– Professor James Morley

Maintaining the policy interest rate at 4.75% appears to be more appropriate than raising or lowering the rates. However, there is currently an unusual amount of uncertainty about the most appropriate level for interest rates.

The Reserve Bank of Australia is due to hold its monthly board meeting today, amid conflicting economic indicators. Business and consumer confidence have dropped while inflation accelerated last quarter to the fastest annual pace in three years.

Because there are lags between the implementation of a monetary policy and its effects on real economic activity and inflation, policy should be forward looking and consider all possible scenarios for future economic conditions. The forecasts for these conditions are currently very mixed.

Last week the ABS showed that consumer prices gained 3.2 percent in the year, however a gauge of Australian manufacturing released today dropped to a two-year low in July.

I put the highest weight on maintaining the current rate, but also place more weight on an increase than a decrease in rates.

The near-term outlook for inflation is mixed. Headline inflation is running above the target range, but should be expected to fall back into range within the next year as the large increases in food prices due to the Queensland floods ease. Also, the large increase in world oil prices has eased somewhat in recent months. At the same time, the low unemployment rate suggests limited slack in labour markets and only a small downside risk for underlying inflation.

The near-term outlook for real economic activity is dominated by the strong growth of exports to fast-growing Asian economies and the concomitant investment boom in the mining sector. The high Australian dollar somewhat mitigates the overall upside risk of an export-led boom. Also, consumer sentiment and retail sales have shown some recent weakness, which can be expected to persist over the near term. There is also a small, but non-negligible risk that debt crises in the United States and Europe will have contagious effects for the entire world economy, including for Australia. A recent rise in unit labour costs of wages relative to productivity suggests some upside risks for the impact of real-economic activity on inflation.

James Morley is a Professor of Economics at the Australian School of Business, UNSW.
He is also a member of the newly-established Shadow RBA Board. Made up of senior Australian economists, the shadow RBA board pilot project runs from August until October with each round occurring on the Thursday before the decision by Reserve Bank of Australia board. Each Shadow Board member reports percentage weights on what he or she believes to be the most appropriate interest rate.