The RBA's 'inconsistent' message on inflation has some of Australia's top economists baffled

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  • Australian inflation, no matter how you measure it, is very weak right now.
  • The RBA says a further improvement in the labour market will be required to return inflation to its mandated target range.
  • However, based on changes flagged to its economic forecasts, an improvement won’t be required to lift inflation to the bottom of its target range by the end of next year.
  • Underlying inflation has remained below target for over three years. The RBA has consistently pushed back the timing of when it expects it will return to target.
  • It now appears only an improvement in labour market conditions will prevent the RBA from cutting rates.

Australian inflation, no matter how you measure it, is very weak right now.

According to data released by the ABS last month, headline consumer price inflation (CPI) grew by just 1.3% in the year to March this year. Underlying inflation wasn’t much stronger, growing at 1.42% over the same period.

Even the RBA’s preferred underlying measure — trimmed mean inflation — only rose by 1.6% from a year earlier.

All are weak, all are below the RBA’s 2-3% medium term target and all decelerated further away from this level in the March quarter of this year.

Despite the news, the RBA held off cutting official interest rates this week, though it acknowledged that a further improvement in labour market conditions — lower unemployment — would likely be required if underlying inflation is to return to its mandated target range.

“There [is] still spare capacity in the economy,” RBA governor Philip Lowe said in the May monetary policy statement. “A further improvement in the labour market [is] likely to be needed for inflation to be consistent with the target.”

So in order to push inflation back to its target, unemployment, in the RBA’s opinion, will likely need to fall in the years ahead.

Ahead of the bank’s updated economic forecasts that will be release in the Quarterly Statement of Monetary Policy (SoMP) on Friday, the RBA flagged that underlying inflation will lift back to the bottom of its 2-3% target range by the end of next year.

“The central scenario is for underlying inflation to be 1.75% this year, 2% in 2020 and a little higher after that,” Lowe said.

However, curiously, the RBA doesn’t expect unemployment — currently sitting at 5% — to fall much, if at all, over the same period.

“The unemployment rate has been broadly steady at around 5% … and is expected to remain around this level over the next year or so before declining a little to 4.75% in 2021,” Lowe said.

So, on one hand, the RBA told us that lower unemployment will likely be required to lift inflation back to target. But, according to its economic forecasts, unemployment doesn’t need to fall to get inflation back to target.

Confused? Don’t worry, you’re not alone.

The seemingly contradictory statements have got some of Australia’s topped economists scratching their heads.

“Somewhat confusingly, the [RBA] reveals the May SoMP will forecast the unemployment rate unchanged at 5% through 2019 and 2020, before declining to 4.75% in 2021,” said Sally Auld, chief economist and head of fixed income and FX strategy at J.P. Morgan in Australia.

“At the same time, core inflation is expected to reach 2% in 2020, so the implication is that even stability in the unemployment rate is enough to lift core inflation.”

While Auld suggest this seemingly contradictory view may be reconciled when the RBA’s forecasts, including the technical parameters that underpin them, are revealed, she says that assessment that stable unemployment will be enough to lift underlying back to within target is at odds with the evidence seen over the past year where both unemployment and inflation fell.

“This runs contrary to the experience of the past year,” she said.

ANZ Bank’s Head of Australian Economics, David Plank, was another to point out the discrepancy between the bank’s commentary and forecasts.

“The anticipated rise in inflation to 2% comes despite no change in the unemployment rate ‘over the next year or so’ that seems to contradict the Board’s judgment ‘that a further improvement in the labour market was likely to be needed for inflation to be consistent with the target’,” he said.

“We’ll have to wait for the details in Friday’s Statement of Monetary Policy (SoMP) to see what generates this rise in core inflation.

“As things stand there seems to be an inconsistency between the inflation and labour market forecasts.”

While the confusion between the need for lower unemployment to boost inflation and the bank’s forecasts may or may not be resolved in the coming days, from a broader perspective, the RBA’s track record for consistently pushing back when it expects inflation will return to target risks further eroding it’s credibility to “keep consumer price inflation between 2–3%, on average, over time” as it’s current mandate requires.

“The problem for the RBA is that inflation has been undershooting its forecasts and the 2-3% inflation target for several years now,” said Shane Oliver, Chief Economist at AMP Capital.

“The longer this persists the more the RBA will lose credibility, seeing low inflation expectations become entrenched making it harder to get inflation back to target and leaving Australia vulnerable to deflation in the next economic downturn.”

Auld at J.P.Morgan also believes the RBA is now testing the limits of its inflation mandate.

“Despite [inflation being noticeably below what the RBA expected] and the fact that core inflation has run below the bottom of the target band since 2016, the board elected to keep the cash rate unchanged [in May],” she said.

“This is surprising to us and pushes the flexibility of the inflation mandate close to limits.

“As it stands, the RBA’s new forecasts for core inflation are implying average quarterly reads of 0.5% for the remainder of the year. This seems ambitious to us.”

The Australian economics team delivered an even more blunt assessment in the title of its post-RBA meeting note.

“Do they [the RBA] even target CPI?,” it questioned.

Seemingly, while the RBA discusses inflation a lot, it now appears to be far more interested in the labour market when it comes to the outlook for policy settings.

Philip Lowe indicated as much, acknowledging that the RBA board “will be paying close attention to developments in the labour market at its upcoming meetings”.

If that’s what it’s focusing on, it’s safe to say that’s what it’s future policy decisions will be based on too.

Given its commentary that a “further improvement in the labour market [is] likely to be needed for inflation to be consistent with the target”, it implies that any further weakening in leading labour market indicators, or lack of progress in lowering unemployment, will necessitate additional policy stimulus.

We’ll get plenty of data in over the next two months, including two jobs reports, Australia’s Q1 wage price index along with a scattering of leading labour market indicators, including that currently favoured by the RBA, and the one that just happens to be the strongest, ABS job vacancies for May.

Any signs of weakness should be enough to warrant easier policy, based on the RBA recent comments.

However, if that occurs and the RBA fails to respond, then questions will be understandably raised as to what exactly the bank is truly focused on.

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