Context
Inflation in Australia (and the rest of the world) took off after the COVID pandemic, after an almost 30-year period of lowish inflation.
It was initially stoked by lockdowns (which reduced spending and increased savings) supported by government payments to mediate the economic impact of the pandemic. It was further exacerbated by supply constraints associated with restarting global supply chains and the war in Ukraine (a large global food producer).
Australia has seen two phases to this inflation story. Initially, it was hit by increasing goods prices (related to global supply constraints). Subsequently services prices increased as price increases were built into the input costs of the (largely domestic) services sector. Services sector inflation remains elevated. [Note: The most recent print of goods inflation in this chart is affected by measurement issues discussed below].
Internationally, Australia was (perhaps 6 months) late to the post-COVID inflation peak. We have been further behind the US curve when it comes to its decline, and return to target.
Uniquely, and at the urging of the Government, the Australian central bank took a softly-softly approach to tackling inflation. Interest rates were raised later and not as hight as comparable countries, The objective was to minimise the impact on the labour market of fighting inflation (ie. to protect jobs). As a result, core inflation remains well above the target range. Australia is the only Anglosphere nation not to have reduced interest rates after the current inflationary cycle.
Going forward, my baseline expectation is that price growth will continue to slowly moderate back to the target range by the middle of the 2025. This is consistent with the view of the Australian central bank in their latest statements on monetary policy (SOMP).
My expectation is that we will see two central bank policy rate reductions, each of 25 basis points, from the current 4.35 per cent to 3.85 percent (which would leave interest rtes on the slightly restrictive side of neutral). I expect these will occur in May and August, but there is some likelihood (say 30%) that the first rate cut might occur in February 2025. There is also a small chance (say 30%) we will see a third 25 basis point reduction towards the end of 2025, leaving interest rate policy close to a long-run neutral setting (which I have around at 3.5%, around 100 basis points above the long-run inflation target).
However, there are risks to this inflationary and interest rate prognosis, and they are mostly on the upside. These risks (discussed below) are:
- low productivity growth
- reduced population growth
- low GDP growth and stagflation
- international uncertainties
Productivity growth
Productivity refers to the outputs that an economy produces for a given set of inputs. Productivity growth over the long run puts downwards pressure on inflation and allows for wage growth to exceed inflation. It underpins an improved standard of living. At the moment, we are in a productivity growth slump. GDP per hour worked in Q3 2024 is much the same as it was in Q3 2016.
The consequence of a productivity slump is less headroom to accommodate wage increases without causing inflation. So what does wage growth look like? With the Wage Price Index (WPI) growing at 3.5 per cent per year (3.2 per cent annualised), in the context of low productivity growth, it is worth keeping an eye on.
Reduced population growth
The labour market is tight and may be tightening. The latest print has the unemployment rate at 3.9 per cent. Although I would be cautious with taking this latest print as confirming a trend, it is worth keeping an eye on.
Why keep an eye on it? First, there is a short-run relationship between the unemployment rate and inflation known as the Phillips curve. So far it has been heading in right direction for inflation to return to the target band. However, a tightening labour market could see inflation increase.
Second, we have maintained a low unemployment rate - around 4 to 4.1 per cent - over the past year in the context of record population growth. If the rate of population growth slows now, it might make the labour market even tighter (putting upwards pressure on inflation). Unfortunately, the different measures of population growth from the ABS have conflicting stories.
Low GDP growth
Growth in the Australian economy is stagnating. Apart from the pandemic, it lower than it has been since the beginning of the post 1990s low inflation era.
While we are not experiencing 1970s style stagflation, we are are facing some of the same policy conundrums. Some people want lower interest rates to restart the economy. Others are concerned about inflation, and believe we should be cautious about lowering rates (and perhaps even raise rates for a period). It is the same conundrum that left interest rates too low for too long in the 1970s and 1980s. Again, something to keep an eye on.
International uncertainties
Inflation in Australia is correlated with global inflation. In this context, it is worth noting the US 10-year bond has risen a percentage point since early September. The bond market expects interest rates to rise under Trump (implicitly, they expect higher inflation). The global inflationary head-winds may prove challenging in 2025.
Conclusion
Inflation should continue to moderate in 2025, allowing the Reserve Bank the opportunity to lower interest rates. However, I would expect only two or three interest rate cuts in 2025, and I would remain alert to the risk of further inflationary pressures.
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