What’s all this talk about inflation?

Just as we welcome the faster than expected recovery in economic activity, ongoing fiscal stimulus and strong labour markets – here in Australia, and more broadly around the world as the vaccine roll-out steams forward – a double edged sword is appearing.

Suddenly, financial markets and companies are worried about inflation – in Australia and in other major economies. And it’s being raised in almost every meeting and forum I attend.

Now, bear in mind, we have not seen inflation as a ‘concern’ for some time. Since the GFC, the worry has been that inflation has been too low, which is why interest rates were already ultra-low and most central banks were already using unconventional policy measures when the pandemic hit. In Australia, core inflation has not been within the Reserve Bank of Australia’s (RBA) 2-3 per cent policy target band since Q4 2015 and has not been above the band since Q1 2010 at the height of the mining boom.

Perhaps the emergence of these concerns is not surprising with US core inflation rising 3 per cent in the year to April, a pace not seen since 1996, while private wages – as measured by the employment cost index – rose by 3 per cent in the year to Q1 2021.

And bond markets have reacted in force to this, as well as a hint from the US Federal Reserve that it may at some time in the next few months consider what tapering bond purchases could look like. The US ten-year bond yield has jumped from 0.93% on the first day of trading this year to 1.63% currently - Taper tantrum, anyone?  

The Australian ten-year bond yield has jumped 65 basis points from 0.98% at the start of this year. Partly this is in response to US yields – which anchor global rates – but also reflects headlines in Australia around skills shortages, supply disruptions, and the prospect that the June quarter inflation print – released in late July – will show annual headline CPI accelerating to over 3 per cent, from 1.1 per cent in the March quarter. This would be the fastest inflation since mid-2010.

Naturally businesses are concerned about the implications for their cost base, their consumers and importantly for monetary policy settings, funding costs and valuation models. And for some, these concerns are overwhelming the good news that the economy is recovering faster and stronger than expected. 

We are seeing some inflation

There is undoubtedly asset prices inflation, just look at house prices, at equity markets and even Bitcoin. That is no surprise in a world of ultra-low interest rates, that is awash with liquidity, both of which are pushing investors up the risk curve. 

We are also seeing some producer price inflation, with global supply chains taking longer than expected to recover from the COVID-19 shock, in terms of production disruption, but also temporary and permanent shifts in global consumption patterns. There’s a global shortage of semi-conductors; iron ore prices have soared; shipping rates are through the roof (the Shanghai Containerised Freight Index has more than doubled since the start of 2020).

And anyone trying to build or renovate a home in Australia will tell you about price pressures, with demand stoked by the Government’s HomeBuilders grant and other Government initiatives. The data backs it up too – looking at the Producer Price Index, input prices to house construction rose by 1.1 per cent in the March quarter and output prices rose by 1.4 per cent. The consumer faced higher prices, but also benefited from the various Government measures, which largely netted out. Analysis by the Australian Bureau of Statistics shows, that before these grants, the retail price of building a home (not including land) rose sharply. 

But are we seeing generalised inflation?

So, there are pockets of inflation, just like there are pockets of the economy doing well and others that are still struggling.

Without underplaying the impact of inflation in those sectors, it is generalised, economy-wide inflation that drives monetary policy and therefore bond markets and funding costs. The Reserve Bank of Australia sets monetary policy based on underlying inflation – or more specifically the trimmed mean – and recently shifted its framework to respond to actual inflation, not forecast inflation as has been the case for many years.

Headline CPI rose by 0.6 per cent in the March quarter, to be 1.1 per cent higher over the year. The trimmed mean rose by just 0.3 per cent – half market expectations – to also be 1.1 per cent higher over the year, a new record low. 

Now, data is still being impacted by the pandemic – both in terms of base effects and policy settings. And this is why we are expecting June quarter headline CPI to print above three; the same quarter last year saw the largest decline in quarterly inflation in the 72 year old history of the data, largely reflecting the introduction of free childcare and the sharp fall in global oil prices that feed through to the petrol pump. The removal of that policy, rising petrol prices, and the base effect, will naturally push annual inflation higher.

While the RBA has forecast CPI inflation at 3 per cent in the year to the June quarter 2021, the forecast for the trimmed mean is just 1½ per cent. Moreover, the RBA sees both headline and underlying inflation rising to just 2 per cent in the year to June 2023.

Now the central bank can, of course, be wrong, but even the latest long-term consensus economics publication from April, which surveys private sector forecasters, suggests that inflation won’t reach 2.5 per cent growth until 2026.

Moreover, while there was some evidence of demand-pull inflation in the latter half of 2020, that pressure moderated in the first quarter of 2021, particularly in housing-related goods. Indeed, the share of expenditure classes in the CPI basket experiencing rising prices in the quarter (seasonally adjusted) fell by nearly 5 percentage points to 59 per cent, while average quarterly rises also remain below levels consistent with inflation being within the policy band.

That is, we do not appear to be seeing a generalised inflation pulse.

Meanwhile inflation expectations have lifted, but not to worrisome levels. Consumers’ inflation expectations (as measured by the ANZ-Roy Morgan weekly consumer survey) have risen from their pandemic lows, but at 3.7 per cent remain below the 4 per cent readings seen through 2018 and 2019. Meanwhile, the more responsive inflation-linked bonds have seen a sharp rise in the break-even yield, but again only back to 2018 type levels, when inflation was still below the RBA’s target band. The break-even yield on the 2030 bond has risen by just below 0.6 per cent in April last year to a little over 1.90 per cent currently. 

With a strong global economy, and stories of skills shortages and supply chain disruptions, how can that be?

The global backdrop is undoubtedly important for a small, open economy like Australia, and research shows that the global inflation pulse feeds through to Australia. Certainly, if inflation takes off in the US, China, UK, EU and other major markets, then some of that will find its way on to our shores. But even in the US, there is a question-mark over how transitory the current pressure is.

The supply chain will, over time, adjust and prices should settle lower than current rates. But that isn’t really where the debate is; the uncertainty is whether the stimulatory fiscal policy settings – especially in the US - will push aggregate demand enough to generate sustained inflation pressures; and/or whether labour markets will strengthen to the point where wage growth accelerates meaningful.

Economic modelling using the EY-MARTIN model shows that spare capacity in the labour market and wages growth is the single most important determinant of underlying inflation. The rule of thumb in Australia is that wage growth needs to be running around 3.5 per cent annually for inflation to be at 2.5 per cent, the mid-point of the RBA’s target band. 

Other factors are also important, of course. Spare capacity in the economy (or the output gap) which is influenced by government policy, the virus and vaccine developments, and also the extent to which households drawdown on their war-chest of savings.

The exchange rate is also important for tradeable goods and services, as well as influencing input prices more generally.  A stronger Australian dollar – which most forecasters expect - flows through to weaker inflation. Even if that forecast proves incorrect and the currency depreciates, globalisation and price sensitive consumers have meant that the ‘pass through’ to retail prices from input price rises or changes in the currency has diminished significantly in the past decade or so.

The influence of wages on Australia’s cost base, and therefore prices is illustrated below. Wages make up forty per cent or more of the cost base across housing construction, restaurants and cafes, domestic household services, childcare, education, medical and dental services and recreation, sports and culture services. 

While JobKeeper was incredibly effective and saw the unemployment rate peak much lower and earlier than expected, and the recovery in the domestic economy has driven the unemployment rate down to 5.5 per cent, wages growth remains anaemic. The wage price index rose by 0.6 per cent in the March quarter to be 1.5 per cent higher over the year. That’s a long way short of where it needs to be to lift inflation, and that number itself was boosted by the delay in the implementation of minimum wage increases from last year. 

That is not to say that there are not areas of skills shortages and wages pressure in some parts of the economy. But it’s largely contained to those areas that rely on migration; including hospitality, food trades and preparation; factory processes; agriculture, sales assistants and ICT professionals. Over time, the border will re-open and those pressures should ease.

If we look at the economy as a whole, there continues to be spare capacity in the labour market. The unemployment rate is above ‘full employment’ – now there is much debate about exactly where so-called NAIRU is, but it’s clearly below 5 per cent, likely in the low 4’s and could even start with a 3. Moreover, under-employment remains elevated at 7.8 percent, so total under-utilisation is 13.3 percent. EY research earlier this year modelled how this relates to wage growth and found that underutilisation needs to be sustained below 12 per cent to generate meaningful wages growth. 

The RBA believe that generating inflation that is sustainably in the target band requires “the labour market … [to] tight enough to generate wages growth that is materially higher than … currently. This is unlikely to be until 2024 at the earliest.”

So financial markets are wrong to worry?

Well no. I’ve worked through enough cycles and crises to know that you ‘never say never’. But the economic framework would tell us that the impeding run of numbers that will show a jump in inflation likely do not represent the start of a high inflationary cycle.

The Reserve Bank Board continues to reiterate that “It will not increase the cash rate until actual inflation is sustainably within the 2 to 3 per cent target range”¹ which most economists believe to mean that we need two to three consecutive inflation readings with the trimmed mean printing above two. Given the starting point, there’s certainly some upside room before we need to worry.

That said, there is no doubt that the economy, and labour market particularly, is recovering faster than expected. If that continues, and unemployment falls to the low 4s faster than expected, then wage growth is likely to pick up earlier than anticipated, and policymakers may need to respond earlier than currently indicated.

If that happens, it’s not such a bad ‘worst case’ outcome. An economy running hot, generating real wage growth for the first time in years. That will push inflation higher but we  know how to deal with inflation that’s too high, it’s been done many times before - what we’ve seen in the past decade or so that monetary policy has not been very good at dealing with low inflation.

In fact, rising inflation would give the Central Banks the ability to raise rates off the floor where they are now, and that builds a buffer for the future. And that is surely preferable to the alternative, where the recovery stalls and policymakers must again respond to weak demand and too-low inflation.

So, the cash rate looks set to be held at 0.1 per cent for some time – perhaps, if current momentum continues, not quite as long as early 2024, but certainly for a period. That does not mean that monetary policy in totality remains where it currently is. In fact the RBA have already announced that the term funding facility will not be extended at the end of the June; a decision will be taken in July about whether to extend the yield curve control aimed at the April 2024 bond (seems unlikely); and there’s the question as to when the Bank starts to taper its bond buying programme. In other words, fixed rates are likely to rise before the short end or in other words the yield curve to steepen. Indeed, we are already starting to see major banks lift fixed rate home loans.

So, there are still funding considerations that need to be worked through. Indeed, there is likely to be ongoing financial market volatility as incoming data points are absorbed and as financial markets continue to second guess the pace, timing and format of policy withdrawal. That will have an impact across households; corporates and, of course, governments – all of which will likely need to refinance at higher interest rates at some point in the future. 

What happens if financial markets are right?

Rising interest rates cannot be ruled out. And certainly, that flows through to the decisions made by businesses, households and governments.

From a government perspective, it’s about ensuing nominal economic growth is faster than the average cost of debt. For households, most of the exposure revolves around the housing market, where lending standards have a built-in buffer. For businesses, it’s around hurdle rates – which actually haven’t come down as much as you would expect given the cost of funds, so that’s already an issue for business investment.

Rising interest rates can certainly slow the economy, generate volatility in financial markets and negatively impact some, most likely the marginal borrower or marginal investment/purchase.

But the real risk, surely is high interest rates, more than rising interest rates.

For example, when applying for a mortgage, APRA requires the bank to ‘stress test’ to see whether the mortgage is serviceable at the prevailing interest rate plus “at least 2.5 percentage points”. That is, there is a buffer built into the system, but should the mortgage rates rapidly rise by more than the buffer, then there would be some real financial stability concerns.

The experience of many major economies post-global financial crisis is important to consider. Wage growth and inflation were remarkably contained even in economy’s that hit full employment and central banks were only able to lift the cash rate slowly and taper bond buying very gradually – not one central bank got back to square on their balance sheet. Take the US, for example, while the unemployment fell to 3.5 per cent, wage growth lifted to just 3.2 per cent , core inflation to 2.4 per cent, while the Fed funds rate peaked at 2.4 per cent, far lower than the 5.3 per cent seen prior to the GFC or the 6.5 per cent in late 2000.

That suggests, that even with an earlier than anticipated commencement of a tightening cycle, the pace is likely to be slow enough for the real economy – for businesses and households – to adjust. 

Putting it all in perspective – how high could interest rates go?

The answer to that will be determined by the economy. Can we push economic growth high enough, for long enough, to erode spare capacity in the labour market and economy more broadly?

One framework to consider this is the neutral interest rate – sometimes referred to as R* - which is the real interest rate that is neither contractionary or expansionary for the economy and supports full employment while keeping inflation constant. Think of it as the long run interest rate if the economy was running at its potential. Like ‘full employment’ though it is not observable and changes over time. In fact, R* has been falling as the chart below shows.

Monetary policy settings are clearly stimulatory currently, the real (or inflation adjusted) cash rate is negative. But, this framework suggests that even if we got to the point where wage growth was too strong and inflation was sustained above the RBA’s band, a real interest rate just above zero would start to calm the storm and act like a break on the economy and inflation.