Nov 05, AU Edition


It comes like a thief in the night and empties wallets of purchasing power. And it means debtors make off like bandits. What is it? Inflation – and with oil prices high, it’s making a comeback. Can Australians cope? What can you do? And what happens if interest rates and unemployment rise in concert with prices, as they did in 1970s America? SHAUN DAVIES and MATT JOHNSON report.

One hundred thousand dollars a year may sound like a lot, but for Melodie Darmody and her husband, Mick, it’s a struggle to make ends meet on that sort of combined income. They don’t lead a flash lifestyle, carry huge credit card balances for luxury purchases, drive expensive cars, or live in a ‘McMansion’ or what newspapers refer to euphemistically as a ‘leafy suburb’. Instead, they live near Campbelltown in Sydney’s sprawling western suburbs in a house they bought before the property market took off like a rocket, and their driveway is home to a 1983 Ford Fairlane and a 1997 Falcon Futura. Family holidays are spent with relatives in country New South Wales, and they haven’t been to the dentist ‘in years’. She’s a reporter at a community newspaper, he’s a teacher, and with bills to pay and two kids in childcare, they have precious little in their pockets at the end of a fortnight.
‘We do our budget fortnightly’, Melodie says, explaining their situation. ‘We pay $1000 on the home loan, $155 on the car loan and $600 on childcare. Groceries are only about $100 and the fuel bill at the moment is around $100. That’s really it. There’s not much to spare – when insurance and things like that pop up it’s a big stretch. We’ve got to save up for those costs for a few pays. We’ve got a payment now one now for the car insurance and we had one for house insurance a while back, and they’re about $600 each.’
Like millions of other Australians, the Darmodys lives are very price-sensitive. Which is why the prospect of inflation, spurred on by rising petrol prices – which make the costs of transporting raw materials to factories and finished goods to market that much more expensive – is so daunting. Already, the prices of some key staple items such as milk have gone up, with two of Australia’s biggest dairy concerns, Dairy Farmers Group and National Goods, hiking prices in September. And Reserve Bank Governor Glenn Stevens recently indicated that the biggest threat to Australia’s economy, which has over the past decade weathered American recessions and Asian meltdowns with aplomb, is inflation.
‘The issue before us in the next year or two is whether the world and Australian economies can adapt to higher energy and resource prices without a significant bout of inflation’, he said. Commonwealth Treasurer Peter Costello has echoed Stevens’ concern, and – even more worryingly for mortgage-holders like the Darmodys – indicated that increasing inflation could lead to higher interest rates as the government attempts to put on the brakes.
In short, it seems like a sure bet that prices are heading north, and every Australian will, quite literally, be forced to pay the price. As John Edwards, Chief Economist at HSBC says, ‘there’s no doubt that we’ve had a big hit [from fuel prices] recently’, and that there’s also ‘no doubt it’s going to turn up in higher prices for a wide range of goods’.

How bad? Bad.
In terms of how far the average families budget could be forced to stretch, it is crucial to note that oil prices are not yet at all-time highs. Worse price spikes have been seen – especially in the 1970s, when inflation was such a world-wide problem that it arguably brought down two U.S. presidents (Gerald ‘Whip Inflation Now’ Ford and later Jimmy Carter, whose opponent, Ronald Reagan, popularized the idea of the ‘misery index’, or the sum of the then-double digit unemployment, inflation, and interest rates). On 17 October 1973, in the wake of the Yom Kippur War, OPEC cut off supplies to Israel, the United States, and its allies. As a result, the price of oil surged by about 135% in the Christmas of 1973. After adjusting for inflation, the price of oil increased by almost 220% between 1973 and 1974.
As a result of this, Australian inflation rate began to accelerate. Higher prices at the pump led to higher prices for just about everything else, and inflation reached a peak of 17.6% per annum in March 1975.
In the 1970s, the Government of the day controlled the interest rate, and as increases were unpopular – as they are today – the Government was slow to act when oil started pushing prices skyward. The wrong decisions were made, and inflation got out of control. Today, the RBA would increase the interest rate as inflation pushed up prices, and thereby limit how far the inflation infection could spread.
Since 1990, the RBA has kept the rate of interest about 3.6% higher than the rate of inflation – so 17.6% inflation might have meant interest rates at 21.2% per annum. At that rate, repayments on the average Australian mortgage of $230,000 would rise to a little over $4125 each and every month for 20 years.
If such astronomical interest rates seem unlikely, they have precedent. After the second oil shock in 1979 – this time the result of the Iranian Revolution – US monetary policy was handed over the modern breed of central banker. As Chairman of America’s Federal Reserve Bank, Paul Volker (Alan Greenspan’s predecessor) oversaw an increase of 6.5% from the time of his appointment to April 1980. The US saw rates peak at around 17.6%, and brought the economy to the brink of recession. Rates were cut to prevent recession, however when it became clear that inflation had not been beaten rates were push up still farther, to a peak of 19.1% in June.
Speaking on oil prices and the consequences of Hurricane Katrina, research director at economic analysis firm 4Cast, Alan Ruskin, commented that ‘it would not be surprising if oil prices had now spiked by so much that they would not be absorbed by the profit margins of firms, but rather would be passed on to consumers in the form of higher prices’. He added that ‘it is fear of such an inflationary spiral that encourages central banks to increase rates, in the knowledge that the more they respond now, the lower the risk from inflation in the future’.
Future shock
So what is the risk to inflation rates, the Australian economy, and families like the Darmodys? The increase in milk and dairy prices appear to be the thin end of the wedge, with the increase in oil prices and associated costs flushing out the usual suspects.
On September 21 the ACTU called for a four per cent increase to worker’s minimum wages because ‘petrol prices and other rising costs (were) putting working families under pressure’. The Australian Chamber of Commerce and Industry (ACCI) immediately countered this suggestion, calling it ‘Whitlamesque economic mismanagement’.
‘The ACTU somehow seem to have forgotten that one of the most significant economic mistakes of the 1970s was to index wages to changes in prices in the context of the then-oil price shock’, ACCI chief executive Peter Hendy said at a conference in Sydney.
‘This is the type of thinking can kill an economy stone dead, end economic expansion and doom a society to inflation, recession and major job losses.’
Hendy has a point. It’s widely accepted by economists that the problems associated with the oil shocks of 1974 and 1979 were exacerbated when governments around the world gave into public pressure and accommodated unions’ (understandable) attempts to restore the value of the average pay packet. The majority of businesses were doing it just as tough as workers, and were forced to increase prices so they had something with which to fill those (now fatter) pay packages. This led to an inflationary spiral, where workers asked for more money to make up for the increased cost of living, and firms increased prices and laid off workers to make up for the increased cost of labour.
infart1.jpgIt is widely accepted that the Government erred in leaving rates too low for too long; and by failing to take steps to counter inflationary wage claims. Artificially propping up the wages of average workers ensured that demand for oil and other goods remained reasonably strong, despite skyrocketing prices – the tonic of higher prices was resisted and the market was prevented from correcting itself.
Another bout of such mismanagement would meet with resistance from the RBA. Interest rates would be increased until folks with loans were so broke that firms would not be able to sell much if they kept putting prices up. The threat of bankruptcy would force firms to refuse claims for an increase in wages that could only be funded by increasing prices.
Central banks have already been forced to re-assess their inflation outlooks in the light of Hurricane Katrina. Oil prices were rising before Hurricanes Katrina and Rita severely damaged oil production and refining capacity in the Gulf of Mexico. China’s (and to a lesser extent, India’s) voracious appetite for all kinds of commodities, and particularly energy, has driven the sustained increase in the price of a barrel of oil.
But while the demand the demand for oil is higher than it has ever been, the true bottleneck is in refining capacity. Oil needs to be turned into petrol or gasoline before it becomes useful to your average family in the western suburbs of Sydney. And right now, it’s easier to take extra oil out of the ground than it is to build the extra refining capacity required to transform that oil into something usable. As a result, refiners are able to charge a little more for their services, and the price of fuel has risen by still more than the price of oil. The consequence is that the threat to inflation from more expensive oil is greater than is suggested by the increase in oil prices alone.
Heading for a spiral?
The Reserve Bank of New Zealand was among the first central banks to sound the inflation alarm. It warned, in September’s Statement on Monetary Policy, that rates may have to rise as a result of increased fuel prices; it upgraded its inflation forecast to 4% by the end of June 2006 as a result (its upper limit is 3%, like the Reserve Bank of Australia). In anticipation of the RBNZ increasing the rate of interest, financial markets have responded by increasing the rate of interest of Kiwi debt by about 50 basis points (0.5%), suggesting that they expect the RBNZ to increase rate to 7.25% by Christmas.
Other central bankers have lately joined the chorus. The US Federal Reserve’s Richard Fisher said that the Fed is watching for inflation pass-through to prices, and the European Central Bank’s Bini Smaghi signalled that the ECB also has concerns about Oil, commenting that the Bank is ‘closely evaluating how the European economy is reacting to oil prices’.
The latest inflation data suggest that Australian interest rates may also be about to rise. TD Securities supplies the main monthly estimate of Australian inflation; their estimate of inflation for September suggests that inflation has broken above the RBA’s 3% upper target. Stephen Koukoulas, Chief Strategist at TD Securities, highlighted the advance of another inflationary spiral, telling Investigate, ‘it is important to note that the inflation acceleration is spreading beyond the direct and clear effects of higher petrol prices.’
‘Inflation is accelerating to worrisome levels and is above the top end of the RBA target range. With the economy also picking up and wages growth rising, the RBA will be increasingly keen to increase interest rates to guard against an even more dramatic inflation problem in 2006. An interest rate rise before year end is now on the cards.’As a result of this, TD Securities expect that the RBA will increase interest rates to 5.75% before Christmas.
The risk of inflation from higher oil prices has shifted sentiment back toward an increase in Australian interest rates. Over the past few months, the bias of professional opinion has shifted from a cut over the next six months, to expectations of an increase in interest rates.
loan6.jpgIn the Australian Financial Review’s most recent regular survey, only one economist said they expected rates to fall over the next six months, while eight expected rates to increase, while the remaining 18 expect rates to remain at 5.5%. If the horizon is extended to the end of June 2006, 10 favour an increase, and 16 see no change. More might be expected to tip an increase once data covering the period with the biggest increases in fuel costs are released.
Ray Attrill, research director in 4cast’s Sydney office, agrees that the pressure is on the RBA. He says that ‘the RBA will be under pressure to increase rates, as higher energy prices boost both inflation and growth’, adding that ‘the RBA should be comparatively free from concerns about choking growth, as Australia benefits from higher prices via exports and investment, as it is a net energy exporter’. As a result, 4cast predicts that ‘the RBA will increase rates to 5.75%, by March 2006’, and that there is a 40 per cent chance rates will increase further, to 6% by the end of June of next year.
UBS Senior Economist Scott Haslem is more pessimistic, and tells Investigate that ‘the re-emergence of inflation risks in the September and December quarters [will] lead to rate hikes [at the] end of 2005/early 2006’. He nominates 5.75% by Christmas, and 6% before the end of March – an increase that will see average mortgage rates hop from 6.8% to 7.3%.
A quarter-point increase in the rate of interest adds about $35 per week to the average $230,000, 20-year mortgage. An increase from 6.8% to 7.3% would therefore add about $70 per month to average mortgage repayments. But this is not where the pain of higher oil prices stops. Between June 2004 and June 2005, the average price of petrol was about $1.02. The average household spends about $35 per week, or about $153 per month on fuel, so unless people drive their cars less this year, petrol prices of $1.25 per litre will add about $35 per month to the average fuel bill – the equivalent of another quarter-point increase in the interest rate.
Though many see this worst-case scenario as unlikely, US investment banking behemoth Goldman Sachs recently released a research report that predicted that oil prices may rise as high as US$105 per barrel. They believe that ‘oil markets may have entered the early stages of … a “super spike” period’.
Oil at $105 per barrel would result in pump prices of about $2.02 per litre. Assuming that they don’t make major cutbacks to their driving, this will add about $150 per month to an average household’s fuel bill – the equivalent of more than a 1 percent mortgage rise. Central banks would increase interest rates, making mortgages more expensive. And companies would have to pass on increased costs to customers and workforces, which would surely be forced to absorb budget-cutting layoffs. In sum, it’s a recipe for the ‘misery index’, and something that would be devastating to families like the Darmodys.