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Inflation, interest rates and wages – an object lesson on why ‘it’s the economy, stupid’

Australia’s annual inflation rate rocketed to an annualised 5.1% year-ended March 2022, prompting an inevitable interest rate move of 0.25% just weeks later. Meantime, in the midst of the election campaign, one of the few issues to catch the attention was the implications for wages increases, as households seek to play catch-up with already increased cost of living pressures.

As the former US President Bill Clayton once said, these are the reasons why in elections, “…it’s the economy, stupid!” After all the analysis is done, the message is clear, percentage inflation rates and interest rates are just numbers: but the cost of living and the wages households receive, that’s personal and not just a macro economic concept.

With inflation at these levels it was clear that there was really only one path to be followed by the Reserve Bank of Australia (RBA) at its next Board meeting and that was up. This is now the start of a tightening cycle with the expectation that more rate rises will follow in the months ahead.

The inflation rate was the fastest increase in prices since the GST and following that abnormal period, the fastest since 1995. We can see the movement of the CPI below.

image001

After years of holding interest rates at historic low levels (0.1% per annum), the RBA was always going to increase interest rates in 2022, no matter what it said a year and less ago.

The reasons are written into the economic data.

All the measures the RBA are tracking are above its policy band of 2-3% growth per annum.

More significantly, the non-tradable items (such as rents, house prices, childcare, hairdressing, education, gas and electricity) rose 1.8% in the March quarter and 4.2% for the full year. The increases in non-discretionary items such as these mean this prices growth is not transitory, or even temporary.

These are expenditures that are required – its pretty tough to cease spending on those items – and because demand is inelastic, prices for them rarely decline, so there will be no shift down from the current levels. That means the inflationary impact of them rising is structural and a result of activity in the Australian economy.

As a consequence, the RBA lifted official interest rates for the first time since November 2010. The new rate of 0.35%, up from an ‘emergency’ level of 0.1% is still unbelievably low in long-term historical context. More relevantly perhaps, given the natural level of interest rates (wherein the economy is growing, but inflation is within the target range) is around 3.0% per annum, we can expect more interest rate rises to come in this tightening cycle.

When interest rates rise, the cost of capital increases. That will slow some economic activity, though not noticeably for a few months yet. There will also be an impact on mortgages and there will be much discussion about households and their capacity to cover the cost of housing, amidst the other costs that are increasing.

So, of course, the mind and attention turns to wages and wages growth, because for households, that is the means by which they keep pace with rising costs represented in the CPI or inflation rate. However, real wages have been in decline and are back around 2014 levels. Real wages essentially adjust the pay packet by the inflation rate, to better represent whether wages are keeping up with costs applicable to the typical household. They are not, as the chart below from Greg Jericho at The Guardian shows.

image002

An important element missing in discussion in the cost of living, and by extension on the wages price index, has been the wider context. In economic terms the reason prices rise is that at a macro level, demand exceeds supply. It is usually a sign of the economy growing beyond capacity.

The immediate tools available to policy makers are to curb demand by increasing interest rates (monetary policy) or reducing government spending (fiscal policy). In the longer-term supply constraints can be assisted through improvements in productivity (eg. infrastructure expenditure, business investment, training).

The RBA is independently in charge of monetary policy and it has commenced acting. It will dampen demand, over time.

Fiscal policy is more challenging. The experience of the past two years has seen critical government support to the economy, via businesses and households, as a response to keep the economy in some shape during the pandemic. There is no doubt that has kept the economy strong and aided a faster return to growth than would have otherwise been the case.

However, a detailed analysis by Chris Murphy published in a Budget Forum series 7 April 2022 and recently updated in the Australian Financial Review suggests that while the support was absolutely necessary, the level of compensation exceeded the income losses, by a fairly wide margin.

Murphy’s modelling shows that with no government response, the private sector would have lost $119 billion in real income, due to the pandemic in 2020 and 2021. However, the actual fiscal response provided, directly and indirectly was $265 billion. Modelling this level of demand, Murphy forecasts CPI peaking at 5.7% well above the RBA’s forecast in February of 3.25%.

It has been said before, but the pandemic probably saw too much, go to too many, for too long. That is not a particular criticism because what else was the Government to do? But for all that it was compelling, there are implications.

Australia is in a similar situation to the US where work by the Federal Bank of San Francisco shows that real personal disposable income was on average 7% above trend during 2020 and 2021 despite the economy being in recession. It estimates this increase in income contributed around three percentage points to core inflation. In March 2022, headline inflation in the US was running at 8.5% and is reportedly continuing to climb.

Whether in Australia, the US or elsewhere in the world, inflation is rising rapidly. The fiscal responses will take some time and some governments will be very reluctant to deploy them. That leaves monetary responses and interest rates and they are rising, with most markets expecting continued increases for the next two years.

Historically, interest rate rises have immediately impacted housing construction. Housing approvals have eased in recent months. Though it will take several months to see if the pace of reductions increases – that is a likely outcome – there may well be as much interest in whether all the previously approved housing in the pipeline proceeds.

Rising interest rates are the next challenge for the supply chain to manage.

Posted Date: May 17, 2022

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