All eyes on third-quarter inflation numbers

The second-in-command at the RBA, Ric Battellino, has delivered a balanced and thoughtful speech in which he gives the bank's take on local and global economic developments. I would summarise my analysis of this speech as follows:

1. The RBA's base case is for the global economy – a crucial variable for setting Aussie monetary policy – to grow at a trend pace, with unusually high (but equally unknowable) downside risks at this juncture.

2. However, the RBA is not going to forecast these downside risks, because that's an impossible task. It will watch and wait for the world to confirm what is actually going to happen.

3. The central story around the Aussie economy remains intact in terms of the secular private investment boom. The floods combined with sundry offshore crises temporarily knocked the local economy off balance during the first half of 2011. Subject to the aforementioned global risks, the future should not be radically different to what the RBA previously expected, which, I suspect, means a forecast for gradually rising core inflation with the path determined by today’s third-quarter CPI combined with previous revisions.

4. The Aussie economy is, as I have argued here before, already getting the benefit of "notable" stimulation via reductions in fixed-rate loans to 6.3% or less, reductions in variable rate loans (by 10 to 15 basis points), and a depreciation in the currency from its USD1.10 highs.

5. As my CPI preview anticipated, everything really hinges on the third-quarter numbers and what this tells the RBA about the pulse of inflation. A very low number (similar to what New Zealand got yesterday, which is typically well-correlated with the Aussie results) would allow the RBA to pull down its inflation forecasts to 2013 to within the target 2% to 3% per aannum band, albeit on a still rising trajectory (perhaps it would keep a 3-handle in 2013).

6. To one school of thought, this would in turn enable the RBA to make a once-off technical adjustment to the cash rate to bring it back to "neutral" at the November board meeting. Complicating this decision is the fact that a lot of the recent data flow has been very healthy, and an inflation-targeting central bank would not ordinarily mind having a "mildly restrictive" rate setting given its longer-term view of the world (and the fact that rate changes today target prices over a two-year horizon). I would venture that any technical adjustment is going to be much more motivated by tactical and political considerations (mainly building up long-term goodwill for when the real inflation battle begins);

7. The argument against a technical adjustment is that it is not going to make a big difference to anything (ie, one 25bps move), it is not going to be passed on fully by the banks (thus we are probably only talking about 15-20bps), and the RBA may look very silly if Q4 core prints high, which is a risk, and it needs to start bumping rates back up again.

The bottom line is that as Battellino notes, monetary policy remains extremely complex, and he and RBA governor Glenn Stevens are earning every dollar of their way-below-major-bank-standard pay packets (i.e., for a top 15 major bank executive). To be clear, Battellino is not preparing the market for cuts in particular. He is seeking to give the RBA as much room to move as possible. Right now, flexibility is the name of the game. The RBA board members don't want to look like idiots irrespective of whether they have to cut, hold, or, heaven forbid, hike.

Christopher Joye is a leading financial economist. The above article is not investment advice.