The latest data on consumer prices and wages for the March 2015 quarter highlights that price pressures across the economy continue to abate. Headline CPI growth for the March quarter, and for the year to March 2015, was very low, mostly as a result of the large fall in fuel prices over the previous two quarters. Adjusted for outliers, the measures of core or underlying price changes have remained fairly stable and are just below the middle of RBA 2-3% target range. Over the last few years, CPI growth has been trending down and this latest CPI data is in line with that trend – still reflecting softer demand conditions. Wage price growth confirms that weaker demand for labour still exists despite some recent indications that there has been a pick-up in the labour market.
In the past I’ve argued that slower CPI growth was one piece of a bigger picture showing that the Australian economy has been growing too slowly as it transitions away from the investment phase of the mining boom. While some argue that economic growth is reasonable at current levels, unemployment and underemployment have continued to grow and income growth has stalled as a result of significant falls in the Terms of Trade (ToT). Hampering the transition for the non-mining sector, has been a persistently high AUD despite the falls in the ToT.
Across a range of indicators there isn’t much evidence of inflationary pressure in consumer prices the economy, although there is some risk that further falls in the AUD will result in higher imported inflation.
Underlying CPI growth remains in the middle of the RBA range and is stable
The headline measure of CPI for the quarter grew by a mere 0.3% and by +1.33% over the year (seasonally adjusted). That’s a very low level of CPI growth and sits well outside of the RBA’s 2-3% band. But the large outlier in that data is the fall in fuel prices over the last two quarters.
The trimmed mean and weighted median, which are the preferred measures of core or underlying price growth trends, removes these types of outliers. The chart below reveals that while headline CPI growth has slowed considerably, both measures of core CPI sit well within the RBA band, ticking up slightly in the latest quarter:-
Annual growth of the weighted median is now +2.43% and the trimmed mean is a little lower at +2.32% – the trimmed mean is the preferred measure of the RBA.
On a category basis, we can start to get an idea of the outliers driving this much lower headline figure:-
Over the last two quarters in particular, petrol has had the single largest negative impact on headline CPI. Falling fuel prices have helped to offset growth in prices across a range of categories. Fuel is also a production input.
Unfortunately, continued declines in fuel prices are not going to last. According to official data collected by the Australian Institute of Petroleum for the week ending the 3rd May 2015, the benchmark price for fuel in Australia (Singapore prices for 95 Octane petrol) has increased by approx. 20% since it bottomed in late January/early February 2015. This will likely show up in the next quarter CPI – reducing the stimulatory impact on both households and businesses.
Growth in Education in the latest quarter is largely the result of seasonal factors (start of the new school year).
Housing (mostly the purchase of new dwellings) continues to contribute to price pressure throughout the domestic economy. Of all the categories that make up the CPI, the purchase of new houses by owner occupiers has made the largest contribution to growth in the CPI in the last year of +0.64% points of the 1.4% point increase.
Strangely enough, the only categories that didn’t contribute to price growth over the last couple of quarters were those with some exposure to the recent falls in the AUD – Communication, Furnishings & Household Equipment and Clothing and Footwear all have high imported content. Some more on this shortly.
An insightful view of the drivers of price pressures in the economy is that of tradable versus non-tradable categories. This helps to isolate the price changes in the domestic economy (“non-tradables”) from those impacted by global exchange (“tradables”). Changes in non-tradable CPI is thought to reflect changes in the domestic economy such as labour costs and productivity.
Non-tradables continue to be the main contributor to CPI growth
During the investment phase of the mining boom, higher demand for labour and other productive inputs placed greater pressure on prices in the domestic economy (“non-tradables”). As we transition to the production phase, non-tradables continues to be the main contributor to CPI growth but domestic price pressures are now well below the decade long average, picking up somewhat in the latest quarter:-
More than half of the domestic price growth in non-tradables over the last year is coming from a concentrated core of four categories – these are: Purchase of New Housing by Owner Occupiers, Medical and Hospital Services, Rents and Domestic Holiday and Travel.
The growth in non-tradable CPI is likely to have more to do with the ongoing rise in house prices (new home sales in this case), fuelled by none other than lower interest rates.
Separating out price changes for goods versus services is also a good way to ascertain the role that labour might be playing in driving consumer prices (services contain a higher labour cost component). Historically, prices within the Services component of CPI have grown at a faster rate than Goods, but that trend has shifted over the last three years:-
Looking at the change in prices for market goods and services ex volatile items, growth in Services prices has slowed, especially over the last year, and at the same time growth in Goods CPI has increased. Both are now growing at the same rate annually, around 2%. This suggests far less pressure from labour/wage growth within the economy.
Growth in wages remains at record lows
Last week the ABS released the Wage Price Index data for March 2015 and this confirmed that wage growth continues to slow down. Wages are growing at the slowest rate since data collection on this series commenced. If you use core CPI to deflate the series, then real wages are not growing at all.
The slowing wage growth data confirms that tight labour market conditions are not driving domestic price growth.
The latest slowdown in the growth of wages is widespread across industries. Only a handful of industry sectors recorded either no growth or an increase in the annual rate of wages growth between December and March quarters. These were: Info media & telecoms (0% pt change), ‘Other services’ (+0.07% pt change) and Mining and Retail Trade wage growth declined only slightly by 0.1% points.
In a speech earlier this week, Deputy RBA Governor, Philip Lowe stated that “restraint in aggregate wage growth” will assist in the transition of the economy as mining investment declines and we look to non-mining activity to fill the void. Restraint in wage growth may be required, but current low growth is the result of the relatively high levels of unemployment and underemployment that currently exists in the labour market – in other words, less demand for labour. The RBA is focused on doing what it can to support business via lower wage growth, a lower dollar and lower interest rates in the hope that this will lead to higher employment growth. As the economy is experiencing, these measure take time to embed. That said, there have been some encouraging signs of improvements in the labour market. Mostly, there has been improving levels of male participation and, for the first time in a few years, there have been consecutive months of a slight reduction in the total number of unemployed persons. These have been welcome improvements, but they have been moderate at best. There still remains significant excess capacity in the labour market, which is why wages growth continues to slow. If this improvement in key labour market metrics continues and accelerates, we may start to see growth in wages, but only once some of this excess capacity is reduced.
While lower growth in wages may help to improve the competitiveness of local business, in the short term it could also limit consumption growth and borrowing capacity.
In the past, lower growth in wages could easily be ‘supplemented’ with a dose of debt-driven consumption via lower interest rates. Forces are combining to place pressure on this model working as successfully as it did in the past – interest rates are already low, household debt is already high both as a % of GDP or as a % of income, wages growth is low and importantly, concerns about unemployment are at high levels. The recent NAB Quarterly Consumer Anxiety Index for March 2015 shows that consumer spending intentions in the face of these challenges are focused on non-discretionary items.
Increases in intentions to pay off debt and to save/add to Super and investments highlights a more conservative approach to spending and consumption. Yet at the same time, intentions between the last two quarters have also increased for ‘use of credit’. This suggests some pressure already on the household budget – especially given the obviously low, and falling, level of spending intentions in the more discretionary areas (eating out, entertainment, personal goods etc.). While these pared back intentions are likely to keep a lid on consumption growth, a reasonably favourable Federal budget seems like it could boost confidence.
“It is, however, unlikely to be in Australia’s long-term interests to engineer a consumption boom by encouraging people to borrow large amounts against future income. This is especially so when debt levels are already high and prospects for future income growth are not as positive as they once were”, Deputy RBA Governor, Philip Lowe, 18 May 2015, Managing Two Transitions
Despite falls in the AUD, tradable CPI growth remains low even after adjusting for fuel
Since the start of the decline in the ToT (during the Dec 2011 quarter) the AUD has remained persistently high. The RBA has continually tried to talk down the AUD, claiming that it was overvalued given the large falls in the ToT and commodity prices. The AUD peaked back in mid-2011 and remained elevated for some time (above parity with the USD). The most substantial falls have occurred during two periods 1) early-mid 2013 and 2) Aug 14 to Mar 15. Since its peak, the AUD has fallen by 30% against the USD and is currently trading at around US79c – the RBA wants the AUD lower, closer to US70c in order to provide support for non-mining export and local importing competing industries.
“The Australian dollar has declined noticeably against a rising US dollar over the past year, though less so against a basket of currencies. Further depreciation seems both likely and necessary, particularly given the significant declines in key commodity prices. “RBA Governor, Glenn Stevens, May 2015 Statement on Monetary Policy Decision
On a trade weighted basis, the AUD has fallen by approx. 20% and the AUD trade-weighted exchange rate index, adjusted for relative consumer price levels has fallen by approx. 15%.
From a prices perspective, the theory goes that as the currency falls, import prices rise. The surprising thing is that there has been less negative impact on tradables than expected, given the declines in the AUD so far. According to the Westpac 2015/16 Budget Report (page 12), import prices are not as heavily weighted to the USD as our exports. According to Westpac, approx. 70% of our exports are denominated in USD.
Several trade exposed categories have in fact experienced ongoing deflation i.e. technology products. Upon closer inspection, there is some evidence that imported inflation has been picking up.
In March 2015, annual CPI increased by 1.4% points over the year prior. This increase was made up of non-tradables contributing 1.77% points to that increase and tradables contributing -0.37%points to that increase. As mentioned, the decline in contribution of tradables over the last two quarters has been driven by lower fuel prices.
Even adjusting for the decline in fuel over the last 2 quarters, tradables would continue to make a smaller, albeit positive, contribution to overall CPI growth. The contribution of automotive fuel to the total CPI has been quite stable over the last several years (prior to the recent fall in oil prices), so the average back to June 2011 is fairly representative. Using this average in place of the actual index for fuel over the last two quarters shows that tradable CPI would still be making a smaller and slowing contribution to overall CPI growth.
Going back to the examples of consumer durables with high imported content – motor vehicles, furniture & furnishings, clothing & footwear and audio, visual & computing equipment, the view of the RBA is –
“for much of the past five years or so the pace of deflation for these items had been more than expected given movements in the exchange rate, partly as a result of a reduction of margins along the supply chain“, Source: RBA Statement on Monetary Policy, May 2015 .
Work completed by the RBA on retailer margins (RBA Statement on Monetary Policy – Recent Developments in Retail Prices and Margins, February 2014) suggested that retailer margins had not been decreasing and instead retailers had more success in negotiating lower prices via wholesalers, bypassing wholesalers altogether within the supply chain and/or sourcing cheaper alternatives globally. Pressure not to pass on higher import prices to consumers is also the result of softer trading conditions domestically. There is evidence to suggest that local firms have taken advantage of improvements in technology and global wage disparities to source and deliver cheaper products, even in the face of a falling AUD. For example, retailers such as Target, K-mart or H&M can import ladies t-shirts manufactured in Bangladesh, retail them in Australia for $5 a unit and make a profit – rather than source them locally.
Looking at the Import Price Index, there is clearly some price pressure within these categories as a result of the recent fall in the AUD. The point is that some of the price pressure from a lower AUD doesn’t show up in the CPI – which doesn’t mean it isn’t there. In the latest quarter, Fuel was the off-setting factor, but most other categories, especially the larger categories by weight/import volume, saw increases in import prices. In fact, the two largest categories by weight in the index – Misc. Manufactured Articles and Machinery & Transport Equip made the largest contribution to the overall increase in import prices in the latest quarter:-
The price index for Machinery and Transport Equipment, which accounts for over 40% of the import price index by weight, jumped by 5% in the latest quarter. This category is made up specialised machinery for industry, power generating machinery, telecoms, road vehicles (including air cushion vehicles), electrical machinery and other transport equipment. The correlation between the change in import price and the change in the AUD is strong at -0.89. This is how the relationship has been trending:-
The other significant contributor is Misc. Manufactured Articles, which accounts for approx. 14% of the import price index by weight. This price index increased by 5.4% in the latest quarter. As the name suggests, this category includes misc. articles such as Furniture, Clothing, Footwear, Prefab Buildings and Structures, Professional, Scientific and Controlling Instruments and Photographic and Optical Goods, among other things. Again, the correlation between changes in the AUD trade weighted exchange rate and import prices for Misc. Manufactured Articles is strong at -0.91.
For the moment, the AUD remains at around US79c, which will keep further import price increases low for now. But it also might take some time for the effect of recent falls in the AUD to make their way to consumers via higher prices as supply agreements are renegotiated etc.
Inflation expectations remain low compared to historical averages
On balance, inflation expectations have been trending down and remain below historical averages. This reflects expected lower wage growth, excess capacity in the economy and lower economic growth. This is likely to keep expectations for future interest rates low.
As we transition from mining investment boom to the production phase, growth has slowed and this has resulted in excess capacity across the broader economy. Lower CPI growth and higher unemployment reflect these relatively weaker conditions. Is growth likely to improve? The economy has received several boosts recently – a significant, and somewhat unexpected drop in fuel prices (which is now reversing), a fall in utility pricing related to dropping the carbon tax, a decline in the AUD and two further interest rate cuts so far in 2015. It would be difficult to argue that these have not had some positive effect on various parts of the economy – house prices aside. The economy certainly hasn’t fallen into a heap, but despite these measures, the outlook remains soft. How much powder do we really have left should things worsen from here?
- Employment, demand and confidence are already soft – a worsening in any of these elements could hit a tipping point.
- The Government deficit is already high and any requirements for a solid stimulus spend might see the AAA rating removed.
- Household debt is already high and with wage growth slowing, there is less capacity for households to take on more debt to stimulate the economy.
- To that end, interest rates are also low and seem to be losing their ability to generate a productive investment response outside of housing speculation. But interest rate cuts are good for households strapped by mortgage repayments.
The one area of potential is business. Debt levels remain well below historical levels, so there is capacity to take on debt to invest. The federal budget was certainly favourable to small business – at least in encouraging small business to go out and buy (on credit) equipment to write-off immediately. There may be a good sugar high from that. The effect of falls in the AUD on local competitiveness will likely take some time to manifest. Fingers crossed business decide now is the time to ‘have a go’.