- Inflation in Australia is not going lower, but it is not heading higher;
- The underlying economic trend is starting to improve
- But it will be impacted by the coronavirus, at least in the short term;
- For the next couple of months the RBA will be happy to keep the cash rate on hold.
The recent news flow highlights the difficulty in predicting the economic and financial market outlook. There was the release of the CPI figure. The timing of the data is well known and economists have tried-and tested models to predict the likely outcome (forecasts for the quarterly CPI are typically pretty good). But at the same time there has been news of the spread of a new strain of flu, an event and outcome that is far more difficult to forecast.
Inflation: Not going lower but not heading higher
First, the CPI numbers. The Q4 data indicated that headline inflation picked up by around half percentage point from the start of 2019. The movement in the RBA measure of underlying inflation has been less impressive, remaining at around 1.5% over 2019. The flat lining of the underlying measure is consistent with an economy growing both below trend and with excess capacity (ie, the unemployment rate is too high).
The rise of inflation over recent times largely reflects the impact of a weaker exchange rate (impacting traded and goods inflation) and higher food prices (a result of the drought and swine flu in China). Going the other way, inflation was held down by the big increase in the supply of housing (resulting in lower rents). Measures of inflation that are mainly impacted by the underlying state of the economy (such as non-tradeable and service inflation) were broadly unchanged over the past year.
Low inflation has surprised analysts for much of the past decade (although forecasts have been adjusting lower over the past couple of years). With economic growth currently below trend and excess capacity to be evident for some time inflation will most probably remain under the RBA’s target for some time yet.
Last November the RBA expected that their measure of underlying inflation would be around 1.75% at end-2020 and 2% at end-2021. With the subsequent GDP and CPI data printing broadly in line with their expectations, RBA forecasts are likely unchanged. We will get an update when the next Statement of Monetary Policy is released (7th February).
Over the past year there has been discussion whether the RBA should just accept that inflation will be lower for longer and adjust their CPI target down. To date the RBA has disagreed saying that inflation of around 2-3% is right for sustainable economic growth.
And there have been recent developments that would give the RBA comfort that the CPI could (eventually) move back within their target band. The proportion of items in the CPI basket rising by less than 2% is at its lowest level in about 5 years (and the proportion rising by more than 3% at its highest).
Another reason why inflation could head higher is that unit labour costs (essentially wages adjusted for productivity growth) has been rising over the past three years (mainly reflecting weak productivity growth). In the short term firms can either absorb this higher cost within margins or reduce other costs. But if unit labour costs keep rising the pressure will be on firms to start increasing prices.
There has also been a (modest) rise of global inflation over the past few years. This mainly reflects the increase of commodity prices (notably food and oil). But the stronger state of the global economy (reflected in declining unemployment rates) has also probably played some role.
One of the key worries for the RBA last year was the ongoing decline of inflation expectation. As Japan has experienced, if households and firms don’t expect prices to rise it is pretty difficult for inflation to head higher. And like in Japan, an important reason behind the decline of expectations has been that actual inflation outcomes have been low.
Going forward, surveys suggest firms continue to expect that achieving price rises will be difficult. But they also say that price rises are easier to achieve now than when the economy was doing it tough during the GFC or in 2011-13 during the European debt crisis.
Concerns over strong competition is one reason why firms are not jacking up prices. Another is that consumer expectations of prices rises have been on a downward trend since the GFC. Consumer inflation expectations rose a little over the second half of last year (perhaps a result of the rise of petrol and food prices).
Financial markets have noted the consistently low CPI outcomes and over the past couple of years been marking down their inflation expectations. While market expectations did pickup over the last few months of 2019 they remain below the bottom end of the RBA’s 2-3% target.
The economic data released over the past couple of months suggests that the economy picked up a little in the second half of last year. Better signs for the global economy are also developing. Inflation looks to have bottomed although there are yet to be any clear sign that it is rising. At the time of writing financial markets are pricing in another quarter percentage point rate reduction (expected in the second quarter). The RBA has made it pretty clear that it is not averse to further rate cuts. But they will likely be happy to sit on their hands for the next couple of months to see whether the economic pickup is sustainable.
Coronavirus: Clear short term economic impact, less likely long-term impact
Just as the economic data might be taking a turn for the better along comes the coronavirus (note that a coronavirus is a family of viruses that impact humans and some animals). Flus are around every year, and some years (such as 2003 and 2017) are worse than others. This particular virus looks to be more contagious than the SARS virus of 2002-03. But (at this stage) the mortality rate is about one-quarter of SARS. A new virus always gets plenty of attention probably because there is always some uncertainty about how deadly it will become.
Financial markets have reacted with initial concern about the coronavirus outbreak, with both equity and interest rate markets lower and volatility higher. There is no doubt that the short-term economic impact of the virus is negative. Just in itself the Chinese Governments’ efforts to stop the spread of the virus before an antidote can be discovered will have significant economic implications. A large reduction of tourism and retail spending both in China and globally is a certainty. Already tourism from China to Macau is down 80% compared to the same time last year.
Empty streets don’t tell the complete story. These days’ people don’t have to turn up to the shops to do shopping. Chinese production will be lower, although much of the industry was largely shut anyway in late January because of Chinese New Year.
If the experience of the SARS virus is replicated then economic growth in China will be significantly weaker this quarter. But this will be largely offset by higher growth in subsequent quarters as firms and consumers make up for lost spending and production.
The economic impact of the virus could be higher this time because the consumer is a bigger part of the Chinese economy and the Chinese economy is a bigger part of the global economy. But the Chinese Government has been quicker in addressing the virus outbreak this time than during the SARS outbreak. And we can be confident that the Chinese Government will do whatever it takes to ensure there are no sustained economic implications.
Many countries (including Australia) will feel the economic pain of less Chinese spending. Most probable the effect will be short term and modest (0.1-0.2%). The impact of the virus on the data will make it be harder to get a reading on the underlying economy.
We live in interesting times!
Peter Munckton - Chief Economist