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Economic and Financial Market Update: The Price Is Right

30 July 2021

Summary:

Inflation in Australia is picking up;
But it remains comfortably below the RBA’s target;
Sustained economic growth domestically and globally growth will be needed to ensure ongoing inflation will be higher;
Stronger growth will happen, although the Sydney lockdown is a serious bump on that road.

The Q2 CPI number was up a big 0.9% in the quarter (3.9% over the year). You have to go back to the pre-GFC days to see a higher annual number. The size of the increase was not a surprise. Measures such as trimmed mean and weighted median showed underlying inflation has risen from its lows but is well below the RBA’s 2-3% target band.

The ongoing inflation rate is currently running at about 1.75% in Australia. This is below the inflation rate the RBA want to see before raising rates. Inflation expectations are consistent with stronger price growth in the short term. But they are not yet consistent with ongoing inflation to be as high as the RBA would like.

The RBA has made wages growth a major factor to be watched. Prices are often set on a cost-plus basis and labour costs are the biggest cost for most firms. And wages growth is the main determinant of the strength of consumer spending. But it is total business labour costs that matter for firms. A more productive firm can afford to pay higher wages.

A chart of wages growth and inflation shows that they have moved together over the past five years. But in the preceding years the relationship was not as tight. Wages growth has its main impact upon domestic-produced service prices. At any one point wages influence on inflation can be overwhelmed by movements in goods prices that are determined by global factors and movements in the exchange rate. And Governments’ set the price for a range of important services (childcare, health, utilities, insurance).

The tightest relationship with inflation in Australia is inflation in the other developed countries. Global factors drive important commodity prices (such as oil). Important influences that have kept prices low in one economy (technology, global competition) have kept them low in all. If major developed economies (particularly the US) are having a strong run of economic growth that will likely mean that all countries will benefit. The link between developed economies has only got tighter since the de-regulation of financial markets as money can now flow easily to the regions offering the highest returns.

Once the Sydney lockdown is over (which we all hope is soon) then the economy is likely to bounce-back sharply. For a period of time demand will again be strong and at a time of limitations to supply of labour and some materials. This will mean higher inflation than current RBA expectations. And therefore they will need to move earlier than their current view (H1 2024). But the uncertainty created by the Sydney Lockdown means that they will be in no hurry to change their view, at least for the rest of this year.