Consumer prices in Australia fell 0.2% in the first quarter, the Australian Bureau of Statistics reported yesterday. That sounds like good news for consumers because food fell a little, along with household furnishings, while clothing and footwear, transport, communication, and recreation and culture all saw major drops.
The data also showed that not only did the cost of living for Australians fall in the three months to the end of March in a headline sense, but the underlying rate of inflation (which excludes volatile items) fell to just 1.55%, the lowest level on record.
That appears to suggest some real positives for householders.
Commsec chief economist Craig James said rental cost growth is the lowest in 21 years, technology deflation has the cost of audio-visual equipment are at the lowest prices on record, and if you are looking for a bit of fun, games and hobby prices are also continuing to plumb new lows.
So why does this data have the top end of town, as well as bank and market economists, all a flutter and now suddenly calling for the RBA to cut rates as soon as next week?
The answer, as Warren Hogan pointed out in noting Australia now risks being dragged into the zero interest rate club, is that if “global pressures push inflation in Australia down, the real interest rate will increase, resulting in a tightening of financial conditions in the economy”.
Consumers live in a nominal world so the concept of “real” interest rates is a strange thing to contemplate. But essentially the “real” rate of interest is just the nominal rate minus inflation.
To Hogan’s point, until yesterday we thought the “real” rate of interest in the Australian economy in the first quarter was around 1.8% (2% RBA rates minus the 0.2% expected inflation rate). But instead the data shows that the real rate of interest is 0.4% higher, at 2.2% once the negative inflation – deflation – of 0.2% is factored in.
That is a handbrake on growth because the cost of borrowing is effectively higher than the RBA, and everyone thought.
That is why economists are saying rates need to fall in Australia to compensate for the effective tightening falling prices entail.
But what about deflation?
Just as one swallow doesn’t make a summer neither does one negative print mean Australia is in the grip of deflation.
Certainly the first quarter’s fall in prices is concerning but what Australia currently has in year on year terms is disinflation. That’s where the rate of inflation is falling, prices are still rising just at a slower rate. That’s very different than outright deflation where prices actually fall across the economy.
But the RBA will be fearful of slipping into deflation because of the negative feedback loop that can have on the economy.
As Hogan pointed out “lower than expected inflation will put downward pressure on nominal economic growth, interest rates, wage growth and, ultimately, investment returns across the economy”.
Deflation takes this cycle and super-charges it because consumers alter their behaviour even further to account for no threat of price rises. They can, and often do, delay purchases knowing prices are likely to fall. That in turns lowers aggregate consumer demand, business activity, wages and so on in the cycle that Hogan articulated.
That negative feedback loop then becomes the trap the economy can become mired in.
Deflation is “terrible for land or real asset holders as they fall in price” Westpac Senior economist Justin Smirk told Business Insider. It’s “great for savers and bad for borrowers as the real value of what you pay back/receive rises over time (that is it can buy a lot more)” he added.
But Smirk also said that in an Australian context the narrowness of the CPI means it would only be true deflation if rents and property prices were also falling. Then it would be truly broad based and could potentially and materially impact consumer behaviours.
That’s not the case now. We’ve just had one negative print of headline CPI.
But clearly, in a nation with where a large percentage of household wealth is tied up in property, a substantial part of which is also carrying big debts debt, the RBA will want to do everything it can to forestall even the slightest notion that Australia could end up with deflation.
Take me for example: I’m already thinking of not buying the new car I need.
And that is why the economic forecasting community flipped so quickly to calling for rate cuts and, along with the market believes, the RBA is likely to cut as soon as next Tuesday.
The Australian economy has been doing well recently and the RBA has been more ebullient about the broadening economic transition.
It won’t want to risk that trend and that suggests the RBA will keep cutting rates until it can stabilise the falling level of inflation.