Too early to go out hiking

QE can go but.

Today the ABS will finally put out the 2021 Q4 inflation numbers. In all likelihood they will be quite high, with Westpac estimating that prices will have risen by 1.1 per cent in the quarter to be up 3.1 per cent in the year.

A CPI print this large will inevitably lead to a round of calls for the RBA to quickly lift interest rates. But this would be a mistake.

Economists both inside and outside the bank have spent the past two decades publicly linking the path of interest rates to the rate of inflation. And for much of the time this is an important truth! High inflation often indicates high periods of aggregate demand which in turn requires higher nominal interests to stabilise the economy. 

3.1 per cent is above the RBA’s target band and the cash rate is currently at the low, low rate of 0 per cent. Why shouldn’t the RBA kick of a cycle of hikes at its February meeting?

A core problem

The first and most obvious reason is that inflation as measured by the headline consumer price index is a fairly noisy measure of price growth. The expected print for the trimmed-mean rate of inflation is only 2.4 per cent, well within the target band and in the lower half if you want to split hairs.

More fundamentally the current uptick in inflation around the world has been driven in large part by temporary, Covid19-driven shocks to supply chains. 

A supply-side shock that is expected to quickly resolve itself requires a much smaller increase in interest rates compared to one that may last for several quarters.

Why? While high inflation can be quite harmful to households and businesses, the real risk of an increasing inflation rate is not the direct effect from a single quarter of rising prices but the possibility that it metastasizes into higher inflation expectations more broadly. If households and businesses start to expect that wages and prices will be increasing at an accelerated pace then what might have started as a one-off burst of inflation might end up plaguing the economy with high inflation for years to come!

Fortunately there currently seems to be very little risk of this occurring.

Expected inflation remains well anchored, with the exception of fickle household surveys all of the RBA’s measures of expected inflation over the next couple of years remain well within the target band. Even in the US which has an inflation rate over 7% (!) expectations of inflation in the medium term are for it to rapidly decline back towards their inflation target of 2%.

Across the developed world there is widespread recognition that even as Omicron wrecks havoc on supply chains today this disruption won’t last forever. And when supply chains become unstuck inflation will come down in turn.

More importantly this uptick in inflation comes after 5 long years of inflation undershooting. The RBA’s mandate allows for a degree of divergence from the 2-3% range (though it is somewhat vague about how much divergence is permissible). Thus even if the inflation rate drifted north of 3% over the course of 2022 this would still be consistent with the mandate. Indeed there is some evidence that making up for the previous undershooting would be beneficial - allowing the price level to return to its previous expected trajectory.

That being said I think the RBA will ended their program of quantitative easing. The one consistent theme of the past year is that volatility is much than previously expected! Variants keep emerging, supply chains are more fragile, unemployment keeps falling, the list goes on. To match this higher volatility the RBA will prefer a much more nimbler set of policy tools than the QE programs which has been committed to several months in advance. The RBA won’t need to lift interest rates in February, but in this new uncertain world they will want the flexibility to do so at a moments notice.