Fear grips the Reserve Bank

The bastids waited too long to raise.

http://www.news.com.au/story/0,23599,20021516-2,00.html

Fear grips the Reserve Bank

August 05, 2006 03:15am

THE Reserve Bank faces the gravest threat to inflation since the early 1990s, warning it may turn into a wage-price spiral that would need to be reined in with higher interest rates.
In what economists described as warning that the “inflation genie” may escape, the bank admitted the biggest risk to the economy was that inflation became entrenched as trade unions demanded bigger pay rises and businesses sought to recover rising costs by putting up prices.

The bank has not faced such a challenge since 1994 when the economy was just emerging from recession.

Its response at the time was to raise rates from 4.75 per cent to 7.5 per cent in the space of just four months, leading then Opposition leader John Howard to proclaim that the government had delivered “just five minutes of economic sunshine”.

On Wednesday, the Reserve Bank raised interest rates 25 basis point to 6per cent, the highest level since 2001, in an effort to contain a worrying spike in inflation.

Economists believe the bank could lift rates again before the end of the year, a scenario they warn could scupper the recovery in national house prices, particularly in the eastern states.

Major banks yesterday moved to lift their variable mortgage rates amid warnings that house prices will fall in every city if rates were to rise a third time this year.

Sydney would be worst hit, with prices falling up to 10 per cent, said Louis Christopher, general manager of Australian Property Monitors. Prices in Brisbane and Melbourne would fall up to 18 and 15 per cent respectively. “If there is a third rate rise this year, it’s going to be very nasty,” Mr Christopher said.

The fear among economists and the Reserve Bank is that rate rises do not contain inflation — which is already running above the bank’s 2-3 per cent comfort zone — as businesses put up prices to recover higher costs and workers demand higher wages as a result.

“The real concern about inflationary expectations is if it translates into higher wage claims and higher prices, that’s when you let the inflation genie out of the bottle with a wage-price spiral that feeds on itself,” ANZ treasury economist Warren Hogan said.

The bank said yesterday it would be watching the economy over the next few months to see whether its two interest rate rises this year were sufficient to contain the risk.

It says underlying inflation will rise to 3 per cent, which is right at the top of the band it is expected to defend, and stay there for the next two years.

However, this does not include extreme price movements, such as soaring petrol and banana costs, which would push the inflation rate up to 4 per cent.

The bank said the most important risk – one that would force it to raise rates further – was that people started building the higher 4 per cent figure into their expectations.

“There are upside risks associated with the domestic economy operating close to capacity,” the bank said. “Most importantly, the current high level of headline inflation may lead to some pick-up in inflation expectations.”

It said there was some sign this was happening already. It cited a survey showing trade union officials expect inflation to average 4.2 per cent this year and 4.1 per cent next year. Three months ago, they were counting on inflation of only about 3.3 per cent. A Melbourne Institute survey conducted in July also shows that consumers expect inflation this year to be 4.1 per cent.

The Reserve Bank said financial markets were pricing “inflation-proof” bonds on the basis that prices would rise at a rate of 3.5 per cent.

The Reserve Bank says wages are also rising faster than is generally believed. The official wage price index shows wages are rising at an annual rate of 4 per cent, up from 3.5 per cent a year ago.

However, staff shortages are leading companies to offer bonuses, rapid promotion and more attractive work arrangements to attract and keep staff. Including bonuses, wages rose by 1.2 per cent in the first three months of the year.

The bank said the risks to inflation were “evenly balanced”. The danger of rising inflationary expectations were offset by a possibility that the world economy may slow sharply.

It said that so far, business had been taking a lot of the pressure of higher costs on the chin, accepting lower profit margins rather than trying to pass costs on to consumers. Excluding the mining and finance industries, business profits have fallen in each of the last three quarters and are now below their long-term average level.

“It appears that businesses’ margins are being squeezed by rising material and labour costs,” it said.

However, business costs are continuing to rise. The Reserve Bank said business leaders had been warning of increasing costs of products derived from oil, such as plastics and packaging.

The Reserve Bank believes that excessive demand from both consumers and business is creating a temptation for companies to pass on costs.

Although Reserve Bank governor Ian Macfarlane said earlier this year that the Government could afford tax cuts, the bank’s review of the economy said the big-spending budget was adding to consumer demand.