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Economic Update: Inflation - the short and long run story

30 November 2023

Summary:

Inflation is coming down;
The moderation in the October CPI number wasn’t as good as the headlines suggested;
There has been speculation that inflation could be higher and/or more volatile in the future;
A structural shift of inflation is not yet clear in the data.

Latest on inflation

The monthly October CPI data came in lower than expected (it actually declined in the month), leaving the annual inflation rate at under 5%. A low monthly number was consistent with the most recent NAB business survey. The trend decline in ‘underlying’ inflation though has slowed in recent months and is something worth watching.

Developments in the global economy suggests that further declines in the annual inflation rate are almost certain in coming months. Indeed, my judgement is that the current inflation run rate in Australia is somewhere between 3-4%. The big question though, is whether inflation will moderate enough to get it back to 2-3% without the need for a significant slowing in economic growth.

Central banks (including the RBA) are currently focussed upon the non-housing service sector (e.g., hairdressers) as a part of the economy where prices are ’sticky’. Maybe this will turn out to be a worry, but the pick-up in service-sector activity lagged that of the goods sector post-COVID. The service sector has also been more heavily impacted by labour shortages. And so, we should expect that service-sector prices would be high now. The extent of the rise of service-sector prices has to date, not been obviously different to goods prices, nor has it yet clearly proven to have been more ‘sticky’.

Perhaps a bigger concern has been the rise in financial market inflation expectations. The concern is that higher inflation expectations will be reinforcing, if inflation is expected to stay too high it will be too high.

My view is that the rise of financial market inflation expectations is not reflecting any significant change of investors’ central-case outlook on inflation. I think the issue has been financial market uncertainty about the inflation outlook. Inflation has risen and has been away from central banks’ targets for a couple of years, with central banks forecasting that it will remain above those targets for at least a couple more. If central banks forecasts are right, that inflation comes back within target by end-2025 (or earlier), then expectations should decline.