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Thursday, 30 January 2014

3 reasons the Reserve Bank can't overlook the inflation genie

Inflation targeting

All too often, real estate-slanted commentary on interest rate decisions follows a line something like: "With dwelling prices in 'X' doing 'Y', then interest rates should fall..."

Which would be all well and good if we had a dwelling price targeting Central Bank. But we don't. We have an inflation-targeting Central Bank.

The most recent inflation print from the Australian Bureau of Statistics at last showed what some commentators have been fearing of flagging for a while: signs of higher inflation.

In particular, some experts believe that a lower Aussie dollar will be reflected in higher prices at the fuel pump, which is clearly bad news for motorists: we might see a petrol price of well above $1.50 per litre through 2014, although that remains to be seen.

The headline consumer price index (CPI) print was 0.8% for the quarter and the 'core' inflation came in at 0.9% for the quarter and 2.6% over the past year. 

The Reserve Bank's own chart pack has shown for some time shown a notable split on where the inflation is coming from (non-tradables being items which are not readily exported or important - such as medical services or housing). Note the 'imported' tradables deflation, largely brought about by the rapidly climbing exchange rate at the end of 2011 and in 2012.

Non-tradables and Tradables Inflation graph

While there will no doubt be some discussion about 'looking through' the inflation to allow the economy to grow, there are a few reasons why a subsequent strong inflation print could cause interest rates to be hiked.

The challenge as ever facing the Reserve Bank, is to keep inflation under control while allowing the economy to flourish. Who'd be a central banker?

1) RBA policy

The Reserve Bank has a policy of targeting inflation and keeping CPI to within 2-3% over the medium term as part of its approach to price stability. In fact, here is the RBA's monetary policy in full:

"The Reserve Bank is responsible for Australia's monetary policy. Monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’). The cash rate influences other interest rates in the economy, affecting the behaviour of borrowers and lenders, economic activity and ultimately the rate of inflation.
In determining monetary policy, the Bank has a duty to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term."
So, in effect, the bank's hands are to some extent tied. If we want a Central Bank which overlooks inflation, then we need a new policy. 

Interestingly, Australia's policy of a 2-3% target range of inflation reflects a higher target than our major trading partners. The US Federal Reserve has an inflation target of 2% and so does the Bank of England (not that the BoE has had much success in hitting its target in recent years!). 

2) Credibility

I think the key point is credibility. It's all well and good a Central Bank attempting to imply that "we'll get tough on inflation next time around" but, like the boy who cried wolf, credibility can be quickly lost.

Therefore it is important that announcements are followed up with appropriate future policy. When credibility is lost, monetary policy may no longer have the desired effect and the system breaks down.

Moreover, where businesses don't believe policy announcements are credible, they tend to expect higher inflation and behave accordingly - wage-setting behaviour is adapted, wages tend to rise with inflation to follow, in all likelihood with little or no benefit from increased output. 

Despite having 'missed' the inflation target band on occasions since 1993 as the chart below shows, the RBA notes that the inflation target is a medium term average of 2-3%. At times, CPI will inevitably run outside the target band, but broadly speaking markets seem to believe that the Reserve Bank is serious about its inflation target. 

As a result of this the Reserve Bank retains some power in its 'jawboning' - comments made in interviews concerning bringing the level of the Australian dollar down, for example, can have an effect while markets believe in the credibility of the Central Bank and its Board.

Of course, one of the challenges for a Central Bank is that in order to continue to meet a medium term average inflation target of 2-3%, the Board needs to look "out of the windscreen" and "not out the window". Not a great analogy, but one that is frequently applied in this case.

3) Human nature

Perhaps a slightly less important point, but although we tend to think of central bankers as aloof, like you and I they are human, and by and large they probably do care about what people think of them.

On any Board, it stands to reason that some members will hold more sway than others (particularly the Governor, one would assume), leading some to suggest that central bankers can gain reputations for being 'tough' or 'soft' on inflation (or 'hawkish'/'dovish' as it is sometimes labelled).

This is led some academics to spend (too) much time discussing whether there should be some kind of automated monetary policy system i.e. "If X happens to inflation, then interest rates should be Y". I'm not even sure this is a good idea in theory, but it's certainly a terrible idea in practice.

In reality, economies are complex and human experience must play a part in attributing importance to the various sectors of the economy and the way in which they will interact with one another.


Of course, housing markets, and particularly dwelling construction, will be one element considered by the Reserve Bank at its meetings in 2014. Further, the financial crisis has shown the Central Banks would be foolish to turn a blind eye to asset price bubbles in order to concentrate solely on an inflation target.

If you take a read of the Minutes of a Monetary Policy meeting, you will see that a broad range of issues are considered under the broad headings of International Economic Conditions, Domestic Economic Conditions and Financial Markets. 

An inflation targeting Reserve Bank must consider the current and future trajectory of the inflation rate, and therefore if we have another strong core inflation print on 23 April, one would have to assume that the top of the inflation target band would be in danger (the most recent prints are following an upwards trend) and therefore interest rate hikes may follow.

It will be interesting to see how 2014 pans out. Future markets seem torn, and on balance, suggest that perhaps a cash rate stuck at a generational low of 2.50% is the most likely outcome for some time to come yet.

Monday, 27 January 2014

Sydney's newest suburb emerges from the earth...

At the King Street Wharf end of Barangaroo, Lend Lease is busily constructing a high rise commercial tower block. 

At the far end (Harbour Bridge/Rocks end) landscaping is underway to recreate the same contours as were present at the time of the first fleet, before the site was flattened.

Until recent years the area had been used as a shipping terminal. 

The site will also include parkland, harbour front apartments (with hefty price tags) and, eventually  in 2019, a new $1.3 billion Crown Hotel complex tower and VIP-only gambling casino. 

This assumes that the final permits are granted by the Independent Liquor and gaming authority. 

James Packer has pledged to do everything he can to make the hotel the finest in the world. The proposed designs, it has to be said, look stunning. 

Saturday, 25 January 2014

A coming UK property hotspot - take note

From the London Daily Telegraph today:

"More diggers and cranes may be heading to Croydon, where plans for a £1bn project, led by a new Westfield shopping centre, has created a wave of interest. 

Over 2014 the developers will hope to receive outline planning permission, and can then go about buying up the land they need. 

Forward-thinking investors might want to take a punt soon, before buyers flock to the new hot spot and push up prices."

This is close, but not quite correct.

Forward-thinking investors have already bought property in Croydon, before the newspapers started telling everyone else to, because we are forward-thinkers... ;o)

Croydon is located in South London, 15km (9 miles) to the south of Charing Cross and fast train links have commuters to Victoria in 15 minutes or London Bridge in 13 minutes.

According to almost every forecasting house, it's going to be another corker of a year in London property, but not so much at the top end of the market which has recently shown some signs of cooling as foreign investment pulls back.

A capital gains tax will be introduced on foreign owners in 2015.

This will likely impact the ultra-premium sector of the market.

In the more reasonably priced stock, however, prices are heading north, particularly for those who buy in the right zones. 

"Savills agrees that 2014 will see a continued increase in prices, with Greater London catching up with prime central London. It expects the commutable area around the capital to increase by five and six per cent, with central London rising three per cent. "

Sunday Times: Pricey property locations and their cheaper alternatives

A recent piece from the UK's Sunday Times, this article which looks at some of the world's priciest property locations and where you might have to try instead if you can't afford them.

Here are some of the world's super-expensive real estate markets they mention and where you should consider trying as a next-best bet):

"Can’t afford the heady prices in Verbier? Slope off to Nendaz

If the price of Megève is too steep, go round the mountain to St Gervais

Priced out of Portofino? Wander on up to Camogli 

Forget Provence — look west to Gascony

Turn away from South Beach and move to downtown Miami 

Say au revoir to Paris’s Latin Quarter and hunker down in the 17th, 10th or 11th arrondissements

Leave Barcelona and head to the Maresme coast

If Naples is too hot, cool down in Sarasota 

Muscled out of Manhattan? Head to Queens"

And here's the full Sunday Times section on Australia:

"If you can’t stretch to Bondi Beach, move along to Sydney’s Inner West

"Ask anyone who has holidayed in, or moved to, Sydney lately, and they won’t mention the weather or the beaches first; they’ll tell you about property values and the stratospheric cost of living. This year alone, Sydney house prices have risen by 13%, according to RP Data, propelled by a mining investment boom and Asian buyers. Bondi Beach, a prized enclave near the financial centre, is for the super-rich only, with detached homes starting at Aus$2m (£1.16m).

So those who are at home in pin-stripes during the week and flip-flops at the weekend are setting up their barbies in Inner West suburbs such as Erskineville, Newtown and St Peters. Still close to the centre, and with plenty of bars and restaurants, they are popular with younger buyers. Pete Wargent, Director of AllenWargent, a buying advisory agency in the city, says entry-level terraces in these areas start at Aus$700,000, but that doesn’t mean it’s easy to buy into the next hotspot: properties are often sold at auction, adding to the tension among competing buyers."

In fact, the tension among competing buyers is even more so the case since I made the comment late last year, with prices in the inner west having really taken off. 

I note, however, that the Sunday Times is incorrect in its assertion that Sydneysiders wear flip-flops at the weekend. They wear thongs, lol.

Saturday, 11 January 2014

Broadway construction

Was just at the cinema this afternoon down at Broadway (Sydney). 

New tower blocks sprouting up all over the place in Sydney as part of the city's construction boom.

The construction index shows that residential construction is expanding, particularly in New South Wales it seems.

The movie I watched was Saving Mr. Banks (virtually half price voucher for Hoyts Cinema from Broadway - $10). Much better film than I was expecting!

Less happy news from the construction of the new suburb down at Barangaroo this week where there was an untimely death on site.