Who cares about inflation? Most of us actually like cheaper groceries and lower petrol prices. But low inflation may be the trigger for the RBA board to cut the cash rate. This note takes a deeper dive into the data to help us assess the potential for further cash rate cuts
What actually drives inflation?
The inflation of any country is driven in part by local wages and imported inflation. Local wages will rise where local demand for labour is nearing or higher than local supply. Imported inflation, on the other hand, is driven by global labour markets and commodity prices. While this is a simplistic summary, 90% of inflation or more is driven by these two factors over any meaningful period of say two years or more.
For any economy then, the impact of global inflation depends on the goods and services it imports. For Australia, that’s heavy machinery, vehicles, chemicals, medical supplies and some refined commodity products like petrol and steel. These goods have prices set by global demand so when those prices rise (in AUD terms), we import inflation. On the other hand, the vast majority of our services are locally “produced”, and as such the majority of price rises are caused by wage inflation in Australia, not anywhere else in the world.
So the argument that Australian inflation will rise is based on expectations that either our imported global inflation will rise or local Australian wages will rise. Neither of these is supported by data at present, and in fact there are strong arguments to the contrary.
If others believe that Australian inflation will rise, then it is likely to cause the AUD and/or Australian interest rates to rise, creating a trading opportunity for investors with lower inflation expectations.
The global inflation argument
A popular argument for Australian CPI getting ready to rise is that US and UK inflation has recently risen. This is a deeply flawed argument as:
- UK inflation is hardly surprising, given the massive fall in the GBP and their reliance on imports for much of the CPI basket. This is not a sign of global inflation
- US inflation is wages driven. We looked at factors pushing up their CPI:
a. Services and housing drove 120% of their inflation last year. These are domestic factors, not global.
b. Imported goods or goods that the US makes. However, Australia imports such as cars, furnishings and clothing all fell in price in the US, suggesting deflationary pressure on Australia – not inflationary
Furthermore, Europe and Japan’s recent tiny increases in inflation are hardly signs of global inflation returning, when these economies are still being propped up by massive quantitative easing (QE) stimulus and record low interest rates. The slightest sign of a tapering of QE or rising in interest rates will severely dampen inflation.
Global inflation is still very weak. Imported goods from China, Japan, the US or Europe are still falling in price. This is caused by massive overcapacity in China and the US, which in turn was caused by overinvestment post GFC when central banks attempted to stimulate their economies with loose debt. China, in particular, is not afraid to export deflation. Saving a Trump win and even then reliant on a conservative Congress, any global action against China will be extremely slow so China represents downward pressure on “global” CPI. With the level of excess capacity in steel in particular, this cycle has years to last.
Australia needs local inflationary pressure via wages
Australian wage growth remains sluggish. The simple reason is that the demand for employment, as measured by the total number of hours demanded by employers, remains lower than population growth. The simple economics of having a labour pool growing faster than demand is that wages will not grow; employers simply don’t have to pay more for the next hour of employment they “buy”.
Demand for labour kept pace with population growth since the end of the mining investment boom until the start of 2015. Since then demand has flat lined, and is set to weaken further as the construction cycle likely stumbles in 2017 and 2018. Financial services and professional services also remain weak. That leaves government, education and tourism to apply enough pressure to push up wages – and therefore inflation.
But if the AUD rises, education and tourism face declining demand. This means that the pressure on the RBA to keep the AUD below 80c is higher than most people assume.
The data shows that Australian CPI is weak
The RBA looks at “core inflation” – specifically “trimmed mean”, which excludes volatile items like petrol and food prices. As per Figure 1 below, trimmed mean inflation is under 2% and low enough to suggest an ongoing easing bias. We expect to see one to two cuts in 2017. But, at current levels it is probably not weak enough to warrant the RBA spending one of its six remaining bullets.
Figure 1
Source: FIIG Securities
Services CPI (driven by local wage growth) is weakening
Comparing “domestic CPI” vs “global CPI” in Australia, Figure 2 splits up goods and services, in both cases excluding volatile/one offs. Goods CPI has recovered from the 2012 lows caused by global deflation, but Services CPI is at its lowest point since the 1990s recession. We’ve used a two year rolling trend line to make the chart easier to read, but you can see the underlying data – the fainter lines – show the same story.
Goods versus services CPI
Figure 2
Source: FIIG Securities
Conclusion
Demand is not rising enough to create inflationary pressure in the domestic market, and the circumstances in the US and the UK are localised and irrelevant to our economy. What we need is for demand to rise, and that requires some sectors of the economy to experience an above average growth phase. Australia is running out of options and now needs exported services like education, tourism, financial services or professional services to fire, as well as the property sector to avoid a sharp downturn. That outcome is far more likely with a lower AUD and lower interest rates.
While the RBA might preserve their five or six remaining bullets, don’t underestimate the weight of the easing bias that sits on their shoulders as 2016 draws to a close.