Australia has an inflation problem.
It’s not rising inflation, the kind that central bankers know how to fight.
Australia’s problem, like much of the developed world, is the exact opposite. It’s the type of inflation problem that central bankers have increasingly come to hate. It’s the one that the Fed, the ECB, the Bank of Japan, and now the RBA are fighting. The one that modern monetary policy seems to be almost powerless to combat.
It’s one that the crashing price of oil has reinforced as a global central banker issue du jour.
Australia has a problem with falling inflation and it has important implications for everyone, from workers who are less likely to get solid pay increases, to businesses which will have less power to increase prices, and therefore profit margins.
Lower-than-expected inflation rates also put a dampener on taxation revenue for governments. Just last week, Business Insider reported on how a significant force in behind the deficits running up for Australian governments are over-estimations of growth in revenue.
Anyone who lived in the Australian economy when monetary policy was calibrated for higher rates, because inflation was higher, will likely be cheering at a 2% cash rate. Anyone who had mortgage or was in business at the time will remember the 17% home loans and the pervasive concerns about about personal or business bankruptcy.
Likewise, the resultant availability of home loan rates below 4% is a boon for Australian home owners. That would be the case at least if they hadn’t used the extra borrowing power to drive up prices. That just mitigated the benefit of lower rates with a bigger loan.
The banks loved it though. More borrowers using lower rates to drive prices up means a higher average loan size and so more profits, even though rates are low. Equally though, despite all their recent protestations and the strong-arm tactics from the banking regulator APRA to rein in investor lending, the Reserve Bank encouraged this.
That’s because Australia needed to make the economic transition after the mining investment boom. Housing and construction were central tenets to that transition, to bridging the economic gap left behind as activity in the resources sector fell rapidly.
But even as Australian unemployment starts to fall again, as more workers than ever before in Australia go to work each day, and even with an Australian dollar that has fallen 20% in 15 months or so, inflation is still largely absent in the Australian economy.
The recent TD Securities monthly inflation gauge for November showed consumer prices in Australia were flat for the second month in a row. That saw the headline inflation rate print 1.8%. That’s not as low as the official Australian Bureau of Statistics headline inflation rate of 1.5% but the absence of inflation in the economy is worrying enough for the RBA to leave the door ajar to more rate cuts in 2016.
Why they might be opening the door to cut rates is obvious. The Reserve Bank has done a great job of keeping inflation in the middle of the 2-3% band since the exchange of letters between then Federal treasurer Peter Costello and then RBA governor Ian Macfarlane agreed to mandate that as the target range.
(Note: The actual agreement was to focus on underlying inflation but to make this discussion more accessible I’m concentrating on headline).
History (and the continued fall of energy prices) shows that at 1.5%, Australia’s headline inflation is at risk of slipping down and through the bottom of what has been the RBA’s “tolerance range” as it manages “through the cycle.”
Central banks worry about a lack of inflation, and ultimately deflation, for two primary reasons. First, low or falling prices mean consumers don’t lose anything by not spending today. They assume prices will be around the same level in the future and so can delay purchasing.
That hurts economic growth as HSBC China’s chief economist highlighted in a note about China’s doom loop of low inflation and its negative feedback loop with growth.
The second reason central banks worry about low inflation or deflation is this economic growth aspect. A lack of inflation, and pricing power, could signal a weak economy and a lack of aggregate demand.
So what gives? Why is Australian inflation so low?
The first thing is the big technological element. RBA governor Stevens has on a number of occasions in the past referenced the number of plasma TVs a boatload of iron ore could buy. That ratio went up sharply both because the price of iron ore rose but also because the cost of plasma screens had come crashing down.
This technological aspect of deflation was something that Moelis & Co. chief executive Ken Moelis touched on in a CNBC interview recently.
Australian based economists Business Insider spoke to also point to some of the issues Moelis identified which are increasingly important to understanding what’s going on in the local economy.
Moelis, and others, basic premise is that technological advances drive prices down. That can be either through a lower cost of production, and hence cheaper prices, or because technological advancements mean you get more stuff for the same price.
Riki Polygenis, senior economist in the NAB’s markets team, told Business Insider that it’s an important factor in terms of how the CPI is calculated by the ABS.
Inflation is notably negative in components where technological change is rapid such as audio, visual & computing. This is where the quality adjustment from the ABS comes in – when you get more features in a TV for instance than in the equivalent model in the past for the same price, the ABS would record that as a price decline.
In other words more stuff per dollar of purchase price is actually disinflationary.
Polygenis also pointed out that competition in the Australian economy is fierce at the moment, especially from offshore retailers.
“While the lower AUD increases the competitive position of Australian retailers vs offshore internet sales, the existence of so many offshore competitors is maintaining pressure on pricing (as consumers now have more transparency),” she said.
That’s a point Ken Moelis also made. He noted that, “in our world right now, you have so much technology driving price transparency, pricing power, efficiency.”
While that’s great for consumers it also sounds a lot like the perfectly competitive environment we learn about at University and high-cost iron ore producers are currently relearning.
Under that scenario no seller, retailer, or producer has sustainable pricing power. All similar goods become commoditised and sellers take the market price regardless of advertising, packing and so on. This forceful lid on prices across a whole slew of sectors crushes profitability and, therefore, the ability to reinvest and grow.
That is of course, unless you have a premium product like Arnotts Tim Tams. Then the seller or producer can demand and receive higher prices.
This all sounds great for consumers, but in the long run the companies that have to take lower prices, or who lack pricing power in order to increase prices as costs rise, have to “take every cost out of their income statement they can possibly find,” says Ken Moelis.
Those costs include wages.
That might help explain why Australian wages growth has slowed to just 2.27% per annum. That’s the lowest level on record.
Kieran Davies, Barclays Bank’s Australian chief economist, told Business Insider this weakness in wages feeds directly into the low level of inflation.
Davies said that his analysis on consumer prices indicates that “stagnant unit labour costs are responsible for the slowdown in underlying inflation in recent years.”
So we have something of self-reinforcing negative feedback loop which is likely to see inflation structurally lower if the theory holds true.
Maybe that’s why there is nothing central bankers can do to get inflation rising sustainably around the world.
But, with wages starting to rise in the United States and with a slim chance that the Saudi’s and OPEC may start to build a floor under the oil price lowflation might be about to face its first real test since the end of the GFC during 2016.
Ken Moelis doesn’t think so. He thinks we are in a structurally lower inflation environment. He says technology – think shale oil – has also given access to new resources. So this isn’t a cycle, he says, but a long term trend.
We don’t have a lower oil because of a new oil field that was discovered in Saudi Arabia. We have lower oil because of a new technology…Technology doesn’t seem to cycle. It seems to accelerate. So if we are in a technologically driven deflationary market, I think you will see it last longer than people think.
That has important implications for Australia.
It suggests workers continue to get low wages rises. It suggests unless you are selling a premium product, like Tim Tams, you might struggle to get a price increase. And it means that even though monetary policy is looking impotent in the face of these global forces the RBA might be closer to a rate cut in 2016 than the market and most pundits believe.