Tuesday 31 January 2017 by Opinion

Smoky outlook for Australian CPI and interest rates

Low Australian wage growth and inflation keep pointing to a slowing economy. Much of our inflation is “fake news” – it’s just tobacco taxes.  The real figure is below 1% pa.  Worse still, the global outlook for trade – critical to Australia’s prospects – is uncertain due to Trump’s aggressive actions and growing debt concerns in China 


The Australian Consumer Price Index (CPI) is not just below market expectations, but is getting worse. It’s moving in the opposite direction to US inflation which is likely to be boosted further by Trump’s trade, tax and infrastructure policies. For Australia, lower inflation leads to lower rates and lower rates leads to a weaker currency.  For the US, higher wages, higher tariffs and fiscal stimulus means higher rates and a stronger currency.

The gap in interest rate expectations between Australia and the US is growing. The wider the gap in interest rate expectations, the wider the performance in the related currencies, with higher interest rates linked to higher currency performance.

Simply, if you have cash to invest somewhere you are more likely to invest in the country offering higher interest rates. You can’t access those higher rates without buying that country’s currency, one way or another.

Inflation has become so weak in Australia that increases in tobacco excises represented 38% of the core inflation figure. That’s the same as housing’s contribution and more than health and education combined, despite tobacco being just 2.32% of the CPI basket compared to housing’s 22.3% share. See link below to an article last July discussing the implications for Australian interest rates. 

US inflation has returned to its target level of around 2% pa.  As CPI is a measure of past price increases, any impact by Trump’s inflationary policies isn’t included yet – that will come later this year or early next year. US inflation is already back to historic norms as, unlike the rest of the world, their economy has recovered. Further, employment has been created from US economic growth, largely driven by consumer spending and business investment. Employment growth has pushed up wages, and as wages are 60% to 70% of CPI in a mature economy, wage growth has pushed up inflation. 

On the other hand, employment growth in Australia has been very weak, failing to keep up with population growth.  Australian wage growth is at its lowest point on record. Therefore inflation is fundamentally weak, artificially pushed up by statistical noise such as tobacco excise increases and not true signs of a strong economy like wage increases.

Comparing US and Australian inflation on a like for like basis and excluding tobacco excises as they do in the US, Australian inflation is now just 0.8% pa. US inflation was last at that low level in 2010, at the depths of their post GFC recession.

Source: ABS, FRED

What’s more, Australia’s economic outlook has darkened over the past year as the probability of a Chinese  hard landing increases. China’s debt pile will soon exceed 300% of GDP and can only be reduced by massive write offs – depleting their reserves – or by increasing their trade surplus. The latter seems impossible now with Trump in the White House, so the outlook is weak for Chinese companies, particularly in the steel and property sectors that are so important to Australian exports.

Investment strategies

Unless you believe inflation is suddenly going to rise, the recent increase in Australia’s longer term rates will reverse. Given the outlook for the US, Australian longer term rates could fall below US yields for the first time since the Asian crisis in the late 1990s.

With that, we offer three investment strategies:

1.   Extend duration on Australian corporate bonds

That way you lock in higher returns when we expect domestic long term interest rates to fall

2.   If you want to hold CPI linked bonds as a hedge for longer term inflation, look to extend duration

We expect low rates and low inflation to persist. Short dated inflation linked bonds provide limited protection. Longer dated inflation linked bonds are preferable.

3.   Increase non AUD holdings as a percentage of your overall portfolio, particularly USD

Higher US inflation and interest rates should boost the US currency relative to the Australian dollar.


Australian demand is low, wage growth is low and therefore inflation is low. Interest rates may stay at their current levels but only if rates in other economies, like the US, were to rise. Otherwise the absence of real, fundamental evidence of inflationary pressure in Australia will drive the RBA to leave rates lower for longer.