Inflation genie leaps from the bottle… and that changes … maybe something

 

Australia’s underlying trimmed mean inflation was 2.1% for the year-ended September 2021, landing inside the RBA target band for the first time since 2015. Like the proverbial genie in the bottle, when inflation escapes its confines, it is notoriously difficult to get it back, let alone put the stopper in.

After more than six years in which inflation – measured by the Consumer Price Index (CPI) – sat under the Reserve Bank of Australia’s (RBA’s) target band of 2.0 – 3.0% per annum, the September quarter saw inflation tick inside the target band and retain significant upward bias.

The underlying inflation measure, known as the trimmed mean, removes the impact of most volatile items. As the chart below shows, the ‘genie’ of the trimmed mean lifted from a fairly benign 1.6% to 2.1% in the September quarter. It has to be expected, as John Kehoe has commented in the Australian Financial Review, that the December quarter’s results will see another rise as the nation spends its way to a very delayed gratification.

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However, as Kehoe also wrote, the significant majority of the September quarter’s rise in the CPI was directly linked to higher oil prices – a global consideration, not merely a local matter – and to cost increases associated with new home building.

While these factors are, to some extent, fuelled by global conditions that include supply chain disruptions and related shortages, the simple reality is that inflation only arises because of expenditure and increased expenditure at that. It is, above all else, behaviour of Australian governments, businesses and consumers that has pulled the stopper and allowed the genie to escape the bottle.

At one level, that is all hyperbole, because the RBA’s preferred band for inflation is 2.0 – 3.0% per annum and 2.1% is barely in bounds. But, all expectations are for further inflation growth and we could argue that ‘trimming’ the volatile items is a little cute because those volatile items do not cease to exist just because they are removed from some measures.

As Greg Jericho wrote in The Guardian in late October, it is transport costs – up 40% since April 2020 – that have made most of the difference to the CPI over the last year and ‘inflation is hardly running wild’ at 2.1%.

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Jericho also confirmed the inflation expectation remains relatively low, when measured against the Australian Government bond rate. The next six months at least shows a pretty modest inflation expectation, as the next chart demonstrates.

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There is of course much talk right now about interest rates rising in 2022 as a result of rising inflation. Previously, the RBA guidance was that interest rates would not be rising until 2024. That has been modified in recent days leaving the official position open to interest rate rises in 2023. Still some difference with market perceptions.

There are some pretty good reasons for thinking that although prices are increasing, the real underlying increases – those that will be evident in a year’s time when the world settles a little more – may not be as dramatic as everyone thinks and that might suggest a rush to increase interest rates is unlikely.

First, the volatile items (like fuel costs) flow into the costs of materials and goods that have to be transported, so adding even to the trimmed mean – so inflation is not as high as we think it is. Second, Australia is awash with fiscal stimulus and unspent holiday money that will dry up as the nation opens right back up. Third, on the other side of the time-bound home building boom, given zero net overseas migration and the absorption of pent up demand, housing faces a demand and activity decline, if not a slump. Other sectors will likely be similarly impacted.

Finally, and this could be a very big factor weighing on the RBA, a huge amount of household debt was booked into the housing sector at very low interest rates over recent years, with a lot of stress likely to be caused by even the most modest rate rises, in particular if wages growth does not keep pace with higher costs.

Despite this, the ‘bond market’ – really just the average price of Australian Government bonds – has factored in earlier rate increases. At one level, we could be forgiven for thinking that the finance sector is working to wag the dog here, and as Cecille Lefort and Ronald Mizen wrote in the Australian Financial Review:

“Markets are betting rising inflation will persuade the central bank to increase interest rates sooner and faster than its forward guidance, and are now pricing in a 75 per cent chance of a rate rise in February 2022, and wagering close to five more next year alone.”

We can see the punter’s ‘spread’ below, that demonstrates the expectation.

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The chart shows the gap between the April 2024 bond yield and the RBA stated position of 0.1 %. The suggestion is markets believe inflation is stronger and running ahead of the RBA’s forecasts. Leave aside the bond market ‘punters’, the macro-economic forecasters at AMP and the Commonwealth Bank expect rate increases to start November 2022 – in one year’s time.

Well maybe, but does the latest inflation data really point to that, or is it just a piece of information from an overly noisy period of an utterly disrupted couple of years? Time will tell, as with most things.

Why interest rates could matter

So, why does this matter for our industries? The RBA is keen to maintain strong demand as the economy recovers from the COVID lockdowns. The policy objective of an inflation target of 2-3% is to encourage employment and wages growth and the virtuous and self-sustaining circle of business investment.

This, combined with the current low cost of money has created boom conditions for housing. However, at some stage the economy will reach capacity, where growing demand can only fuel inflation. True enough, that could come on a little sooner than otherwise expected because of factors like the zero net overseas migration and low population growth, but while less people is a constraint on capacity, it is also a constraint on the demand that can fuel inflation.

At the point capacity is exhausted and demand continues, interest rates will need to start rising to bring the economy back into equilibrium.

Changes in interest rates are a critical driver of activity in the housing market and if the last few years have taught us anything, it is that sustained low interest rates are among the most potent fuels for a robust housing market.