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 Markets and Money

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From the Archives…

The US Federal Reserve: What a Humiliating Failure!
3-05-13 – Bill Bonner

The End of the Road
2-05-13 – Bill Bonner

Why Apple’s Advantage is Gone
1-05-13 – Dan Denning

The Kamikaze Rally That Could Drive Stocks Higher
30-04-13 – Dan Denning

Australian Deficit: Where Did the Money Go?
29-04-13 – Dan Denning


Greg Canavan is a Contributing Editor at Markets & Money and Head of Research at Port Phillip Publishing. He advocates a counter-intuitive investment philosophy based on the old adage that ‘ignorance is bliss’. Greg says that investing in the ‘Information Age’ means you now have all the information you need. But is it really useful? Much of it is noise, and serves to confuse rather than inform investors. And, through the process of confirmation bias, you tend to sift the information that you agree with. As a result, you reinforce your biases. This gives you the impression that you know what is going on. But really, you don’t know. No one does. The world is far too complex to understand. When you accept this, your newfound ignorance becomes a formidable investment weapon. That’s because you’re not a slave to your emotions and biases. Greg puts this philosophy into action as the Editor of Crisis & Opportunity. He sees opportunities in crises. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines charting analysis with more conventional valuation analysis. Charting is important because it contains no opinions or emotions. Combine that with traditional stock analysis, and you have a robust stock selection strategy. With Greg’s help, you can implement a long-term wealth-building strategy into your financial planning, be better prepared for the financial challenges ahead, and stop making the same mistakes that most private investors do every time they buy a stock. To find out more about Greg’s investing style and his financial worldview, take out a free subscription to Markets & Money here. And to discover more about Greg’s ‘ignorance is bliss’ investment strategy and the Fusion Method of investing, take out a 30-day trial to his value investing service Crisis & Opportunity here. Official websites and financial e-letters Greg writes for:

 


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