Australian Investors Should Accept Higher Inflation As A Medium Term Prospect

MELBOURNE AUSTRALIA (Daily Reckoning): Looking at the Friday to Friday performance of the All Ordinaries Index, one could be forgiven for thinking that not much had happened. All that there was to show for the week's action was a tiny seven point gain.

Between that though, the All Ords had put on a 1% gain first thing on Monday before falling by over 2% on Wednesday, only to see a similar sized gain on Thursday.

Even before the market opened on Thursday morning one could tell that it wasn't going to be a half-hearted rally. Investors were in, boots and all. Admittedly, much of the false jockeying for position faded as the open neared, but stocks such as BHP Billiton (ASX: BHP) and Rio Tinto (ASX: RIO) still opened at a healthy premium to the previous day's close.

Before the market opened it looked as though BHP could open at a 10% premium, and Rio at a 7% increase. By the time it all kicked off those overly bullish numbers were reduced somewhat to a 2% and 1% gain respectively with both stocks holding on to these positions throughout the day without gaining much more.

By the end of the day the whole market had picked up many of the pieces from the previous day's sell-off, with the All Ordinaries gaining by 1.8% and then closing out Friday with a slight fall to take the week's gain to just 0.1%.

As we intimated last week, much of the action was following market activity in the United States and the whole subprime mortgage debacle. By the end of the week the market had once again turned towards the outlook for the supply, demand and price of commodities.

Added into the mix was the interpretation of comments from Reserve Bank of Australia Assistant Governor Malcolm Edey. He told the Australia-Japan Economic Outlook conference in Sydney on Friday that Australian inflation is "more likely to be too high than too low."

The surprise is not so much that the RBA have indicated the potential for higher rates of inflation. The surprise is that it takes the RBA to indicate the potential for higher rates of inflation. The other surprise is the apparent unwillingness of investors to recognise higher inflation as a medium term prospect.

The Assistant Governor told the conference that inflation is "still higher than ideal. It implies that inflation is more likely to be too high than too low in the period we can foresee."

He went on to say, "some of the factors pushing up underlying inflation last year remain in place," clearly referring to high commodity prices, rising demand and an increase in wages. He continued, "the bank will be giving careful consideration to these developments, along with other incoming data, as it continues to review inflation prospects month by month."

Not forgetting that the last quarterly inflation figure had inflation running above the top end of its 2-3% target band. Whether the RBA likes it or not, commodity prices are still running at high levels, higher than where they were three years ago despite having fallen from the elevated levels of the middle of last year.

As we have mentioned countless times before, it is reasonable to expect that there will be a lag as rising commodity prices filter through the system. Crude oil remains tied around the USD$60 a barrel mark. Try hedging that exposure for the same price as four years ago, namely USD$30. It can't be done.

Other commodity prices such as copper and nickel have had similar, if not more impressive, appreciations in price.

Edey commented further by saying, "The economy has moved closer to full capacity, with recent indicators pointing to stronger conditions in the second half of the year." It looks like there is only one direction for inflation.

Kris Sayce
for The Daily Reckoning Australia

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