The Great Game of Interest Rates and Inflation


It's taken a while, but the RBA has joined the international currency war by cutting official interest rates to an all-time low. We're not sure whether it will have the desired effect or not. Chances are we'll need further interest rate cuts to really see the dollar fall to a point where it starts to relieve pressure on various dollar sensitive industries.

Reading through the Reserve Bank of Australia's statement, you get no indication a rate cut is coming until the second last paragraph. This is where it brings up the dollar for the first time, and expresses concern that it's stayed high for the past 18 months while commodity prices and interest rates have declined.

So it's clear that the RBA is lowering interest rates to weaken the dollar, straying into territory currently occupied by the big boys of international finance. It's a dangerous game and comes with all sorts of unintended consequences.

Perhaps China will accomplish what the RBA will struggle to achieve. That is, slow down to such an extent that it spooks our financiers and makes them demand more bang for THEIR buck. The result? A weaker dollar...but that's probably a story for later in the year.

Here's another issue for future consideration. Inflation. Official inflation in Australia is 2.5%. But domestically generated inflation is much higher. As you can see in the chart below, 'non-tradable' inflation is around 4%. On the other hand, 'tradable' inflation, resulting from goods and services that come in from offshore, is around minus 1%.

A strong dollar no doubt has much to do with keeping this 'tradable' inflation in negative territory. A much weaker dollar then would eventually push this inflation component above zero and beyond. And because of Australia's lack of productivity growth over the years, 'non-tradable', or domestic inflation will likely remain stubbornly high. Unless we have a recession...

The upshot of all this is that if the RBA succeeds in pushing the dollar down it will feed into a higher inflation rate, which will prevent further interest rate cuts...or, force interest rates higher.

But if China succeeds in pushing the dollar down, which might bring on a recession, you might see a negligible impact on overall inflation, even though the two different components would move in the opposite direction.

It's all guesswork, and the bottom line is that it doesn't really matter. Lower interest rates will not help the economy beyond a short term bump in activity. The sharp fall in official rates over the past few years certainly have not reignited credit growth, increased GDP growth or improved our standard of living. What's a few more cuts going to do?

It may prolong the property Ponzi scheme (again). It may prolong asset price inflation for a little longer, and it may ease the burden on indebted households for a little longer too. But as Christopher Joye writes in today's Financial Review:

'It is tempting to keep on debasing the price of money to stimulate near-term growth. But at some point the music has to stop. When it does, governments might find the ensuing costs were not worth it.'

Indeed they will. But by that time there will probably be another bunch of 'leaders' in office, blaming previous 'leaders' for the nations' current woes.

We'll make one more point about the interest rate issue before we move on. The banks immediately passed the cuts on. This just goes to show how well they are doing right now. Because of this, they don't want to raise the ire of any revenue hungry politician and give them a reason to start sniffing around in search of super profits. You gotta love the banks...they know how to play politics...

Regards, Greg Canavan for The Daily Reckoning Australia

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