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Inflation – Have we peaked? Opinion Summary

Understanding when inflation may have peaked is important because it should signal the trajectory of future interest rates movements. However, this is generating more speculation than the final episode of the classic TV show Twin Peaks!

Given the “poor” December Quarter CPI result of 7.8% released on 25 January 2023 which was up from 7.3% recorded in the September Quarter there was an expectation from commentators that interest rates would need to go up further.

However, reflecting the lag in data there was also a “hope” from observers that inflation may have peaked and that after this increase the RBA might pause to see the impact of the rate rises since 4 May 2022.

The big deal flowing from the RBAs’ first Board meeting for the year on 7 February 2023, was not that interest rates increased by a further +0.25bps to 3.35% but that RBA Governor, Philip Lowe flagged further rate increases (note plural) to come. In the media release following the RBA meeting stating:

“The Board expects that further increases in interest rates will be needed over the months ahead to ensure that inflation returns to target and that this period of high inflation is only temporary. In assessing how much further interest rates need to increase, the Board will be paying close attention to developments in the global economy, trends in household spending and the outlook for inflation and the labour market. The Board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that.”

This increase and the prospect of further rate rises ahead creates significant challenges for mortgage holders. RateCity quoted in the Guardian commented that the rate rise means the average borrower with a $500,000 loan is likely paying an extra $908 a month since rates started to rise last May and for a $750,000 loan, the latest rate increase means an extra $1,362 a month since May.

Significantly the impact shows up in increased “Mortgage Stress”. Recent Roy Morgan research shows further increase in the number of mortgage holders in the “At Risk” category defined as certain proportion (25% to 45% depending on income and spending) of after-tax household income.

Source: Roy Morgan Single Source (Australia), Oct – Dec. 2022, n=3,550. Base: Australians 14+ with owner occupied home loan.

With the February rate rise the Roy Morgan model shows an increase to 24.7% of mortgage holders regarded as at risk and if there is a further rise in March then this could go to 26.3%. These impacts are significant and effect household spending and flow right through to demand for housing and employment which directly affect our industry.

This is serious medicine and at times the reason behind this jolt to the economy gets lost. So why is inflation such a scourge that we need to inflict this degree of suffering on ourselves?

The key here is “inflationary expectations”. If people have a view that prices will continue to rise then those expectations can feed an upward spiral. For instance, this can be reflected in wage increases above the RBA target range for inflation of 2-3% or businesses seeking price rises above the increase in input costs. Sue Mitchell writing in the Australian Financial Review reinforced this point. In reviewing the recent profit results for major retailers, she observed considerable gross margin expansion pre-COVID to now.

Gross Margin
Improvement

Gross Margin
First half 2020

Gross Margin
Dec half 2022

JB HiFi

22.1%

22.8%

Good Guys

20.7%

23.2%

Breville

33.85%

35.1%

Temple & Webster

32.8%

46.5%

Source: Sue Mitchell retail review AFR 17/2/23

Governor Lowe put this in context when responding to questions at recent Senate Estimates hearings on 14 February 2023 stating “we want get inflation down because it is dangerous …its corrosive, it hurts people. It damages income inequality, and if it stays high, it leads to higher interest rates”.

Emphasising similar points Tiff Macklem, Governor of the Bank of Canada in an address on 6 October, 2022 commented:

“High and unpredictable inflation creates uncertainty and unfairness, distorting decisions and undermining confidence in our economic system. It erodes the value of money. It distorts and confuses the information and incentives that consumers, entrepreneurs, savers and investors rely on to make their economic decisions. That means workers and businesses have less to show for their work, and it’s harder for everyone to plan for the future.”

So where does this leave us.

The recent retail sales data for December show a month on month decline of -3.9% but sales were still higher by +7.5% on December 2021. In terms of unemployment the data for January shows there was a slight increase in seasonally adjusted terms of 21,900 people. This takes the unemployment rate to 3.7% which is still at 50-year lows. The rate rises are certainly having an impact but is it sufficient. It won’t be known if these are trends until the next round of data to be published later in February and early March with the December quarter GDP information.

In the meantime, the release of the RBA’s February Statement on Monetary policy provides an update of forecasts.

The Statement on Monetary Policy is issued 4 times per year and it is interesting to go back to February 22 to compare the forecasts then to now. At that time actual Trimmed Mean Inflation (core inflation) was 2.6% (the blue line) with a peak of 3.25% expected in June 22.

Herein lies the problem. In the 12 months since, inflation rather than being transitory has moved to 6.9% (the blue dash line) and is now forecast to take until 2025 to get back within the target range. This is a full 12 months later than the earlier forecasts.

In monitoring this “higher for longer” outlook one also needs to be mindful that there may be other fundamental shifts in the economy leading to higher costs. Lawrence Summers, a distinguished US economist, in a recent talk at the American Economic Association, mentioned the post pandemic need for increased investment spending. Commenting, that building redundant capacity for more just-in case (rather than just in time) supply chains plus investment in technology for the energy transition, will boost demand for investment. This demand for capital has the potential to impact the level of interest rates in the years ahead.

Coming back to the RBA forecasts, not only does it show the marked difference over the past 12 months but the likelihood that interest rates will need to do more heavy lifting to ensure “inflationary expectations” don’t take hold.

Posted Date: February 26, 2023

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