• Inflation in Q2 2019 came broadly in line with expectations;
• The data does not argue for a near-term rate cut;
• But rate reductions are more likely if current inflation is combined with further rises in the unemployment rate;
• A lot of the focus about why inflation is so low has been on structural factors (such as technology);
• But the state of the economy still matters.
The Bay City Rollers were one of the big bands of the mid 1970s. For an economist one of the reasons that the ‘Rollers’ standout is that the year of their first big hit (‘Bye Bye Baby’ in 1975) was also the year when inflation peaked. By the end of the 1970s the world had seen the best of the Rollers, and they spent the next twenty years or so doing the odd tour. The end of the 1970s also saw governments decide that inflation was the dragon that needed to be slayed. They created independent central banks that spent the next twenty years getting inflation down. Central banks have been so successful that the current worry is whether inflation is too low!
Given that concern it was something of a relief that the Q2 inflation number came broadly in line with expectations. But it is now almost five years that inflation has been under the RBA’s 2-3% target band. The moderation of inflation over recent years has mainly reflected weaker service sector prices. And as is often the case during periods of low inflation the difference in price rises across goods and services in the economy is very low.
(over the year % change)
Annual % Change Inflation
(excluding volatile items)
Difference Between Price Changes In The CPI
(standard deviation across category annual % price changes)
Ongoing low inflation is impacting views on the extent of future price rises. Consumer inflation expectations are at record lows, and for the past 3 years have mainly been below the mid-point of the RBA’s 2-3% inflation target. Business inflation expectations are well below their pre-GFC levels (notably in the retail sector). If consumers expect prices to remain low, and firms think there is a cap on how high they can raise prices, then it starts to get more difficult for the RBA to achieve their inflation target.
Consumer Inflation Expectations
(rolling 3 year average, weighted mean)
Frims' View Of Price Rises In The Retail Industry
(2 quarter average)
Much of the recent discussion about why prices are so low has surrounded structural factors. Globalisation is often nominated as an important factor (notably from the emergence of China). Technology has played a significant role, whether by improving price transparency (comparison websites) or allowed the entry of new competitors (Amazon). Technology has also meant there is greater potential for outsourcing, and has increased the ability of machines to do more jobs of humans.
Globalisation is underpinned by the low taxation and regulation of trade. Technology development to date has been broadly based on similar global operating systems. But the Trade dispute means there is a growing risk of the development of separate US and China trade and technologies spheres. The greater availability, access and analysis of data has also helped improve price transparency (and allowed firms to better market goods and services). But different countries are developing policies that may impact on how data is used.
The entry of China into the global trading system increased the supply of goods and services relative to demand. It is a big part of the reason why consumption as a proportion of the global economy is at its lowest point in at least 50 years. China is aiming to make consumption a bigger part of its economy. If it is successful this will lead to higher demand for goods and services and that potentially could impact the inflation outlook.
Composition Of Chinese Economy
(proportion of total)
Consumption As Proportion Of Global Economy
While there has been a lot of focus on structural factors, the state of the economy remains important. Domestic inflation was picking up in 2017 and the first half of 2018 when the economy was doing fine. Company views about the potential for price rises and the sustainability of profit margins declined as the economy slowed over the past year. A key reason why wages (the biggest cost for most firms and therefore an important determinant in how they set their prices) has been so low is the relatively high underutilisation rate (unemployment rate plus the underemployed). All of this suggests that if economic growth strengthens in time inflation should rise.
Firms Views On Profit Margins
(standard dev average, 2 quarter average)
One final big picture point. Worrying about inflation is very much a product of the second half of the 20th century. Apart from the roaring Twenties, inflation was quite often negative in Australia pre-World War Two. And historically extended periods of negative inflation was quite common in the UK.
Long-Term Australian CPI Data
(annual % change, annual data, 10 year rolling average)
UK Inflation Rate
(annual % change, 10 year rolling average)
Inflation is currently low by the standards of the past sixty years, and investors and central banks are worried that it will go lower. In the short term, whether inflation goes up will depend upon the success that central banks (and government’s) have in boosting the economy. The Q2 CPI data does not argue for an immediate rate reduction. But lower rates are likely if inflation stays where it is and the unemployment rate heads higher. In the longer term the structural factors such as how globalisation and technology evolves and China’s success in becoming a consuming nation, will become more significant.
‘Can’t nobody tell me nothin’ is the question currently being posed by Lil Nas. Asking questions about nothing is another sign of how much things today have changed from the inflationary 1970s.
We really do live in interesting times.
Peter Munckton - Chief Economist