Tough choice

A slew of material out yesterday and today has bearing on the medium term outlook for interest rates. First, Reuters reported uncomfortable news on inflation:

A private gauge of Australian consumer prices showed annual inflation ran above target in December, with price pressures likely to grow as the Queensland floods push up food costs.

The TD Securities-Melbourne Institute measure of consumer price inflation rose 0.2 per cent in December, compared to November when it rose 0.4 per cent.

The index was 3.8 per cent higher than in December 2009, above Reserve Bank of Australia's (RBA) long-term target range of two to three per cent.

The TD-MI gauge has tended to grow faster than the official measure of the consumer price index (CPI), which ran at an annual 2.8 per cent in the third quarter.

Official numbers for the fourth quarter are due on January 25.

TD head of Asia Pacific research Annette Beacher estimated the CPI would rise 0.8 per cent in the quarter, nudging the annual pace up to 3.1 per cent.

"Our monthly gauge confirms that uncomfortable inflation pressures emerged in the final months of 2010," Ms Beacher said.

Contributing most to the overall change in December were price rises for fuel, fruit and vegetables, and holiday travel and accommodation.

Those were partly offset by falls in prices for audio, visual and computing, sport and other recreation, and books, newspapers and magazines.

... Damage caused by the floods in Queensland would likely see some food prices climb this quarter, while a massive rebuilding effort in coming months could put upward pressure on wages and inflation over time Ms Beacher said ... "with vast tracts of the Brisbane CBD severely affected by the floods, the concentration of infrastructure to be repaired could exacerbate already stretched labour and building materials, hence the upside to inflation could last longer than the temporary food price spike."

No doubt RBA governor, Glenn Stevens, will 'look through' the food price spikes at the February meeting. But the danger of a medium term labour price spiral will be of concern.

That danger is going to quickly worsen because the government today acknowledged that the:

"...commitment to return the federal budget to surplus in 2012-13 is coming under more pressure as the likely damage bill from the most devastating series of floods in Australia's recorded history continues to mount.

With the still unfolding crisis in Victoria adding to a colossal damage bill in Queensland, Ms Gillard and Treasurer Wayne Swan yesterday conceded that the budget would be stretched by flood recovery and rebuilding costs for years.

Pointedly, when discussing the financial implications of the floods, Ms Gillard did not repeat assurances earlier this month that the promised schedule for a return to budget surplus would be unchanged.

''We will be managing the federal budget so that we can meet the needs of recovery and rebuilding,'' Ms Gillard said. ''I know that there is going to be a lot of effort, money and resources needed to rebuild, particularly rebuild Queensland.''

Mr Swan said the government would be up for a ''very substantial amount … It will involve billions of dollars of Commonwealth money and also state government money and there's going to be impacts on local governments as well.''

This blog isn't arguing against spending this money. What's the point of saving if not for a rainy day?

However, as the coverage on this blog has recently illustrated, the world is quickly swinging from a GFC-deflation toward a recovery led by commodity price inflation. This blog also noted last Friday that Australia's commodity majors are moving to capitalise on this by pushing short term contacts for iron ore (and coal). When they succeed the national economy will face an explosion of cash in the first half of the year.

Late last year, Glen Stevens, observed that Australian monetary authorities are vulnerable to the charge that they haven't raised interest rates early enough in past business cycles. In a November senate testimony the Gov said:

I cannot think of very many cases in history where we looked back and thought, ‘Yep, we tightened too soon.’ I can think of several times where we looked back and thought we should have tightened a bit earlier. I think that if we are doing it right the decisions will be finely balanced most of the time—that is where we should be—and we will probably move a little bit earlier than the moment when it is clear that you have to. That is if we are doing it well. There is some risk that you do things you do not need to do—I agree with that. We have to balance that risk, obviously, against the risk of getting behind the game. Historically, for many central banks, including us, that has tended to be the mistake that we made.

So, in the new normal course of events, we would expect to see rate rises flowing through as soon as the new commodity contracts see ore and coal prices soaring.

Sadly, however, there's a complicating factor: The effect of the floods on asset prices. The SMH also reported yesterday that:

House prices in Queensland may sink as the financial effects of state's devastating floods strain household budgets and dent banks’ willingness to lend, a ratings agency has warned.

Credit ratings agency Fitch said today that while the full impact of the Queensland floods is impossible to gauge at this point, they are expected to have a negative impact on house prices, borrowers and banks.

Property damage may “temporarily or permanently affect” borrowers' ability to pay and could cause “lower than normal recovery rates for damaged properties”, the credit agency warned.

Losses for banks could also mount if people can't fully repay loans. Fitch said lenders' mortgage insurance - insurance held by the banks themselves - does not cover flood damage.

... Defaults on home loans may force Fitch to reconsider assumptions it made about recoveries on losses when it initially rated the mortgage-backed securities linked to Queensland's real estate, it said.

“Moreover, the market value for properties located in the flooded areas might now be permanently adjusted downwards due to future flooding risk," the agency said.

This blogger will add that if RMBS are in the gun for downgrades, so, most likely, are QLD banks. It's not yet clear whether this will be sufficient to prompt an increase in the major's funding costs. Let's hope not. But the piece goes on suggest that:

RMIT Property & Valuation lecturer Matt Myers said the values of the homes depend in large part on how viable the local economy remains after the floods.

“Some areas will see an eventual return to similar values - lots depends on the economy of those areas,” he said.

“If there are jobs, people want to stay, and if enough people have adequate insurance to rebuild, then these areas will do well,” he said. “But I expect some of the rural areas may never fully recover.”

Houses that are blocks away from creeks that have been flooded will probably be valued lower, by as much as 10 per cent, said RP Data's Cameron Kusher.

“For the next five years of so, a flood report is going to be the buzzword for anyone wanting to buy property in Queensland or other states, as well.”

This blogger reckons the article has it backwards. It's not quite so pessimistic in the short term because there will also be increased activity in non-flood affected areas as people move. This could put some areas under upwards price pressure.

Looking further out is a different matter. The article neglects a major problem facing flood-effected home owners - the cost of insurance is going to rise - a lot. As Bloomberg reported yesterday:

The Queensland floods may cost insurers and reinsurers worldwide as much as $6 billion in what might be Australia’s costliest disaster in history.

Insured losses from this week’s deluge in and around the capital Brisbane may be as high as $4 billion, while damage from floods further north late last year may cost $2 billion, according to Milan Simic, managing director of catastrophe modeler AIR Worldwide.

Political pressure is mounting on Australian insurers, which include Suncorp Group Ltd., Insurance Australia Group Ltd. and QBE Insurance Group Ltd., to pay claims as residents return home to assess damage. Those companies are spared from the bulk of the costs by policies designed to pass on the bill.

This blog noted last week that the experience of New Orleans' home owners following Hurricane Katrina was an immediate surge in prices that was followed by relentless deflation, owing in part to onerous insurance premiums, especially at the top end. This blogger reckons a similar dynamic is set to put downward pressure on Brisbane house prices.

So the RBA is also likely looking at accelerated declines in QLD asset prices in the medium term. And there will also be immense political pressure to not raise rates as suffering Queenslanders rebuild.

The RBA is facing a tough choice sooner rather than later. Raise rates and face opprobrium. Or, wait, and get hoisted on its own petard.