Why Inflation is the RBA’s Friend

One thing you can’t help but notice when scanning the financial pages each day is the references to Donald Trump. The bloke is everywhere.

This may be the height of ignorance and stupidity, but if it has the word Trump in the headline, I won’t read the article. I don’t read much political commentary or news anyway, but especially when it comes to Trump, I find it’s all so much noise. And noise is what you want to cut down on when you’re trying to invest sensibly.

Apart from today — which is only for explanatory purposes — I have barely mentioned Trump.

And the point of mentioning him today is to tell you that markets and economies will do what they will, regardless of who is sitting in the White House.

The problem with focusing on Trump or reading about him is that it’s all too emotional. You either think he’s a saviour of the common people, or an utter imbecile.

Your view of him and his actions is tainted. Depending on that view, you might tend to attribute good or bad news to him, when in fact he’s just a bit player.

So do yourself a favour, ignore the Trumpster. More to the point, ignore all the stuff written about him. Most of the world’s media think he’s an imbecile, and cannot help that disdain coming out in their writing, no matter how hard they try to suppress it.

Is the fact that US stocks are at or near record highs because of Trump or in spite of him?

I would say neither. They just are. The main ‘culprit’ is that fact that low interest rates are finally starting to gain traction. The US economy is in reasonable shape, but not so reasonable that the Fed wants to raise rates too quickly.

It’s the best scenario for stocks; a decent economy AND lower for longer interest rates.

Can you say the same for Australia? Will interest rates be lower for longer here too, pushing stocks to new (if not all-time) highs?

It’s an interesting question. But judging from last week’s messaging from the RBA, I think it’s a yes.

Over the past few weeks I’ve been discussing the concept of the neutral, or natural rate of interest. This is the theoretical rate where monetary policy isn’t expansionary or contractionary.

It’s also a mythical rate. No one knows what it really is. You only know when you’ve gone too far…or not far enough.

Anyway, I was talking about this rate in relation to the US Federal Reserve, when last week the RBA brought it up in the minutes to their July board meeting. They guessed that the neutral rate in Australia was around 3.5%.

The market took this to mean that interest rates were way too low and were heading back towards the neutral rate. It put a rocket under the Aussie dollar. Last week it hit nearly 80 US cents.

Then came the news that full time employment continues to grow strongly. That may mean wages will finally start to grow again, giving another reason to start increasing interest rates sooner rather than later.

But all this talk of an imminent interest rate rise started to make RBA officials nervous. It was time to ‘jaw bone’ the market into line. As the Financial Review reported on Friday:

Financial markets and households shouldn’t “read into” the Reserve Bank of Australia’s internal debate over the nation’s so-called neutral interest rate or assume that near-term rate hikes are inevitable in the wake of tightening by offshore central banks, a top official said.

Guy Debelle, the Reserve Bank’s deputy governor, said the global economic environment and global monetary policy settings that have contributed significantly to Australia’s stimulatory rate settings “will likely continue to do so for the foreseeable future.”

There you go. Don’t expect an interest rate rise until the RBA is completely comfortable that the Aussie economy is on a more sustainable path.

The evidence is encouraging so far, thanks largely to a rebound in commodity prices from the lows of early 2016. This boosts national income, and along with interest rates at 1.5%, is highly stimulatory.

However, the fact that Australia’s growth remains tepid with such expansionary settings is a worry.

That comes back to our record high household debt levels. At the margin, households now carry such high levels of debt that more and more income goes toward debt repayments. It is restricting spending in other areas of the economy.

Because consumption represents around two-thirds of economic growth, this is a concern. And it’s a concern for the RBA in its attempt to try and ‘normalise’ interest rates.

When an economy carries a lot of debt, the ‘best’ thing for it is inflation. Inflation reduces the real value of the debt. If nominal wages rise, the fixed value of the debt falls.

That’s why consumer price inflation for the June quarter, due out on Wednesday, will be such an important number for the market. It will go a long way to giving you a better idea of when an interest rate rise is coming.

Having just thrown a dart at the dartboard with one side showing ‘near term rate hike’ and the other showing ‘no hike for ages’, the dart landed just on the latter side.

In other words, I’m guessing the RBA sits on its hands for a while longer yet. Thanks to such high debt levels, the RBA wants to see inflation emerge first, and then it won’t be overly concerned about stamping it out right away (despite what it says to the contrary).

In a heavily indebted economy, inflation is a central banker’s friend.

Regards,

Greg Canavan,
Editor, Money Morning


Greg Canavan is a Feature Editor at Money Morning and Head of Research at Port Phillip Publishing. He likes to promote a seemingly weird investment philosophy based on the old adage that ‘ignorance is bliss’. That is, investing in the Information Age means you have all the information you need at your fingertips. But how useful is this information? Much of it is noise and serves to confuse, rather than inform, investors. And, through the process of confirmation bias, you tend to read what you already agree with. As a result, you often only think you know that you know what is going on. But, the fact is, you really 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. As the name suggests, Greg sees opportunity in a crisis. To find the opportunities, he uses a process called the ‘Fusion Method’, which combines traditional valuation techniques with charting analysis. Read correctly, a chart contains all the information you need. It contains no opinions or emotion. 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 basic, costly 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 Money Morning 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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