Economics Challenge (1 Viewer)

[gnrlies]

I have a simple question that is designed to be thought provoking....

Why is it that CPI inflation for the September quarter 2007 was only 1.9% (below the RBA's 2-3% inflation target), yet the RBA raised interest rates in November 2007, February 2008 and March 2008.

Wheras CPI inflation for the March quarter 2008 was 4.2% - the highest in 6.5 years - and economists are only predicting a 50/50 chance that interest rates will rise in May 2008. Surely if the RBA is serious about inflation targeting it would definately raise interest rates?

Secondly, if the economy was in recession but also had high inflation; would the RBA increase interest rates in order to subdue inflation?

 

[veloc1ty]

Increased interest rates are aimed at slowing domestic demand, and the CPI inflation rate doesn't fully reflect domestic demand because imports have been rising with consumption (adding to the CAD) making aggregate demand look like it's in a better position than it is. So CPI inflation figures alone don't show what's going on; domestic demand could have been high and rising throughout the last IR rises.

Now perhaps they are waiting to see the impact of the constant rises so they might hold off in the next meeting (and/or domestic demand may be slowing and the current CPI inflation is due to past inflation expectation/past IR rises).

For your second question, I would guess no, because they want people to spend more to help dig out of the recession.

(Shoot me down in flames if I'm wrong somewhere/everywhere).

 

[gnrlies]

Increased interest rates are aimed at slowing domestic demand, and the CPI inflation rate doesn't fully reflect domestic demand because imports have been rising with consumption (adding to the CAD) making aggregate demand look like it's in a better position than it is. So CPI inflation figures alone don't show what's going on; domestic demand could have been high and rising throughout the last IR rises.

Now perhaps they are waiting to see the impact of the constant rises so they might hold off in the next meeting (and/or domestic demand may be slowing and the current CPI inflation is due to past inflation expectation/past IR rises).

For your second question, I would guess no, because they want people to spend more to help dig out of the recession.

(Shoot me down in flames if I'm wrong somewhere/everywhere).

haha no shooting down in flames...

I will add some comments but I will refrain from completely answering the question...

I think you are on the right track but perhaps havent said it in the best way.... It is true that demand pull inflation (caused by excessive demand) is not the only cause of inflation (cost push, imported inflation etc are other causes). But I think you are going off on a tangent with the CAD and imports....

Which measurement of inflation is the RBA concerned about is perhaps a question worth considering...

As for the second question, it is worth considering the following question. Is inflation targeting a rule? How does Australia's system of inflation targeting compare to the system they use in the USA (which is similar to inflation targeting but not quite the same)?

 

[munchiecrunchie]

The CPI is the headline inflation rate, and also includes seasonal factors.

If you guys remember, in September 2007 the USA sub prime mortgage crisis kicked in, which may have slowed aggregate demand in the economy; investor confidence dropped. Despite this, it was a one off factor which is not an accurate reflection of the bigger picture of inflationary pressures.

The underlying inflation rate is a more accurate measure of inflation, and I'm guessing it was probably higher during that time.

Also, the RBA uses pre - emptive monetary policy, and their economic forecasts probably saw inflation to rise, and so they acted to prevent it.

As for March 2008 . . . the successive rate rises already implemented are aimed at slowing demand pull inflation. All the sources of the current inflation seem to be cost push inflation, ie food prices and petrol. Further pressure on demand will only hurt the economy. Further, the effect of the previous rate rises is just lagging. More time is needed to see the effects of these unveil. A better solution would be to increase competition, which would drive down the prices.

Correct me if I'm wrong, this is all off the top of my head . . .

 

[gnrlies]

The CPI is the headline inflation rate, and also includes seasonal factors.

Not so much seasonal factors, but more volatile items, or shocks

If you guys remember, in September 2007 the USA sub prime mortgage crisis kicked in, which may have slowed aggregate demand in the economy; investor confidence dropped. Despite this, it was a one off factor which is not an accurate reflection of the bigger picture of inflationary pressures.

The US subprime crisis had very little impact on the australian economy. There was a fall in consumer confidence, but it was most likely due to rising interest rates (in response to inflation). It has affected the banking sector because a lot of australian banks were using a lot of cheap credit from overseas. Since the sub prime crisis there has been a liquidity problem so many banks cannot access overseas funds so they have had to independently raise interest rates aside from the RBA. Other than this though, it didn't really impact on us

The underlying inflation rate is a more accurate measure of inflation, and I'm guessing it was probably higher during that time.

good guess. Headline inflation was low, but the underlying rate wasn't so favourable. In particular, there were a few volatile items that were falling in price (this needs to be the case in order to the headline rate to be lower than the underlying rate). Particularly oil was falling from previous highs, and our australian dollar had appreciated which made imports cheaper. This did reduce the headline rate, but many categories within the cpi did not decline.

Also, the RBA uses pre - emptive monetary policy, and their economic forecasts probably saw inflation to rise, and so they acted to prevent it.

This is a key point, and particularly relates to why the next cash rate decision is so up in the air. The RBA is setting interest rates in anticipation of a level of inflation in around a years time. This is because the transmission mechanism takes this long to work. A rise in interest rates will take some time to reduce AD.

Many economists call inflation targeting "inflation forecast targeting". in 2006 they had a few successive rises in the cash rate. Then they waited a while to see what the impact was. In 2007 when they saw that the underlying rate was still high they increased rates again (despite the headline rate being so low).

Right now the concern is that with a 4.2% inflation figure (they had expected 4% in which case they wouldnt have expected to increase rates again) inflationary expectations might get out of control. This figure is unlikely to be completely impacted by the previous rate rises so it would be unfair to rise rates simply because this figure is beyond the 3% mark.

As for March 2008 . . . the successive rate rises already implemented are aimed at slowing demand pull inflation. All the sources of the current inflation seem to be cost push inflation, ie food prices and petrol. Further pressure on demand will only hurt the economy. Further, the effect of the previous rate rises is just lagging. More time is needed to see the effects of these unveil. A better solution would be to increase competition, which would drive down the prices.

Correct me if I'm wrong, this is all off the top of my head . . .

The comment on competition is probably not important here. But I do agree with you on the nature of inflation. Cost push inflation is an important factor to consider. We cannot be expected to slow the economy down simply because oil prices are rising. this is not what inflation targeting was ever designed for. Obviously we cannot control oil prices with our cash rate. This is something that central banks need to think about (the relative effectiveness of a rate rise verses the costs to output - often talked about in reference to a maximised utility function or a taylor rule).

Personally I think the problem is in the measurement of inflation. The cpi shouldn't be used for our inflation target (note that the RBA uses the CPI - headline inflation, and not underlying inflation when looking at the 2-3% target). The only problem is that the whole premise of inflation targeting is to lower inflationary expectations. If you allow headline inflation to get out of control (even if underyling rates are satisfactory) you can sharply increase expectations.

So I am not advocating a shift to an underlying rate as our target, but I do think that you could argue that the existing system is not sufficiently flexible.

This is the arguement that the US Fed has with inflation targeting, and they have a system where they aim to reduce inflation but there is no institutional requirement for them to do so. Presumedly they will consider the output costs of targeting inflation more than we do (although that is not to say we do not care about output). Ben Bernanke is an advocate of inflation targeting so perhaps they will move closer to our model, but their economic environment since he has been fed chief has not tested him in this sense (he's been tested in many other ways)

 

[veloc1ty]

How is underlying inflation measured?

 

[gnrlies]

The best answer is that there is no one answer.

There is no single statistic that measures underlying inflation in absolute terms. The RBA will consider a number of measures that proport to indicate the underlying rate of inflation.

Here is a description from the RBA on some of the measures it uses:

G.1 Measures of Consumer Price Inflation
The data under the ‘Consumer price index’ heading are from ABS Cat No 6401.0. Percentage changes are calculated from the indices published in ABS Cat No 6401.0. The following definitions apply from the September quarter 2000.
The ‘Consumer price index – All groups’ measure is the total or ‘headline’ consumer price index. The measure ‘Excluding volatile items’ is the CPI (all groups) less fruit, vegetables and automotive fuel.
The ‘Market prices excluding volatile items – goods’ component (formerly titled ‘Private-sector goods’) is the CPI (all groups – goods component) less fruit, vegetables, automotive fuel, utilities and pharmaceuticals.
The ‘Market prices excluding volatile items – services’ component (formerly titled ‘Private-sector services’) is the CPI (all groups – services component) less property rates and charges, health services, other motoring charges, urban transport fares, postal, education and child care.
The ‘Total’ measure of ‘Market prices excluding volatile items’ (formerly titled ‘Private-sector prices’) is the CPI (all groups) less fruit, vegetables, utilities, property rates and charges, health services, pharmaceuticals, automotive fuel, other motoring charges, urban transport fares, postal, education and child care.
The ‘Private consumption chain price index’ is sourced from ABS Cat No 5206.0.
The ‘Weighted median’ and ‘Trimmed mean’ are calculated using the component level data of the consumer price index. Both measures exclude interest charges prior to the September quarter 1998 and are adjusted for the tax changes of 1999–2000. The ‘Trimmed mean’ is calculated by ordering all the CPI components by their price change in the quarter and taking the expenditure-weighted average of the middle 70 per cent of these price changes. The ‘Weighted median’ is the price change in the middle of this ordered distribution, taking also expenditure weights into account. Annual rates of ‘Weighted median’ and ‘Trimmed mean’ inflation are calculated based on compounded quarterly rates. For calculating the ‘Weighted median’ and ‘Trimmed mean’, where CPI components are identified as having a seasonal pattern, quarterly price changes are estimated on a seasonally adjusted basis. Seasonal adjustment factors are calculated as concurrent factors, that is using the history of price changes up to and including the current CPI release. There is a series break at September 2002 due to the ABS publishing the ‘Weighted median’ and ‘Trimmed mean’ on behalf of the RBA from that point forward, using data to a higher level of precision than is publicly available.
For further information on the various measures of underlying consumer price inflation, refer to ‘Box D: Underlying Inflation’, Statement on Monetary Policy, May 2002; ‘Box D: Measures of Underlying Inflation’, Statement on Monetary Policy, August 2005; and Roberts (2005), ‘Underlying Inflation: Concepts, Measurement and Performance’, Reserve Bank of Australia Research Discussion Paper No 2005-05.

 

[munchiecrunchie]

gnrlies your knowledge is admirable . . . are you doing an eco degree at uni?

 

[lionking1191]

The US subprime crisis had very little impact on the australian economy. There

The resultant depreciation in USD alone has extensive effects on aus economy, not to mention the effects on our CAD as a result of the interest rate differentials after the US Federal Reserve slashed rates to stimulate domestic consumption.

 

[gnrlies]

The resultant depreciation in USD alone has extensive effects on aus economy, not to mention the effects on our CAD as a result of the interest rate differentials after the US Federal Reserve slashed rates to stimulate domestic consumption.

Yes but neither of these occurances have had much impact on our economy. You are incorrect to say that the fall in the US currency has had an 'extensive' effect on our economy. This is simply untrue. As for interest rate differentials, this has only really impacted on us insofar as the effect it has had on the exchange rate (which again hasn't really affected us).

 

[mcs-one]

I have a simple question that is designed to be thought provoking....

Why is it that CPI inflation for the September quarter 2007 was only 1.9% (below the RBA's 2-3% inflation target), yet the RBA raised interest rates in November 2007, February 2008 and March 2008.

Wheras CPI inflation for the March quarter 2008 was 4.2% - the highest in 6.5 years - and economists are only predicting a 50/50 chance that interest rates will rise in May 2008. Surely if the RBA is serious about inflation targeting it would definately raise interest rates?

Secondly, if the economy was in recession but also had high inflation; would the RBA increase interest rates in order to subdue inflation?

have underlying inflation and also they consider the infaltion rate over the year or so. so it can go over for a while if it cancels out throught the year or wat ever time period.

 

[lionking1191]

Yes but neither of these occurances have had much impact on our economy. You are incorrect to say that the fall in the US currency has had an 'extensive' effect on our economy. This is simply untrue. As for interest rate differentials, this has only really impacted on us insofar as the effect it has had on the exchange rate (which again hasn't really affected us).

this was in the news:

US Interest Rates continue to fall, placing increased pressure on the RBA
30 April 2008
The US Federal Reserve has cut official interest rates to 2 per cent, their lowest level since 2004, and widening the interest differential between Australia and the US to 5.25 per cent. The US Federal Reserve has cut official interest rates seven times since September 2007, indicating the concern that the central bank has to avoid a US recession. The effects of the global credit crunch has meant that banks are finding it increasingly difficult to obtain funds, and are raising their own interest rates independently of the central bank (a similar thing is happening in Australia where banks are raising mortgage rates by more than the pace of increases in the official interest rate) – this has meant that the decrease in borrowing rates throughout the US economy have not fallen by as much as the change in the official rate suggests. The reduction in US rates places an increasing dilemma on Australia’s Reserve Bank. With new inflation statistics showing that inflation is well above the target band, it seems that the RBA may have to increase interest rates further to bring inflation under control. Yet the risk is that with further interest rate rises, the already-strong Australian dollar may appreciate further (due to increased speculation on the back of the widening interest rate differential), harming Australia’s export performance and encouraging import consumption.

 

[gnrlies]

this was in the news:

US Interest Rates continue to fall, placing increased pressure on the RBA
30 April 2008
The US Federal Reserve has cut official interest rates to 2 per cent, their lowest level since 2004, and widening the interest differential between Australia and the US to 5.25 per cent. The US Federal Reserve has cut official interest rates seven times since September 2007, indicating the concern that the central bank has to avoid a US recession. The effects of the global credit crunch has meant that banks are finding it increasingly difficult to obtain funds, and are raising their own interest rates independently of the central bank (a similar thing is happening in Australia where banks are raising mortgage rates by more than the pace of increases in the official interest rate) – this has meant that the decrease in borrowing rates throughout the US economy have not fallen by as much as the change in the official rate suggests. The reduction in US rates places an increasing dilemma on Australia’s Reserve Bank. With new inflation statistics showing that inflation is well above the target band, it seems that the RBA may have to increase interest rates further to bring inflation under control. Yet the risk is that with further interest rate rises, the already-strong Australian dollar may appreciate further (due to increased speculation on the back of the widening interest rate differential), harming Australia’s export performance and encouraging import consumption.

Yes I do not disagree with this (as you can see I have said all of this in my previous post) but it does not change the fundamentals. The subprime mortgage crisis hasn't really affected australia. The main way it has affected us (actually I was unfair not to include this) is its effect on the sharemarket due to uncertainty. But the subprime crisis was just the pin that burst what was an inflated market (rather than causing the magnitude of the fall). But with the fall in the sharemarket, consumer confidence has gone with it (again something I have already mentioned).

People tend to overstate these things. Australian banks were fairly free from bad credit, and international influence on the australian economy is not significant enough to cause us any real concern. Our export demand is driven by china and india and not the USA. The best way to guage its impact on the economy is by looking at whats happened to GDP. GDP has not dampened since the crisis. So I maintain my position.

 

[haiderr]

I have a simple question that is designed to be thought provoking....

Why is it that CPI inflation for the September quarter 2007 was only 1.9% (below the RBA's 2-3% inflation target), yet the RBA raised interest rates in November 2007, February 2008 and March 2008.

Wheras CPI inflation for the March quarter 2008 was 4.2% - the highest in 6.5 years - and economists are only predicting a 50/50 chance that interest rates will rise in May 2008. Surely if the RBA is serious about inflation targeting it would definately raise interest rates?

Secondly, if the economy was in recession but also had high inflation; would the RBA increase interest rates in order to subdue inflation?

I havnt read all the educated comments above, lol, but here's my say:

Underlying inflation for sept quarter 07 was 1.9%, whereas Inflation excluding volatile items was 2.5%. the rba raised rates then becoz it saw that inflation wud rise in the near future due to increased aggregate demand - increased level of economic activity, increased demands for our good overseas leading to australians havin more money to spend the already high interest rates attracting high levels of foreign investment, mining boom and the unexpected profits of companies etc etc... and they were right, as we all know inflation did rise since september 07.

as for march 08: the rba does not just look at the current rate of inflation n intervene in interest rates. Fiscal policy and microeconomic reform go hand in hand with monetary policy. and the rba saw that the govt has been doing a bit to try to slow down economic activity, and also as the governor of the rba glenn stevens said:

"In order to reduce inflation over time, growth in aggregate demand needs to be significantly slower than it was in 2007. Evidence is accumulating that this is occurring. Indicators of household spending have recorded subdued outcomes over recent months, and demand for credit by both households and businesses has weakened...(also there has been a substantial tightening in financial conditions)...considerable uncertainty remains about the outlook for demand and inflation. On balance, the Board’s current assessment is that demand growth will remain moderate this year. In the short term, inflation is likely to remain relatively high, but it should decline over time provided demand evolves as expected. Should demand not slow as expected or should expectations of high ongoing inflation begin to affect wage and price setting, that outlook would need to be reviewed."

so growth has slowed and will continue to slow, and in other words, rba believes inflation will be in control over the next 12-18 months. BUT it does not want inflation to fall from 4.2% to 2.2% in 3 or 4 months becoz that could hav drastic impacts on the economy. therefore, a raise in interest rates in march wud ve been unnecessary considering the circumstances in other parts of the ecomony. however, if things dont go as expected, the rba says it is willing to step in any time and raise interest rates.

in conlcusion, interest rates are not altered just on the basis of the current CPI inflation rate, other factors are taken into consideration, and the government uses instruments other than monetary policy to control inflation as well, and the rba wud need to take into account that a double force (both from MP and FP) could lead to a rapid decline in economic activity and mayb even a recession which is much harder to mend than a rise in inflation to 4% or 5%.


OMG i just wrote an essay! i wish i was in this mood during my exams, id do so much better !!!!! lol

 

[gnrlies]

I havnt read all the educated comments above, lol, but here's my say:

Underlying inflation for sept quarter 07 was 1.9%, whereas Inflation excluding volatile items was 2.5%. the rba raised rates then becoz it saw that inflation wud rise in the near future due to increased aggregate demand - increased level of economic activity, increased demands for our good overseas leading to australians havin more money to spend the already high interest rates attracting high levels of foreign investment, mining boom and the unexpected profits of companies etc etc... and they were right, as we all know inflation did rise since september 07.

as for march 08: the rba does not just look at the current rate of inflation n intervene in interest rates. Fiscal policy and microeconomic reform go hand in hand with monetary policy. and the rba saw that the govt has been doing a bit to try to slow down economic activity, and also as the governor of the rba glenn stevens said:

"In order to reduce inflation over time, growth in aggregate demand needs to be significantly slower than it was in 2007. Evidence is accumulating that this is occurring. Indicators of household spending have recorded subdued outcomes over recent months, and demand for credit by both households and businesses has weakened...(also there has been a substantial tightening in financial conditions)...considerable uncertainty remains about the outlook for demand and inflation. On balance, the Board’s current assessment is that demand growth will remain moderate this year. In the short term, inflation is likely to remain relatively high, but it should decline over time provided demand evolves as expected. Should demand not slow as expected or should expectations of high ongoing inflation begin to affect wage and price setting, that outlook would need to be reviewed."

so growth has slowed and will continue to slow, and in other words, rba believes inflation will be in control over the next 12-18 months. BUT it does not want inflation to fall from 4.2% to 2.2% in 3 or 4 months becoz that could hav drastic impacts on the economy. therefore, a raise in interest rates in march wud ve been unnecessary considering the circumstances in other parts of the ecomony. however, if things dont go as expected, the rba says it is willing to step in any time and raise interest rates.

in conlcusion, interest rates are not altered just on the basis of the current CPI inflation rate, other factors are taken into consideration, and the government uses instruments other than monetary policy to control inflation as well, and the rba wud need to take into account that a double force (both from MP and FP) could lead to a rapid decline in economic activity and mayb even a recession which is much harder to mend than a rise in inflation to 4% or 5%.


OMG i just wrote an essay! i wish i was in this mood during my exams, id do so much better !!!!! lol

This is pretty spot on...

I would probably downplay the role of fiscal policy, but yes the key point is future inflation projections and not current rates.

 

[boreddd]

why the h*** did you go into "Accouting/Banking/Finance" when you are so good at Eco???... did you get Band 6 in it???

so damn jealous!!!

 

[gnrlies]

why the h*** did you go into "Accouting/Banking/Finance" when you are so good at Eco???... did you get Band 6 in it???

so damn jealous!!!

Huh?

 

[haiderr]

Huh?

lol i guess they were juz praising ur ability in eco.

btw, wat r u doin now? wat did u do at uni?

 

[BackCountrySnow]

Secondly, if the economy was in recession but also had high inflation; would the RBA increase interest rates in order to subdue inflation?

I'll have shot at this Gnrlies.
Slow growth with high inflation means the economy is in a state of stagflation.
To my understanding Keynesians cannot explain this because they believe that there is a direct trade off between the two where you can only have one but not the other. So an increased interest rates would not help.

I guess you need to consider the monetarists to answer this question, from my understanding the monetrists believe in the suggested situation you would need to contract the money supply which means that less cash will be chasing the same amount of goods.

So all up...No? the rba would not increase interest rates..

 

[gnrlies]

I'll have shot at this Gnrlies.
Slow growth with high inflation means the economy is in a state of stagflation.
To my understanding Keynesians cannot explain this because they believe that there is a direct trade off between the two where you can only have one but not the other. So an increased interest rates would not help.

I guess you need to consider the monetarists to answer this question, from my understanding the monetrists believe in the suggested situation you would need to contract the money supply which means that less cash will be chasing the same amount of goods.

So all up...No? the rba would not increase interest rates..

Well no-one is a monetarist these days...

But, they never denied the existence of a short term trade off, just the existence of a long term trade off. Central banks no longer attempt to control the money supply they use the short term money market as their transmission mechanism so we would be stepping away from reality if we were to suggest that the money supply would be contracted.

Inflation targeting is usually run with an implicit taylor rule. Not that it is followed, or formally defined, but you would theoretically be able to prescribe a weigting to output and inflation in terms of central bank decision making. The point I was making with the initial question is just to highlight that central banks tend to talk tougher about inflation than their decisions reflect. For example if Glenn Stevens says in a speech that is is absolutely commited to inflation targeting this is to ensure that the market has faith in the actions of the RBA with respect to keeping inflation low. But the idea that the board doesn't consider the impacts on output flies in the face of facts as we have consistently had inflation over 3% for a little while now (suggesting they are weighing up the consequences of a particularly brutal form of contractionary monetary policy).