Confusion as troubled torch reaches Canberra

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Wayne Swan described the surge in underlying inflation, the biggest in 16 years, as extremely serious and warned it would take at least 18 months to bring the problem under control. Hinting at massive cuts in spending in the 2007-08 budget, the Treasurer also called for trade unions to accept the need for wage restraint.

But with the inflation figures showing large increases in the cost of housing and fuel that are likely to put heavy pressure on the mortgage belt, Australian Council of Trade Unions secretary Jeff Lawrence insisted that an increase in living costs had to be considered in wage claims.

The announcement that inflation was racing ahead of the 2-3 per cent range targeted by the RBA put the brakes on a rally on the Australian stock market.

Following losses of $110 billion on Tuesday, the market opened strongly yesterday, buoyed by the announcement that the US Federal Reserve was acting to ease jitters sparked by the sub-prime credit crisis and cutting interest rates by 0.75 percentage points.

Australian investors leaped upon the US move to add 6 per cent to the All Ordinaries index, but the inflation news pared back the gains to 4.3 per cent by the close of trading.

Mr Swan blamed the surge in inflation on former treasurer Peter Costello, accusing him of making the risk of higher interest rates a "parting gift" to thenation.

The Treasurer said the problem highlighted the need for budget cuts even sharper than the Government`s promised $10 billion "razor gang" savings, given that extra spending could add to the obvious inflation pressures. "What I would say to everybody - quite urgently to employers, employees and to unions - is that we will need to see some restraint to get us through this inflationary problem," Mr Swan said. "That is why the Federal Government has to lead the way."

Mr Swan would not speculate on his budget, refusing to rule out cuts in the defence budget despite a previous assurance to the contrary by Finance Minister Lindsay Tanner.

He also warned that the Government could not produce a quick fix, noting that the Reserve Bank and the Treasury were forecasting elevated inflation, both headline and underlying, "at or around the RBA target band" for the next 18 months.

"The CPI figures show why the Rudd Government has made tackling the inflation challenge a priority," he said.

As business groups backed Mr Swan`s call for wage restraint, Mr Lawrence said there was no evidence that wage increases were causing inflation. "We have got a decentralised enterprise bargaining system and negotiations will take place and all the parties will look at the various factors, and increases in the cost of living is clearly one of them," he said.

"They (inflationary pressures) are the result of international pressures and the failure of the previous government.

JP Morgan`s chief economist, Stephen Walters, said workers demanding higher wages would be one of the major drivers of future inflation pressures.

"If you`re a firm and labour costs are your biggest costs and are going up, consumers are in good shape, then you can pass on the costs through higher prices - there`s inflation right there," Mr Walters said.

BT economist Chris Caton said the Reserve Bank, the board of which will meet on February 5 to consider a rate rise beyond the current rate of 6.75 per cent, faced the dilemma of managing inflation while the global economy faced a slowdown as the US approached a recession.

The financial markets increased the odds, from 16 per cent to 46 per cent, of the RBA moving rates, which economists said was a "line-ball call".

"The RBA has a real problem on its hands. If the only thing you know was the inflation news, there`s no way you couldn`t raise rates," Dr Caton said. "If, on the other hand, the only thing you knew was the state of the world economy, there`s not a way in the world that you`d be thinking of raising rates."

Citi head of economics Paul Brennan said the momentum of the Australian economy showed policy action from the RBA was needed to slow conditions. A rise will be the 11th since the current tightening cycle began in 2002.

"We believe the rise in the annual rate of underlying inflation is sufficiently large to force the RBA to tighten," Mr Brennan said. "The strength of the economy growing at above potential is a key source of the inflation pressures."

MME Capital managing director Tom Elliot said the Australian share market could be further spooked by the likely rate rise.

"It won`t be good for the market. Investors won`t like it, and I think the bounce has been overdone because nothing really has been fixed," Mr Elliot said.

Opposition Treasury spokesman Malcolm Turnbull said Mr Swan`s warnings could alarm households and markets. "Wayne Swan is almost schizophrenic in the way that he talks about the economy," he said.

"One minute he says that the Australian economy is still strong and an in a great position to withstand international shocks, and then with the next breath hesays we are headed for financial peril.

"He has actually exacerbated our economic problems and he shouldn`t be -- he should be speaking in a measured and balanced way."

The emergency rate cut in the US ordered by the Federal Reserve revived the Australian market yesterday after the $110 billion wipeout on Tuesday.

The S&P/ASX200 ended up 225.5 points (4.34 per cent) to 5412.3 while the All Ordinaries rallied by 223.6 points (4.28 per cent) to 5445.6.

Mr Swan was briefed by Reserve Bank boss Glenn Stevens and Treasury Secretary Ken Henry in his Canberra office yesterday after the US emergency rate cut. The economic officials reassured the Treasurer that Australia`s reliance on Asia, particularly China, would absorb external world economic shocks.

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