Last week, the ABS released the March 2016 quarter CPI data. This was attention grabbing stuff with headline CPI falling -0.2% in March. Suddenly, we were in the grip of deflation and many news outlets were quick to latch onto this story. I’m the last person to joke about deflation. Asset price deflation is a very serious threat to our country because we are so highly leveraged and our financial system is ‘all-in’ on housing. I’m also less positive than most about economic growth and recent developments in the labour market. But not much time was spent looking through the CPI data before jumping straight to the “deflationary” headlines last week.
The deterioration in CPI growth between the last two quarters from +0.4% in the Dec quarter to -0.2% in the Mar quarter can be attributed to categories that have more external/international exposure, rather than categories that are more of a reflection of domestic conditions.
That doesn’t mean that domestic factors haven’t played a role in the slowing of CPI growth over a longer period of time. The economy has been growing at below trend/potential as it transitions from the peaks of the mining investment boom and especially since the terms of trade (ToT) started to unwind. This has been highlighted by the RBA for several years now and policy settings have been focused on supporting demand during this transition. But is this CPI print a reflection of how demand in the economy has deteriorated in the latest quarter?
Headline versus core CPI measures
The RBA does not tend to rely on the headline CPI figure in evaluating consumer price pressures for interest rate policy. The focus is more on measures of core inflation – the weighted median and the trimmed mean. Both of these remove the volatile items to provide a measure of underlying strength in consumer prices within the economy.
Annual growth in the trimmed mean has slowed to its lowest level and quarterly growth was +0.2% in March. Annual growth in the weighted median also slowed to its lowest level of growth of +1.4% and +0.1% for the quarter. Both measures are outside of the 2-3% average inflation rate.
Both of these measures have been trending lower for a while and the RBA has tended to ‘look through’ this slowing of consumer price growth. Throughout 2015, there were signs of improvements in the Australian labour market, despite lower wage growth, moderate economic growth and a weakening AUD. From the April board meeting, the RBA assessment was for “reasonable prospects for continued growth in the economy, with inflation close to target” (RBA Minutes April 2016). That was four weeks ago.
Do we still have ‘reasonable prospects for growth’?
In short, when demand conditions are weak, inflationary pressures are likely to be less. In other words, softer price growth, or price declines, are another way of assessing the strength of demand in the economy. The question is whether this CPI decline is indicating a slowing in domestic demand conditions enough to warrant further interest rate cuts.
The tradable v non-tradable CPI series provides the most important insight on price pressure in the economy
An insightful way of assessing the source of consumer price pressures is to look at the tradable versus non-tradable series of the CPI. Consider the example of falling fuel prices throughout 2015. Fuel prices have fallen globally and aren’t necessarily an indicator of a fall in our own domestic demand – we are a price taker in such commodities.
I’ve referenced this RBA paper before and its worth revisiting here – The Determinants of Non-Tradables Inflation. There are several important points:-
“Non-tradable items are exposed to a low degree of international competition. This includes many services that can (in most cases) only be provided locally, such as hairdressing, medical treatment or electricity. The prices of these items should be driven mainly by domestic developments. Therefore, inflation for non-tradable items should provide a relatively good sense of the extent to which demand exceeds (or falls short) of supply in the domestic economy.”
“Tradable items are much more exposed to international competition. This includes many imported manufactured goods such as televisions and computers, as well as some food items and services such as international travel. The prices of these items should be less influenced by conditions in the Australian economy, and more affected by prices set on world markets and fluctuations in the exchange rate.”
And a word of caution about these classifications:
“The RBA acknowledges that in practice, drawing a precise distinction between a tradable and a non-tradable item is difficult. The exposure of an item to international competition is both complicated to measure and a matter of degree. The Australian Bureau of Statistics (ABS) classifies an item as tradable where the proportion of final imports or exports of that item exceeds a given threshold of the total domestic supply. Any item not meeting this definition is classified as a non-tradable. In general, many goods are classified as tradable while nearly all services are classified as non-tradable.”
Throughout the last several decades, annual non-tradable inflation has grown at a higher rate than tradable inflation in Australia:-
Since mid-2013 though, non-tradable inflation has started to abate as the ToT has unwound and as income and wage growth has slowed.
When we break down the growth in tradables versus non-tradables to a quarterly basis, it becomes clear which area contributed to the much lower CPI print in the March quarter.
In the latest quarter, tradable CPI declined by -1.37%. That is a significant fall in just one quarter. On the other hand, non-tradable inflation increased by +0.45% in the quarter – but this is also still below the average for the last several years.
The trend over the last 12 quarters highlights the volatility of the tradable series (this is also evident in the annual series).
We can go a bit deeper. In the latest quarter, the index of tradable categories contributed -0.55% pts to the -0.22% decline in headline CPI. The non-tradable categories contributed +0.33% pts to the -0.22% decline.
Looking at CPI from this perspective suggests that it is less likely that the shift to a negative CPI in the March quarter came as a result of deterioration in demand, or events, within the domestic economy. It appears most of the ‘deflationary’ pressure came from those categories that are more exposed to international competition.
Where did the tradable deflation come from?
Tradables reversed from contributing +0.19% pts to CPI in the Dec quarter to detracting -0.55%pts to CPI in the March quarter. Many categories classified as tradable contributed to this reversal – there were twenty six (26) categories where the change in contribution slowed between the two quarters – that’s over half of the categories classed as ‘tradable’, so the slowdown in price growth was broad. The largest contributors to this reversal came from four (4) main categories:
- Tobacco price index in the Dec quarter contributed +0.26%pts to CPI growth. In the Mar quarter, price growth slowed and only contributed +0.03%pts. This was the single largest contributor to the -0.78%pt decline in tradable inflation between the two quarters. The tobacco federal excise tax biannual tax indexation came into effect 1st Feb 2016.
- Automotive fuel price index contributed -0.18%pts in the Dec quarter. This decline accelerated to -0.31%pts in the Mar quarter. Fuel prices look to have stabilized for now.
- Int’l travel accommodation price index contributed +0.6%pts to CPI growth in the Dec quarter. This reversed to detracting -0.5%pts to CPI growth in the Mar quarter.
- Fruit price index contributed -0.03%pts to CPI growth in the Dec quarter. This accelerated to -0.13%pts in the Mar quarter.
These top four categories were -0.57%pts of the -0.78%pt deterioration in price growth between the two quarters. There were 12 categories where price growth accelerated and 9 categories where there was no change in growth between the two quarters.
Non-tradable growth has been low in historical terms throughout 2015, but did pick up in the March 16 quarter. Nearly half of all categories classed as non-tradable recorded an acceleration in price growth in the latest quarter – this acceleration was broad based. The largest contributors were medical and hospital charges, secondary education, childcare, household fuels including gas and restaurant meals. There were ten non-tradable categories where price growth slowed between the two quarters, but there was only one large one – domestic holiday and travel, which went from adding +0.16%pts to CPI in Dec quarter to detracting -0.05%pts in the Mar quarter.
The notable slow down on the domestic inflation front has been from a slowing contribution from new dwellings and rents. This has been a function of slowing income/wages growth, a tightening of lending standards for housing to curb riskier lending by banks with regard to investor/interest-only mortgages and a general slow-down in housing demand, especially in key mining areas.
What is it saying about the economy?
The split between tradable and non-tradable inflation over the March and Dec quarters suggests that the decline in CPI was not led by the domestic economy. But growth in non-tradable inflation has been lower than average for a while and it is fair to say that this is a reflection of spare capacity in the economy.
The RBA has asserted that ‘transition’ (from mining) will be assisted by wage restraint, stimulatory interest rate policy and a lower dollar (“Managing Two Transitions”, Deputy Governor Philip Lowe 18 May 2015). Based on this, there are several important considerations for the RBA in assessing interest rate settings:-
Wage growth and the labour market – over the last 12 months, spare capacity in the labour force especially, has been reduced, as evidenced by an improved LFPR, a decline in the unemployment rate during 2015 and generally stable levels of GDP growth. Some of the lower wage pressure can be traced back to a rotation out of much higher paying mining-related jobs that may no longer exist into more average-wage jobs. From the last board minutes, the RBA expected a softening of labour market conditions, given the improvement throughout 2015. My last labour market update highlighted that momentum in the labour market is waning. Without accelerating employment growth, lower wage growth will place a brake on domestic spending and demand.
Housing and credit growth is likely to be an issue. A crack-down on lending standards, a focus on increasing bank capital buffers, and in some cases higher overseas funding costs, has led many lenders to raise mortgage rates and slow their investor mortgage lending – the opposite of stimulatory monetary policy. This is going to weigh on the RBA decision making. House price appreciation has been slowing and is falling in some markets. It’s another story altogether whether banks pass through any further rate cuts.
A lower AUD has been one of the key pillars to support the shift toward non-mining industries especially services exports. The strengthening in the AUD/USD since February could be cause for concern for the RBA. This has been partly driven by the US Federal Reserve putting the brakes on further US interest rate hikes. This has weakened the US dollar against most major currencies, but has also helped to stabilize global financial markets.
The minutes from the April meeting on monetary policy certainly opened the way for monetary policy to be “very accommodative”. The ultimate question is whether another rate cut is the stimulus that the economy needs to kick start growth again. Overall lower-than-average trend growth persists, not just in Australia, but globally. The RBA Governor asks whether we are ‘reconfiguring’ to this lower trend growth (“Observations on the Current Situation”, Glenn Stevens, 19 April 2016):
“That would help to explain why ultra-low interest rates are not, apparently, as successful in boosting growth in demand as might have been expected. The future income against which people would borrow looks lower than it did, not to mention that the current income against which some already had borrowed has turned out to be lower than assumed”
“If we could engender a reasonable sense that future income prospects are brighter, that there is a good return to innovation and ‘real economy’ risk taking, and so on, then people might use low-cost funding for more productive purposes than just bidding up the prices of existing assets”
In addressing the issue of lower trend growth, the RBA is also pointing to the need for more action on other policy fronts to support monetary policy.
“It is surely time that policies beyond central bank actions did more in this regard”
There may not be enough evidence just yet for another rate cut, but it’s likely to be a matter of time.