Australian inflation outlook: transition thing

Even if the aftermath of Australia’s latest round of COVID-19 lockdowns is the same as the last one – a relatively rapid economic recovery – an accompanying inflation outbreak is far from the consensus expectation.

The sting in the pandemic’s tail in Australia has doused near-term economic optimism. For instance, Commonwealth Bank of Australia’s economics team has pushed back its expectation for the first Reserve Bank of Australia (RBA) rate hike to May 2023 from November 2022, based on the impact of the latest wave of lockdowns.

A CBA research note says: “Domestic financial-market participants are presently firmly focused on the unfolding COVID-19 situation in NSW [New South Wales] and how it will [affect] the near-term economic outlook. This fixation is completely justified. The economic impacts from the lockdown will be very significant in the near term and the economic data over coming months will deteriorate.”

Many analysts argue that consumer price index (CPI) data were not pointing to a protracted spike in inflation even before the latest COVID-19 outbreak. Core inflation was just 1.65 per cent at the Q2 print, up from 1.2 per cent three months previously but still comfortably below the RBA’s target band despite the base effect of 2020’s anomalous prints.

In late July, RBC Capital Markets research projected that core inflation will “edge slightly higher” over the next 18 months but will likely stay in the 1.75-2 per cent range and predominantly toward the bottom end of it. If this forecast is correct – and noting that since it was made, the situation in NSW has only deteriorated – inflation is not likely to concern the RBA in the medium term.

It may be, however, that the body of evidence is just not yet sufficient to make a confident prediction. Tamar Hamlyn, portfolio manager, interest rate strategies and macroeconomics at Ardea Investment Management, says it is important to understand the subtleties of inflation inputs and, as a result, the pieces of evidence that are currently missing.

Specifically, he points out that the most concerning aspects of the inflation outlook are rising prices in upstream inputs: energy, raw materials, commodity and shipping prices, to name a few. But these tend to have less of an impact on CPI than was historically the case.

“Going back 30 or 40 years, an increase in the oil price would cause widespread inflation because energy was a major part of the value-add of many consumer goods and services,” Hamlyn says. “But we have transitioned to a services economy, in which things like energy and raw materials are a much smaller fraction of the final price of consumer goods and services. Large increases in these inputs to production do not mean we are immediately going to get runaway or permanently elevated CPI.”

TAMAR HAMLYN

We are at something of a transition point at the moment, where we have seen some of the early signs of inflation but we have not yet seen enough to deliver sustained, elevated inflation at the upper end of the RBA target or perhaps even above it.

TAMAR HAMLYN ARDEA INVESTMENT MANAGEMENT

If the signifiers that are in evidence in mid-2021 are to feed through into a protracted inflation breakout, they would likely need to spark a feedback loop of increasing wages and prices. In this context, Hamlyn argues, the factor to watch most closely will be wage growth.

“We are at something of a transition point at the moment, where we have seen some of the early signs of inflation but we have not yet seen enough to deliver sustained, elevated inflation at the upper end of the RBA target or perhaps even above it,” he suggests. “We are looking out for signs of this – and not just for one year but over the next five or even 10 years. It is not yet clear that we are going to see an increase in wages that would point to a protracted period of higher inflation.”

Many analysts have suggested that the inflation spike seen across developed economies in early-to-mid 2021 is “transitory” – a combination of base effect after the pandemic downturn in 2020 and the impact of one-off shocks in specific areas.

Transitory in this sense could mean either that the areas of price elevation ease as the global economy continues to reopen, or that these prices remain high but do not increase further or cause the type of vicious circle that would spark persistently elevated inflation.

Market participants are more concerned about the longer term than a brief inflation spike. Hamlyn explains: “Inflation this year is more or less baked into the cake. What we would be concerned about is any indication that inflation is going to be materially higher than expectations over a really long period. This would be contrary to most market participants’ outlooks and would require a large revision in financial-market pricing.”