instrumental in keeping inflationary expectations anchored.

However, the ongoing tightness of the labour market means wages growth will remain within a four-to-five per cent band, which will make it harder for the RBA to keep inflation within its two-to-three per cent target band.

However, inflation has been pushed along by other factors. While globalisation has resulted in low prices for manufactured goods, BIS Shrapnel says the additional demand has pushed up the cost of energy and food. World supply has been responding and as extra capacity comes on-stream, prices will moderate.

“Food and fuel prices will not return to their previous levels because of the sustained high demand and instances of scarcity,” said Robinson.

“Further, dis-inflation from cheap Chinese goods will not provide the dampening impact in the next decade to the same extent as it has in the current decade.

“The Australian dollar will also come out of the stratosphere as commodity prices ease over the next few years. This will be good news for exporters, but we will lose a key ally in the fight against inflation.”

BIS Shrapnel forecasts slowing investment and consumer spending, and a boost to productivity from prior investment, will push the unemployment rate above five per cent through 2010.

But, as renewed residential construction activity drives momentum in the economy, and GDP growth strengthens again, the analyst expects the unemployment rate will drop back to current levels of close to four per cent by 2012.

“A low unemployment rate means that it wouldn’t take much of a pick-up in investment and employment for the economy to again exceed its speed limit,” said Robinson.

“The result is that we are likely to see shortened investment cycles accompanied by rising inflation and escalating interest rates.

“We are nearing the top of the current interest rate tightening cycle, but it is only a localised peak. The stubbornness of inflation, due to labour constraints, means that we are unlikely to see a return to a low interest rate environment in the absence of the recession.”

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