Yesterday’s much weaker than expected inflation report was a game changer for the Australian economy. There is clear evidence that global economic fragilities are putting deflationary pressures into the economy.
Falling inflation is putting upward pressure on real interest rates and, combined with a stronger than expected Australian dollar over the past year, is likely to result in softer economic activity in the future.
The RBA’s justified reluctance to cut interest rates for fear of stoking another rush of housing related borrowing could mean that Australia will have to accept weaker growth and higher unemployment than otherwise. Even if the RBA cuts rates substantially over the next 18 months, these latest figure highlight that Australia is unlikely to escape the global realities of weak nominal economic growth and low investment returns. This of course, has important implications for the Budget and fiscal policy.
Into the Void
Australia’s problem is one of relative success. In a world of near zero interest rates and quantitative easing, Australia’s economy looks like a wonderland for global investors. Our 3% real growth and 2% interest rates are very attractive to global capital. This has been encouraging unusually strong inflows of money into our economy for many years.
While capital inflows are generally a good thing, they will tend to push up the value of the Australian dollar. The Australian dollar has fallen in recent years but the evidence is mounting that it may not be falling enough. An overvalued currency weakens domestic activity and employment, and puts downward pressure on inflation.
Yesterday’s inflation report highlights the strength of these forces. The weak CPI was heavily impacted by international factors: tradeables inflation fell 1.4% in the quarter to be just 0.6% higher than a year earlier. This important component of inflation should be rising by at least 3% if history is any guide.
This is because the Australian dollar has been falling over the past three years. Forget about the rally since late January this year. What matters for tradeables inflation now is what the currency has done in the past year or so. The weakness in the currency takes time to filter through to retail prices.
And it is not happening this time round.
As has become clear over the past decade, the inflation process is becoming globalised. Supply chains are global while multinationals are increasingly prominent in the retail space. Australia is no different with a raft of global players entering the domestic market in the past half-decade.
Global players have deep pockets and are prepared to compete on price. They don’t require the same return on equity that many of the domestic players are trying to achieve because they are funded in a world of super low interest rates. This brings intense competitive forces into consumer markets and keeps prices low or falling.
The globalisation of the retail sector is actually just fast-tracking a more powerful force from the global economy into Australia: deflation. Global inflation pressures are almost non-existent in a world of ultra-transparency and overcapacity in manufacturing.
While it is premature to describe the global economy as being in a state of deflation, it is not far off. A further slowdown in the global economy could easily trigger these concerns which at present seem limited to parts of North-East Asia and Europe.
Global inflation is about 1% to 1.5% and the latest Australian numbers suggest that we are headed there too, despite the relatively strong performance of the economy. For the RBA, it would be tempting to see these inflation numbers as temporary. The problem is that as global pressures push inflation in Australia down, the real interest rate will increase, resulting in a tightening of financial conditions in the economy.
Is this a persistent shift down in the rate of inflation or will we see a return to the 2% to 3% rates of inflation seen in the past two decades? This is an important question for everyone in the economy, not just the RBA, which is tasked with targeting a rate of inflation consistent with a fully employed economy. Lower than expected inflation will put downward pressure on nominal economic growth, interest rates, wage growth and, ultimately, investment returns across the economy.
The RBA has to strike the right balance between the real interest rate and the level of the currency that keeps inflation steady and unemployment low. Recent moves in the Australian dollar combined with very low inflation could be indicating that the right balance will involve a lower level of inflation in the economy than previously thought. This in turn will mean lower nominal growth and lower returns on capital.
This suggests that some of the low interest rate and wages outcomes in the economy in recent years are permanent rather than cyclical. Indeed, the real risk to the medium term outlook is if inflation falls too far, threatening deflation.
It will be a negative shock to economic growth that would cause inflation to fall further. In an environment of weak economic activity, deflation can do tremendous damage to a heavily indebted economy. This deflation risk must be addressed in advance.
The best way to ward off deflation is to keep monetary conditions accommodative. This week’s inflation number suggests a further reduction in interest rates will be needed to keep Australian policy suitably accommodative.
The RBA may resist the pressure to cut the cash rate ahead of the upcoming federal election, but unless the fortunes of the global economy turn around quickly, the most likely outcome is an RBA cash rate at or below 1% by the end of 2017.
Warren Hogan has been an economist and financial market strategist for 21 years and is the former Chief Economist of ANZ Bank.