10 minute read 14 Dec. 2021
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Is Australia on the brink of a high inflation cycle?

Authors
Jo Masters

EY Oceania Chief Economist

Economist. Pundit. Keen tennis player. Referee to teenage girls. Paddle board lover.

Johnathan McMenamin

EY Oceania Senior Economist

Macro Economist. Keen sportsman. Brewer.

EY Oceania

Multidisciplinary professional services organization

10 minute read 14 Dec. 2021

Rapidly accelerating inflation is the United States is causing trepidation across advanced economies – worried that they may too be on the brink of a similar acceleration in inflationary pressures.

In brief
  • Inflation in the US has accelerated rapidly, to a 39 year high of 6.8 per cent, up from 2.3 per cent at the end of 2019 and three times the ten-year average.
  • Australian inflation has risen, but by a much smaller magnitude, up from 1.8 per cent to 3.0 per cent currently and less than double the ten-year average.
  • Businesses in Australia need to prepare for higher inflation, but we do not expect inflation to accelerate rapidly – as we are seeing in the US.  

Stagflation, transitory, pass-through, hyper-inflation. These are all words ‘du jour’, and the rapid acceleration in US inflation is being monitored with trepidation.

While the delta lockdowns and emergence of omicron have served as a reminder that the pandemic is still with us, businesses are now more pre-occupied with labour shortages and concerns about rising inflationary pressures.

The question is no longer whether we are seeing an acceleration in inflation – that is clearly happening in Australia and many, but not all, advanced economies – but rather if this is the start of a new cycle of high inflation?

This would, of course, be in stark contrast to the past decade where central banks have battled against too low inflation and would require a monetary policy response.

Our assessment is that businesses in Australia do need to prepare for higher inflation, but we do not expect inflation to accelerate rapidly – as we are seeing in the US.  

What’s driving rising inflation around the world?

Global inflationary pressures have risen in the eye of a perfect storm, as global bottlenecks and disrupted just-in-time supply chains were confronted by strong demand, underpinned by government stimulus and a surge in spending on goods (rather than services).

Most economists agree that these pressures should be largely temporary, although it may take another six to 12 months for the adjustment. The Bank of International Settlements recently highlighted that [1]“If energy and motor vehicle prices in the United States and the euro area had grown since March 2021 at their average rate between 2010 and 2019, year-on-year inflation would have been 2.8 and 1.3 percentage points lower, respectively.”

There are some early signs that the momentum in global supply chain dislocation is peaking, with shipping costs and oil prices having declined by 40 per cent and 15 per cent since their respective October peaks.

 

It is not just about supply – demand side dynamics matter too.

Demand for goods has soared across the globe, but how this evolves going forward will vary across economies, with domestic factors such as government policies and vaccination rates playing a pivotal role.

Research by the Bank of International Settlements[2] found that the global common inflation factor accounts for about half of variability in headline inflation in advanced economies, with the role of global oil prices significant. The other half is determined by domestic factors and as the then Bank of England Governor Mark Carney argued[3] in 2015 “domestic economic conditions – conditions affected by domestic monetary policy – still very much matter.”

The importance of domestic dynamics is illustrated by the fact that while inflation has accelerated above ten-year averages across advanced economies, it is more acute in some – the US and New Zealand – and much less worrisome in others, including Australia.

Should we worry about high US inflation?

Inflation in the US has accelerated rapidly, to a 39 year high of 6.8 per cent, up from 2.3 per cent at the end of 2019 and three times the ten-year average. The concern is that this is a portent of what is to come for Australia, and other economies.

Australian inflation has risen, but by a much smaller magnitude, up from 1.8 per cent to 3.0 per cent currently and less than double the ten-year average.

Is Australia simply lagging the US or is there something different here? 

There are clearly global factors at play that we need to watch closely. What happens in the US can hit our shores, particularly as a small open economy. But we also need to be cognisant of the important differences – cyclical as well as technical (the treatment of housing, like including what an owner of a house would otherwise be paying in rent, and the inclusion of used cars, for example) – and that suggests that the inflation cycle in Australia will be more muted than in the US.

The US economy is more at risk of overheating given the size of fiscal stimulus – both in place and potentially coming – and the tightness of the labour market.

The IMF’s tracking of direct discretionary spending in response to the Pandemic suggests the US has so far rolled out spending equivalent to USD5.3 trillion or 25.5 per cent of their economy – more than any other G20 country, and with significant additional spending initiatives coming from President Biden’s Build Back Better plan.

Meanwhile, wage growth in the US has risen to 4.8 per cent in November from 3.0 per cent pre-pandemic. Jobs are coming back but participation has been slower to recover than in Australia – partly reflecting the so-called ‘Great Resignation’ – meaning that the unemployment rate is back at 4.2 per cent. In Australia, wages rose by 2.2 per cent in the September quarter, the same pace as pre-pandemic. 

What has driven the rise in inflation in Australia?

Global factors, domestic policies and base-effects have driven Australia’s headline inflation above 3 per cent for the first time since 2014.  

When we look at the detail, however, strong inflationary pressures are confined to a handful of items in the consumer basket, rather than broad-based price rises.

This chart, which shows every item in the consumer basket, serves as a useful visualisation of this. On the vertical axis is the year-on-year growth in each item’s price, and along the horizontal axis is the weight of the item in the consumer basket. 

While there is always some variation in inflationary outcomes at an item level, the current pattern is unique for two reasons.

First, those items experiencing very high inflation are relatively few but have a high weight in the Consumer Price Index (CPI) – that is, they demonstrate a significant hit to the household budget. This high weighting means that when prices rise in these items, it has a major impact on overall measured inflation.

The reverse is also true.

All these key items have been impacted by the pandemic in one way or another. For childcare it has come off a period of being free; building costs have surged as HomeBuilder incentives brought forward building and renovation activity, while fuel and vehicles prices have risen due to a combination of global factors.

As a result, price growth in many of these items is likely to ease over the coming year, which will be disinflationary. This, and the easing of global supply chain pressures, points to some easing of headline inflation through the second half of 2022.

Second, perhaps more importantly and less talked about, is that the price growth seen across the middle of the basket is lower than long term averages. This is consistent with still-low wage growth, which is the major determinant of underlying inflation. That is reflected in trimmed mean inflation –a key measure of underlying inflation that ‘trims’ the top and bottom 15 per cent of this chart – which has risen, but only to 2.1 per cent.

What would it take for higher inflation to be persistent?

Simply put, inflation expectations and wages growth are the key drivers of inflation.

Expectations have risen, but only modestly, which is consistent with the fact that strong price pressures are not all that broad-based. It pays to watch this closely though. 

Wages also warrant close monitoring – indeed this is what drives most economic models. The rule of thumb is that wages growth needs to be running at around 3½ per cent for (underlying) inflation to be running at 2 ½ per cent.

The labour market has tightened, but wage growth is only just back to pre-pandemic levels, and at 2.2 per cent annually is consistent with low inflation.

While wage growth is accelerating in some sectors (particularly for those on individual agreements), the structure of wage setting in Australia is sticky, as many wages are renegotiated infrequently and are tied to slow moving inflation expectations. A large portion of the workforce is under Enterprise Bargaining Agreements or impacted by public sector wage freezes and caps, so tight labour markets take time to feed through.

Faster wage growth is expected to slowly feed through and lift underlying inflation to the top half of the Reserve Bank’s target band over the latter half of 2022 and early 2023. Headline inflation is forecasts to hover around three per cent.

But again, this needs to be seen in context of higher, but not worryingly high, inflation.

Australian firms should plan for higher, but not historically high, inflation and interest rates – which will require a different strategy from the past five to ten years. This strategy shouldn’t just encompass cost control, which is part of the story, but should extend to productivity enhancing investments, changes in processes and a renewed focus on innovation to make more with less.

Perhaps more importantly, given the vagaries of forecasting – particularly with the pandemic and its consequences – we should all keep a close eye on inflation expectations and wages, as that is what will provide the early signal that we are wrong, and inflation is set to accelerate rapidly. 

Summary

It is difficult to see the backdrop that would drive Australia’s inflation rate anywhere near that of the US – but Australian businesses do need to prepare for inflation and interest rates that are higher than in the past five or 10 years, and that may require a different strategy.

About this article

Authors
Jo Masters

EY Oceania Chief Economist

Economist. Pundit. Keen tennis player. Referee to teenage girls. Paddle board lover.

Johnathan McMenamin

EY Oceania Senior Economist

Macro Economist. Keen sportsman. Brewer.

EY Oceania

Multidisciplinary professional services organization