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Economic and Financial Market Update: Inflation Has Been Too Low (Hopefully) For Not Too Long

05 February 2021

Summary:

Inflation and wages growth is very low;
And all the signs are that in the near term it will remain low;
Making sure that inflation expectations does not decline further will be important;
The cash rate is unlikely to rise for at least the next 3 years.

The economy has had a good past couple of months. The RBA and consensus thinks this good run has further to run, recently upgrading their GDP and downgrading their unemployment rate forecasts. Although the jobs market has improved substantially over the past six months the level of the underutilisation rate indicates it is far from good enough. The tell-tale sign of a subdued jobs market is that wages growth is at its slowest pace on record.

Inflation is very low. And there is noise in the inflation numbers. What price to put on service activities that have endured COVID restrictions is a particular concern. Another is how much will prove to be ‘temporary’ inflation and how much ‘ongoing’ inflation.

The longer inflation stays too low the more likely people will expect it to remain low. Financial markets have already given the RBA’s game plan a tick of approval, pricing inflation to return to the middle part of the RBA’s target (although not within the next 2-3 years). But consumers and firms have yet to get the same vibe.

What factors might drive inflation higher? The biggest single cost that most businesses face is labour costs. Unit labour costs have declined dramatically over the past year. A fair bit of that is temporary and will be unwound. But as the RBA has noted wages growth is extremely low and expected to stay that way for at least the next couple of years. And Australia is currently not importing inflation.

The RBA is going all in to achieve a stronger economy. With fiscal support and some luck with the virus they are likely to achieve their aim. And in time this will lead to higher inflation. But history has shown that inflation can stay very low for an extended period of time. And most likely that will be the case for at least the next 2-3 years.