Aussie Dollar and Today's inflation number

Aussie Dollar and Today's inflation number

The quarterly inflation statistics are one of the most important influences on Reserve Bank monetary policy.

In this post, I provide some background information on interpreting inflation statistics from a practical trader's point of view. I also discuss the possible implications of today's figure on the Aussie Dollar

Market Impact

Inflation figures can affect prices in all the asset classes. From a trader's point of view, short term interest rates and currencies are the 2 instruments normally used to take positions on inflation news.

Longer Term. Over the long term, high inflation weakens a currency. The "Purchasing Power Parity Theory" is often used to explain this.

Take 2 countries in which the cost of producing things is the same and the exchange rate between the 2 nations is 1.0. Assume after 10 years that the cost of producing and selling things in Country B remains unchanged but has risen by 50% in Country A. For example a standard car in country B can still be manufactured and sold for $20,000 but in country A the cost rises to $30,000.

This will cause the exchange rate to decline to .6677 so that the there is no difference between the cost of imported and locally manufactured goods in country A ( i.e. there is purchasing power parity). For example if people in country A import cars, they will pay $B20,000 dollars to the dealer in B. However, at an exchange rate of .6677 people in A will need to pay $30,000 of their own dollars to do this (the same as buying a locally manufactured car).

Shorter Term. If markets are confident that the Central Bank will keep inflation under control over the long term, the currency tends to ignore longer term inflation trends in day to day trading.

In fact the market reaction tends to be the opposite.

Strengthening inflation suggests central banks will increase interest rates and is bullish for the currency. This is because short term capital flows tend to have the greatest impact on day to day currency values. The prospect of rising interest rates causes investors to buy a currency in anticipation of higher earnings.

So from a trader's point of view, stronger than expected inflation numbers tend to push the Aussie Dollar higher while weaker numbers see it sold off. How much depends on whether the change is likely to large enough to change current RBA thinking on interest rates.

Inflation and the RBA

Australia's monetary policy is targeted at keeping the inflation rate at between 2 and 3%  on average over the economic cycle.  This average approach avoids having to take drastic measures to keep inflation in this band in the short term.

It can be difficult to fine tune inflation in a narrow band over the short term. The RBA is prepared to tolerate inflation below 2% at economic cycle lows when demand is weak. It tolerates inflation above 3% near cycle peaks.

From a trader's point of view it's also important to be aware that RBA is forward looking.  It is seeking to impact inflation over the next 12-18 months

Why Bother ?

I often hear people (particularly those with mortgages) ask why we bother trying to control inflation. Why not just keep interest rates down and allow inflation to go up?

There are several reasons why inflation can be costly and cause a lot of hardship. Perhaps the most important is that it causes us to make bad decisions about allocating our resources and capital. For example high inflation is very unfair to savers and people on retirement incomes. Interest earnings do not keep pace with inflation. There is an incentive to borrow money (because interest costs are below the rate of inflation) and to invest in asset bubbles (e.g rapidly rising house prices) rather than productive assets.

Low or negative inflation (deflation) has its own problems. In this case there is a disincentive to spend (things will be cheaper next month). This can feed into an already weak economy causing a destructive loop of weakening activity. It also disadvantages borrowers. The real cost of mortgage interest rates becomes higher.

Inflation measures 

No single way of measuring inflation is perfect. To combat this, the RBA looks at a number of diffent measures and seeks to come up with a representative figure across the board.

Consumer Price Index. Consumer price indices calculate the change in the cost of purchasing a representative basket of goods and services over a period to time.

The quantity of items in the basket seeks to represent what an average consumer buys.  Weightings and components of the basket are adjusted from time to time to reflect changes in consumer habits.

The table above shows the component headings for the Australian consumer price basket. It's always interesting to see that government charges e.g. health and education are consistently near the top of the pops when it comes to price increases.

Other inflation measures.  Markets also follow a number of other inflation measures designed to smooth things out and give a good view of the underlying inflation rate by removing some of the extreme values. Techniques for doing this include core inflation measures as well as the trimmed and weighted means. Core inflation measures remove traditionally volatile numbers such as food and energy from the CPI basket. The trimmed and weighted means are techniques to remove outlying values and concentrate on the central values in each table.

The current situation

The RBA'S May outlook forecast underlying inflation of 2.25% in 2012 and 2-3% in 2013.

Recent monetary decisions suggest that the RBA sees inflation remaining in its target range. Inflation is not preventing the RBA easing rates further if necessary to support a weakening economy or because of deteriorating international financial markets.

Source: RBA

The figures released this morning are for the June quarter. They showed increases of 0.5% for both CPI and the trimmed mean. The March quarter trimmed mean was also revised to 0.4%.

This means that the annual inflation rate over the past 6 months has been 1.2%pa on the CPI measure and 1.8%pa on the trimmed mean.

This paints a broad view of inflation at the lower end of the RBA's target zone or even a bit below .

So from a trader's point of view, today's figure was a bit weaker than expected but probably not by enough to change the status quo on RBA thinking.  The RBA has plenty of  scope to cut rates further if need be.

Something to keep an eye on for the future though would be further weakening of both world and Australian inflation rates over coming months. This would push the RBA to a position where it may need to cut rates to stop inflation getting too low.

Aussie Dollar

Today's figure has not so far pushed the Aussie below the blue trend channel support on the daily chart but there was nothing in the figure to prevent a break of this support if international risk off selling continues on the back of the situation in Spain.

Breach of the trend channel support sets up for a deeper correction perhaps back to the 50 or 61.8% retracement levels