This week’s September quarter consumer price index result was great news for the economy. Although it won’t compel the Reserve Bank to cut interest rates on Melbourne Cup day next week, it does add to the Bank’s flexibility to respond as required in coming months if the economy takes a renewed turn for the worse – as I still fear it might.
But first the good news. The RBA’s two preferred measures of “underlying” inflation rose by only 0.3% in the quarter, and by 2.1% and 2.2% respectively over the year. That was a bit lower than market expectations, which centred on a 0.5% quarterly gain and annual underlying inflation of around 2.5%.
The fact that inflation remains contained despite a 20% decline in the Australian dollar vs. the US dollar – which should push up import prices – is not as surprising as it might seem.
For starters, history suggests that the pass through of higher import prices to final consumer price inflation is quite modest and can take at least a couple of years.
According to estimates by the RBA back in 2011*, a 10 per cent change in the exchange rate only changes overall consumer prices by around 1 per cent, with only one fifth of this effect taking place within a year. In fact, it takes up to 10 quarters – or just over two years – for 75 per cent of the effect to take place.
What’s more, unless this boost to prices lifts inflation expectations – thereby affecting wage and price setting behaviour – its effect on price growth (as distinct from the price level) should be fleeting. Given today’s highly competitive product and labour markets – and more settled inflation expectations thanks to the RBA’s steady hand in recent decades - inflation expectations are likely to remain quite well contained.
Note also the $A’s decline on broader trade-weighted basis has only been 13% in the year ending-September due to smaller declines against other currencies such as the Japanese Yen, Euro and New Zealand dollar. So all up, we might expect at most around a 0.25% hit to annual CPI inflation given the decline in the currency in the past year. And this effect would drop out of annual inflation calculations as soon as the $A began to stabilise.
Yet another factor to consider is that oil prices have declined by a long way, such that petrol prices in the CPI report were down 9.8% on year-ago levels. Given petrol accounts for around 3% of the CPI, that in itself takes off around 0.3% from annual inflation.
Last but not least, the RBA has previously noted that the pass through of exchange rate changes into local prices has been reduced over time – likely because larger global retailers (which are a growing force) tend to “price to market” rather than simply add a profit margin to their costs. So locally, retailers tend to charge what the market can bear, and tend to absorb swings in import costs in any specific country through their margins. Given the still somewhat sluggish state of the economy, retailers would be likely hard pressed to jack up their prices with ease.
Meanwhile, we are seeing the benefits of the weaker exchange rate flow through to the real side of the economy – most notably, so far, through a pick-up in tourism.
Here it is relative price levels that matter – so the cumulative decline in the $A in recent years is having a cumulative impact on international price competitiveness by gradually raising the cost of imports and making our exports cheaper in world markets. That fact that local inflation has not lifted means this exchange rate induced improvement in competitiveness is being maintained in real terms.
In view of the across the board lift in variable mortgage interest rates by the major banks in recent weeks, it’s possible that the RBA might decide to offset this impact on borrowers by cutting official interest rates next week – but I would not hold my breath. As Peter has noted recently, there are tentative signs of life in the economy emerging such that the RBA probably does not yet feel compelled to cut interest rates any further at this stage.
That said, I still worry about the economy outlook heading into next year. The risk of a serious drought is rising, which could slash up to 0.5% of economic growth through reduced wheat output. And by my estimates, the major banks will likely need to raise mortgage rates even further to preserve profit margins in the face of further required costly increases in their capital buffers.
And while the labour market is holding up well, prospects for business investment still appear bleak – with large declines in mining investment not being offset by any decent lift in non-mining investment.
It’s probably best the RBA guards its ammunition – as it may well need to use it to bolster sentiment should these longer term negative forces reassert themselves.
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