After a few wobbles, disinflation has resumed in peer economies. Why should Australia be any different?
Recent inflation data overseas has reminded market participants that sticky inflation need not imply stuck inflation. After a few wobbles, disinflation has resumed in the United States, Canada and New Zealand.
Expectations of near-term cuts in policy rates have therefore come back into frame in the United States and New Zealand; the Bank of Canada has already started cutting, as have the ECB and several other European central banks. Our Chief Economist in New Zealand, Kelly Eckhold, has changed his rate call and now expects the RBNZ to start cutting from November.
The logic behind all these central bank moves is the same. First, tight policy cannot last forever, else inflation would fall continuously and undershoot central banks’ targets. Second, because monetary policy affects inflation with a lag, the rate-cutting phase needs to start before inflation has reached target. Otherwise, policymakers will have acted too late. At some point before reaching target, therefore, central banks need to start reducing the restrictiveness of policy and head towards neutral. Australia is no different to its peers in this regard.
As we have previously argued, there is no reason for the RBA to move in lockstep with its peers. At times, the RBA and the Fed have even moved in opposite directions. But there are limits to divergence. In the current inflation episode, most of the surge reflected a common, pandemic-related shock. Most private sector forecasters expect inflation in Australia to decline into the 2–3% target range at a similar pace to the RBA’s own forecasts – though there are outliers. Anyone arguing that the RBA is a long way from cutting would need to show why Australia would not follow the same broad disinflation trend as its peers.
Common and uncommon shocks
Australia was later to open up after the pandemic than most other advanced economies, and so was later to see the surge in inflation. The RBA is also deliberately choosing a ‘not quite as high for a bit longer’ strategy, in order to hold onto the gains made in getting unemployment down. So there is good reason to expect the RBA to be among the last of the advanced economy central banks to start cutting rates.
The question is, how much later than its peers will the RBA move if the forces driving the inflation process are mostly similar?
There are some Australian-specific factors to consider, but they fall on both sides of the ledger. Housing-related costs are clearly an issue. Part of this is the result of pandemic-era supply chain issues lifting materials prices and so the cost of home-building, but that was a common shock. The catch-up surge in population after the international borders reopened was also common to some peer economies including Canada. This catch-up has boosted demand for housing, lifting both home-building costs and rents, but the boost to inflation – and the drag on productivity – will subside over time as population growth normalises.
A possible Australian-specific factor, as we have previously noted, is that home-building cost inflation has remained higher than in some peers. Recent headlines might suggest a partial explanation for this, though of course other Australia-specific factors could also be at play.
On the other side, though, pass-through of policy rates to lending rates is particularly strong in Australia; IMF analysis in its April World Economic Outlook highlighted this. And unlike some peer economies such as the United States and United Kingdom, growth in the labour supply has remained very strong, slightly outstripping that in labour demand. This is partly because recent migration has been even more skewed to working-age people than usual, so growth of the working-age population has outpaced that of the population overall. In addition, as noted by Westpac Economics colleague Ryan Wells yesterday, the participation rate among those working-age residents remains at historically high levels. Most measures of labour market tightness are well off their highs and wages growth in Australia has already peaked.
The Toyota ‘Five Whys’
The ‘Five Whys’ is a tool developed at Toyota for root-cause analysis. It boils down to asking ‘why?’ at least five times. If your first answer is that B caused A, ask why B happened. And then ask why that happened, and so on. This approach to understanding can be as useful in economics as it is in manufacturing.
In thinking about why the RBA policy path might differ from that of its peers from here, it is sometimes argued that inflation will remain stickier here because the RBA chose that ‘not quite as high for longer’ policy path.
The difficulty with that argument is that we are only talking about a percentage point or so difference in policy rates, for a year or so. Most models of the Australian economy – including the RBA’s main whole-economy model – imply that if the policy rate is 100 basis points higher for a year or so, the peak effect of this on inflation is a reduction of a little less than 0.2 percentage points, about two years later. (If this sounds small to you, you have just discovered the dirty little secret of monetary policy: modest changes in the level of policy interest rates or their timing have only a barely perceptible effect on the policy objective.)
The second ‘why’ then becomes: why would one think that 100 basis points should make so much difference now? Maybe it does, but what is the mechanism? What makes Australia so special, and why now, not at other times?
As we have previously noted, an unexpectedly ugly June quarter CPI result might make the RBA want to wait even longer. But would it be enough to convince it that Australia is on a completely different path to its peers?
The world has been confronted with some seriously unusual shocks over the past few years. And as we have seen over the past week, there are some situations where a small difference in position can make a huge difference to the outcome.
Looking through the noise, though, it is hard to see why those unusual shocks should play out so differently here than elsewhere.
Perhaps we need to remind ourselves that we are just not that special.
