Thursday 28 April 2016 by Opinion

Australian inflation and implications for interest rates

CPI statistics were announced yesterday, sending markets into a spin and the probability of a rate cut next week sharply higher


Australia’s CPI figures were released yesterday, shocking markets with a headline -0.2% decline in prices compared to the December quarter of 2015, and an annual CPI rate (ie price changes since March 2015) of just 1.3% pa, a long way below the RBA’s target rate of 2-3% pa. 

The role of a typical central bank, including the RBA, is to maximise employment while keeping inflation on target. That typically means that when inflation is below their target, they will leave interest rates low or decrease them further in order to stimulate investment and spending, and therefore jobs growth.  Even if inflation is safely within the desired range and not showing material risks of rising, they could lower rates to address concerns about future economic growth. 

The important wording distinction in the central bank’s role is that they try to “maximise employment” not “minimise unemployment”.  This distinction is particularly important as our unemployment rate recently fell to 5.7%, which is typically a sign of moderate economic growth.  However, this figure is misleading.  Australia’s unemployment rate is low because of two unhealthy reasons: firstly, the participation rate (the percentage of the working age population that are in work or looking for work) is falling; secondly, the average weekly earnings rate is falling because many jobs are part-time and wage growth is very low.  The RBA’s mandate is to maximise employment, which means they prefer full time jobs to part time, and they prefer a higher participation rate.  They will stimulate the economy as long as they feel they can create new jobs without pushing up inflation.  With wage growth at record lows, inflation well below their target range, and global economic risks negatively balanced, the chances of an RBA rate cut in May is probably higher than the market’s 53% expectation.

No matter what measure you look at, inflation was far below expectations:

  • Inflation excluding “volatile” items such as petrol was just 0.15% over the December quarter, and 1.55% over the past 12 months, the lowest since the Asian crisis of 1997/98, when the RBA lowered interest rates from 7.5% to 5%
  • Education and Health sectors were the single biggest contributors to what little inflation there was, but education is largely a one off factor as school prices tend to increase at the start of the school year.  Excluding education and health, this quarter was the lowest inflation figure on record (since 1989)
  • “Tradeable goods” had the largest fall in price since December 2008
  • Reflecting the across-the-board nature of low inflation, median inflation was also at a record low

Markets immediately reacted by increasing the odds of a cash rate cut in May from 16% to 53%.  The risks to the Australian economy are rising, and the RBA has made plenty of noises recently about their concerns regarding the global economy and the markets’ apparent complacency. This includes comments made by RBA Governor Glenn Stevens last week in New York, stating that “the relative calm seems a little eerie, perhaps fragile”.  He went on to talk about the “anaemic” global economy, the desperation of measures such as the proposed “helicopter money” in Europe, and the danger of interest rates being held so low for so long was that consumers would slow down spending as both retirees and savers saw lower growth in their retirement funds. 

Stevens and his RBA Board might be generally reluctant to cut interest rates, but the signals are getting louder and louder.  More importantly than what they might decide in May, the longer term outlook for the global economy and the ability of the Australian economy to withstand further global, and particularly Chinese, declines, means that the risks to interest rates in Australia remains on the downside. And of course, lower Australian interest rates during a time when the US and UK interest rates are erring to the upside, means higher risks to the downside for the Australian dollar.