Compared to other developed nations around the world, Australia’s economy is performing OK at present.
The economy grew by 3% year-on-year in the December quarter last year, well above expectations and around its historic average. The labour market, at least up until recently, has been improving, sending the unemployment rate down to 5.7% in April, the lowest level seen since September 2013.
There are other indicators out there that have also surprised. The often discussed and highly-controversial residential property market has surprised many with its recent strength, while there are signs that conditions in Australia’s massive services sector are also improving.
All of which suggests Australia’s economic transition away from the mining infrastructure boom is gathering pace. So, given the malaise in the global economy, things are looking all right.
Until, however, you consider that inflationary pressures remain non-existent.
Indeed, consumer prices actually fell in the March quarter, marking an unexpected, and uncommon, return to deflation, mirroring the increase in disinflationary pressures seen in many other nations.
While many cited plunging oil prices as one of the main factors behind the decline — and it was — that same excuse can’t be pinned on the equally unexpected slowdown in core inflation.
At 1.55% year-on-year, the figure was the lowest level on record. It was that low that it saw the Reserve Bank of Australia cut interest rates to a record-low level of 1.75% just one week later, following up that move with a raft of downgrades to its inflation forecasts for the years ahead, fanning expectations that a further rate cut was seen as close to a given rather than a question.
It obviously surprised the RBA, as it did the vast majority of economic forecasters when the inflation report was released.
So why is inflation plumping such lows at a time when Australia’s economy appears to be humming along nicely?
According to HSBC’s chief Australia economist, Paul Bloxham, the answer is fairly simple. It’s not about offshore factors. It reflects spare capacity in the Australian economy.
“Given the low global inflation story, it is tempting to suggest that Australia is now just succumbing to forces that are beyond local control. This possibility cannot be completed dismissed,” says Bloxham. “However, at this stage, the evidence suggests otherwise.”
He points to the significant slowdown seen in tradable inflation, that determined by local supply and demand factors, along with past below-trend economic growth and the transition away from mining to services-led growth, to bolster the view that it is weakness in the domestic economy that’s creating the disinflationary spiral.
Firstly, the significant slowdown in inflation has been largely in non-tradable inflation. This includes education and housing rents, which had much weaker prices growth in Q1. The factors driving this weakness are local rather than global. Tradable inflation, which is largely imported goods and services, was broadly in line with the level implied by the AUD and import prices in Q1.
Secondly, although local growth has been solid, it has still been below trend over the past three years. Below-trend growth has meant that spare capacity has built up, which is weighing on domestic inflation. For example, although the unemployment rate has fallen, it is still above the full employment level (5-5.25%). As a result, wages growth is at its slowest rate in at least two decades.
Finally, the rebalancing of growth from mining to the services sectors is proving to be disinflationary. This partly reflects that wages tend to be lower in the services sectors than in mining-related areas.
The charts below, supplied by HSBC, put some meat on the bones as to what Bloxham is referring to.
The first shows the breakdown in headline CPI between non-tradable and tradable inflation. The latter is price movements that are largely determined by the global marketplace, rather than domestic factors.
Although domestic inflation, on average, tends to be more stable (or sticky) than tradable inflation, it has been domestic inflation which has been weakening of late, offsetting a rebound in tradable inflation which has come as a result of recent weakening in the Australian dollar.
And the next shows two indicators on Australian worker costs, overlaying unit labour costs from Australia’s GDP report against movements in the wage price index, something which grew at just 2.07% in the 12 months to March, the lowest level since at least the early 1990s recession.
Whether measuring the cost to produce one unit of economic output, or actual wage increases, both have been falling recently, something that Bloxham suggests is due jobs in mining being replaced by generally lower paid work in the services sectors.
Essentially, there are more jobs being created than what are being lost, but the new jobs that have been created don’t pay anywhere near as much.
With this likely to be an ongoing factor in the period ahead, the question now is where it leaves the outlook for inflation?
Based on the median forecast offered by the RBA in its most recent statement on monetary policy, the bank doesn’t see core inflation moving back into its 2-3% inflation target band until at least the middle of 2018, more than two years away.
Though Bloxham expects that inflation will likely remain weak short term, he is more hawkish with his forecasts, suggesting that the RBA’s significant downgrades to its inflation forecasts were “tactical”.
“Our own models have a slightly stronger outlook for inflation, with underlying inflation getting back to 2% a year earlier than the RBA’s central forecast,” he says.
“We see a part of the RBA’s approach as tactical. Firstly, the RBA will be hoping not to get further downside surprises to its current inflation forecast as this could undermine the credibility of the inflation-targeting regime. Secondly, the much lower inflation forecast helps to bolster the RBA’s easing bias, which in turn may help to put additional downward pressure on the AUD.
“A lower AUD is clearly desirable for supporting growth but also for lifting inflation,” he adds.
Although HSBC are forecasting that core inflation will accelerate faster, and further, than what the RBA currently predicts, Bloxham retains the view that another rate cut is coming.
“The recent disinflation can be largely explained as a cyclical phenomenon, rather than a structural one,” he notes.
“If this is the case, the appropriate policy prescription is looser policy. As the RBA has a mandate to maintain price stability, it seems likely that the central bank will need to cut the cash rate further.”
Bloxham, mirroring current market pricing, sees the RBA cutting interest rates once more in August, taking the cash rate to a fresh record-low of 1.50%.
Beyond that, and differing him from some of the ultra-dovish forecasters, he suggests that “stronger domestic growth, which drives a further improvement in the labour market, should lead to a pick-up in wages growth and inflation”.
That’s something he suggests will see the bank leave policy unchanged in the quarters thereafter.