Keeping the inflation genie in its bottle is the name of the game in Central Banking Land. They have one blunt instrument to tame the complex, dynamic and chameleon-like inflation genie; interest rates, the cost of money for everyone. Our Federal Treasurer has labelled inflation as the country’s number one challenge, hardly something to ignore.
Firstly, some context. According to the Reserve Bank of Australia (RBA) and Australian Bureau of Statistics (ABS) inflation is running at 7.8% (annualised) as the latest quarter ending December 2022, the fastest since March 1990. Given the RBA has an inflation target to keep consumer price inflation between 2–3% over the medium term, inflation is both uncomfortably high and unequivocally undesirable given the common-sense explanation that low and stable inflation is the basis for strong sustainable economic growth. As an analogy, high (too hot) or low (too cold) inflation is sub-optimal to it being in target (just right). What then is driving this inflation (heat)?
According to the RBA, recent elevated inflation is broadly based and therefore not attributable to one singularity we can conveniently point our finger at as the sole culprit. Digging deeper, RBA analysis reveals a marked reversal/increase in demand factors and also a material increase to supply factors. Noteworthy that on an underlying basis, the RBA deems that supply shocks account for three-quarters of the pick-up in inflation.
Is the story complete? Not quite, we must remind ourselves that history has taught us that no one has a perfect crystal ball. So, let’s take a deeper dive to ascertain for our ourselves the factors that occupy the driver’s seat, and to also make sense of the fog as we go forward, by examining:
1. Prime suspects, input costs including wages and demand including monetary policy.
2. Suspicious persons, profit dynamics and the conceptual heavyweight.
3. Inflation expectations and other macroeconomic phenomena.
Wages. ABS reports that the seasonally adjusted Wage Price Index (WPI) rose 3.3% over the year to December 2022, whilst the broader figure on wages and salaries rose 2.6%. Furthermore, WPI growth has been at or below 2.5% between 2014 to mid-2022, suggesting declines in real wages. Away from government sources, wage growth (or lack thereof) is also a raging topic voiced by the Australian Council of Trade Unions (ACTU). Our verdict? Not Guilty, a hung jury.
Input costs. ABS’s Producer Price Index (PPI) rose at an annual rate of 5.8% as at December 2022. A reality check reminds us that our economy is recovering from a global pandemic that has created bottlenecks/supply constraints, natural disasters and conflicts in Europe. Our verdict? Guilty.
Demand (domain of Keynesians). In the spirit of classic economic expression, on the one hand, demand may be underlying, whereas on the other hand, it may be incentivised. Looking at proxies, RBA’s ‘Consumption tracker’ breaks down household consumption whilst the real growth rate is self-explanatory. Clearly, demand plummeted during the pandemic and then catapulted afterwards –no doubt assisted by Federal Government stimulus (c.10.6% of GDP). Our verdict? Guilty.
Monetary Policy (domain of Monetarists). Have we forgotten the “new normal” of falling, ultra-low record interest rates between 2018-2022? Did that incentivise the economy to lend, borrow, invest and spend more? Logic would suggest so, as does the lagging inverse correlation between interest rates and the rise credit growth across the board. Our verdict? Guilty.
Profits. According to the Australia Institute: Centre of Future Work, inflation since the pandemic reflects a “profit-price dynamic” or “seller-induced inflation” according to another prize-winning Economist. The former argues a surge in profits has outstripped expansion and by excluding excess profits inflation would have been an annual average of 2.7% per year, barely half of the 5.2% average recorded since end-2019 and that excess profits account for 69% of inflation above target. ABS reports company gross operating profits rose 10.6%, whilst “Mr Market” (ASX 200 Index) has increased 16% per annum since the lows in 2020. Perhaps there is a disturbing truth to “Never let a good crisis go to waste”. Our verdict? Guilty.
Inflation expectations. An astute mind can probably connect the circular dots and foresee implications when today’s expectations define tomorrow’s reality. According to RBA, inflation expectations in one year’s time was 5.2% from Consumers, 5% from Union Officials and 4% from Market Economists, whereas the Melbourne Institute reckons 5.1%. Looking longer-term, breakeven 10-year implied inflation is currently at 2.45%. Naturally, we are not surprised to discover differences, but small absolutes do not translate to small relative impacts. Our verdict? Guilty.
Two potential culprits or ‘Elephants in the Room’ have eluded current debate and deserve scrutiny. An exogenous shock “Quantitative Easing or QE” and a more subtle undercurrent “Global Leverage”.
QE. The RBA from November 2020 to February 2022 purchased $224 Bn of Australian Government Securities, effectively “creating money from nothing” and injecting it into the economy and simultaneously inflating asset prices. We assert this cannot not have had an amplifying impact and note the correlation to Broad Money Growth surpassing 10%. Our verdict? Guilty.
Global Leverage. Whilst Australia may be an island continent it is not an economic island. With inflation currently at 6% in the US, 10% in the UK, 8.5% in the Euro area is Australia an outlier? According to S&P, global debt is at a record $300 Trillion (349% of GDP) and no less than a globally renowned Economics Professor (and crème de la crème of alumni) labels the current situation a ‘debt trap’. Has not unprecedented global synchronisation of loosening monetary policies raised the tide for all boats? Our verdict? Guilty.
Where to from here?
Consensus expectations is for inflation to decrease going forward towards the RBA’s target by 2025, underpinned by the thesis the factors driving inflation are showing signs of easing whilst actions already taken are only beginning to flow through (rising interest rate lag effect). Most recently, this is reflected in slowing of GDP growth to 2.7% in December 2022 and is not out of step with economic rationale, historical experience or common sense. Going forward, we are aligned with consensus view that the direction of inflation will likely decrease however expect a bumpier ride to the downside than the consensus’ smooth glide path.
Shining our spotlight on the inflation debate reveals more than just a number. Economics may sentimentally be labelled as the “dismal science” but there is nothing dismal about the price of everything. Just ask our leaders, who are no doubt hoping the inflation genie returns to its bottle rather than go on a magic carpet ride.