Australia’s inflation rate has turned the corner, having peaked in December at 7.8% with the March quarter result at 7.0%. Despite the improvement, the RBA pounced on latest expenditure data and raised interest rates for the eleventh time in twelve months.
The interest rate rise in May caught some commentators by surprise, because the quarterly and monthly data were both pointing to the peaking of interest rates.
Overall, it seems the speed at which Australia returns to the target range of inflation (2-3% per annum) is exercising the minds of the RBA.
If inflation really takes hold, the likelihood is the RBA would need to keep interest rates higher for longer.
The RBA’s official statement following the meeting reinforces this point:
The Board’s priority remains to return inflation to target. High inflation makes life difficult for people and damages the functioning of the economy. And if high inflation were to become entrenched in people’s expectations, it would be very costly to reduce later, involving even higher interest rates and a larger rise in unemployment. Medium-term inflation expectations remain well anchored, and it is important that this remains the case. Today’s further adjustment in interest rates will help in this regard.
Some recent analysis and commentary suggest one reason it may take longer to get inflation back under control has been the extent of fiscal stimulus used to support the economy during the COVID -19 pandemic. These are always fine judgements and they are made at a point in time when there is limited information or feedback available on the effects of such stimulus.
During the GFC, then Treasurer Wayne Swan coined a term used in different forms since. Essentially it was that in a spending crisis, the key was to ‘go early and go hard’. That certainly happened in the pandemic!
Underscoring this point, Agustin Carstens head of the International Bank for Settlements, commented in a recent speech on global conditions, that monetary and fiscal policy stimulus deployed during the pandemic had been “too large, too broad and too long lasting” and had driven inflation higher.
This point has been reinforced in recent research by Chris Murphy, visiting fellow at the ANU. His modelling found pandemic-era stimulus provided $2 of compensation for every $1 of income the private sector lost because of COVID-19. He concludes this produced a higher inflation outcome than would otherwise have been the case, as the chart below shows.
Source: Chris Murphy, Fiscal Policy in the COVID-19 Era, Economic Papers 2023
Returning to the March quarter CPI, a useful graph in a report by Greg Jericho shows that ‘tradeable items’ and ‘goods’ inflation have eased, reflecting improvement in global and international supply chains.
However, the RBA is concerned services inflation is still high and is broadly based across the economy. In addition, the RBA statement suggests unit labour costs are increasing while productivity remains subdued.
There are a couple of points to make here.
First, we know that service costs have increased because that is where the majority of the workforce is, so wages increases are generally more broad-based in the services economy. In fact, we may need to consider the notion of the Australian economy and the extent to which it changed over the pandemic.
More people than ever before are engaged in the services sectors and we have prioritised – to some extent – service over goods. Writing in the Australian Financial Review in early May, Michael Read pointed out annual inflation in services, by sector, was very strong.
We have copied his table below and importantly, it is of note that services like ‘Rent’ are included. The only way interest rates are going to reduce rents is if demand for accommodation is reduced. But given forecast population increases the only way this will happen is if household formation changes. For instance, if unemployment were to increase from current record low levels, then some “renters” maybe forced “back home” or into some other form of shared arrangement. Sounds harsh when we put it like that.
Second, wages increases are likely to be larger because of inflation, and underscoring the challenge of using interest rates to dampen inflation, we know there can be upwards pressure on wages demand because of those inflationary pressures.
Who’d be a central banker?
The worrying trend is unit labour costs increasing ahead of productivity growth. It is not a big surprise wages are growing faster and labour input costs are growing more rapidly than productivity. Partly that has to do with labour availability and skills, but it might also have something to do with long run under-investment in business systems and infrastructure.
The moderation in prices and therefore inflation is also reflected in the Producer Price Index data for March quarter which shows the input prices to house construction was up 1.6%, well down on the 4.3% increase in the June 2022 quarter.
Of more significance for our industries, the increase in output from construction for housing rose just 0.8%, well down on the 6.0% increase in June 2022 quarter.
It can be observed that the inflationary pressures are dissipating from materials and goods but persist in the services’ sectors. There is a fine line to be walked here, because it is possible that marginal economic activity and employment in Australia swung permanently toward the services sector, during the pandemic.
Bringing inflation under control without destroying a new national emphasis on service provision might be a tough ask when interest rates are the main weapon in the central bank’s citadel.
