Wednesday, July 3, 2013

One of the fears from the worrywarts in financial markets is that the recent dip in the Australian dollar will underscore a lift in inflation.

The Australian dollar has fallen by more than 12 per cent over the last two months and this morning is getting close to a fresh three-year low just under $US0.9150.

To be sure, the lower dollar means that import prices will rise for importers. That is simple. But the transmission mechanism of a change in the value of the Australian dollar to a change in consumer prices and therefore inflation is more complex than this.

The confusion from the inflation worriers is that the costs of doing business are only partly driven by the price a firm pays for the goods it buys and then re-sells. There are other elements, arguably more important than the currency, that will determine whether inflation edges up only a little or rises a lot.

Critical is demand, which is the appetite of consumers to keep buying things. If demand growth is subdued, consumers will simply not pay the extra amount that is driven by the currency fall and firms will be stuck with excessive inventory. This could see them having to discount their goods. The latest news on the pace of consumer demand suggests growth is running below trend, which means that for the consumer price index, the pass-through of higher import costs is likely to be more difficult to achieve as opposed to times when consumer demand growth is buoyant.

The effect of the Australian dollar fall on prices is also significantly diluted given that the cost of the imported item is only part of the selling price.

The retail price of imported items that you and I buy has a significant wage component and is influenced by transport and other domestic costs including things like rent. There is also the size of the profit margin which can be and often is quite variable for importers.

Indeed, when the Australian dollar rose from around $US0.60 to $US1.00 over the four years to the start of 2013, this massive 65 per cent plus appreciation showed up in only moderate falls in imported prices at the consumer level.


Quite simply, other costs were rising. Wages growth was hovering around 3.5 per cent per year and rents at the retail level were also moving higher. What also appears to have happened is that importers pocketed a significant proportion of what was a windfall gain and their profit margin widened. They simply did not pass through the bulk of the lower cost because consumers kept buying their product with the price stable or down marginally.

The very recent dip in the Australian dollar could well see a profit squeeze for importers rather than an inflation lift.

The Reserve Bank of Australia does not share the fears about inflation rising because the Australia dollar has fallen.

Reserve Bank Governor Glenn Stevens in his statement yesterday announcing an unchanged cash rate noted "inflation has been consistent with the medium-term target and is expected to remain so over the next one to two years, notwithstanding the effects of the recent depreciation of the exchange rate."

In other words, the Reserve is noting the inflation effect of a weaker currency but is also taking account of the current soft patch in demand, very subdued wages growth and strong competitive pressures when crunching its inflation forecasts.

The quarterly update of those forecasts will be finalised ahead of the August meeting of the Reserve Bank board and will be re-based on the June-quarter CPI which is released on July 24. If these forecasts lock in an expectation of inflation remaining within the target band and some of the other key economic indicators remain subdued, a rate cut will be delivered. The Reserve will publish its forecasts and the reasons behind them in its quarterly statement on monetary policy on August 9, where it will also have an opportunity to outline its actions on monetary policy and more fully articulate the macroeconomic effects of the lower dollar.

A point the Reserve Bank is likely to also make, which should allay the fears of the inflation worriers is the fact that the floating Australian dollar is now tracking closely with the commodity price and interest rate cycles, unlike the experience of a few months ago. In other words, the currency is doing what it is meant to and is acting as a shock absorber for the economy as if drifts down having previously drifted up. This is a good thing and not cause for worry.

Some import prices will of course rise as the dollar remains low or if it falls further, but because of the current business cycle, it is unlikely to show up in any general inflation pressures. The Reserve Bank is still on track to deliver a further interest rate cut, probably next month, simply because inflation is low and will remain within the target band.

Read more: http://www.businessspectator.com.au/article/2013/7/3/economy/dispelling-dollar-gloom-inflation-horizon#ixzz2XwXNunfQ

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