Non-Tradeable Inflation

Declining consumer prices – March qtr 2016

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.

Source: ABS

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:-


Source: ABS

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.


Source: ABS

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.

Source: ABS

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:

  1. 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.
  2. 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.
  3. 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.
  4. 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.

Growth in wages & consumer prices still low

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.

Source: ABS

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:-

Source: ABS

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:-

Source: ABS

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:-


Source: ABS

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:-


Source: ABS

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.

Source: ABS

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.

Source: NAB

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


Source: RBA

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.

Source: ABS

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:-

Source: ABS

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:-

Source: ABS

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.

Source: ABS

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.

Source: RBA

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’.

 

Consumer prices and the Australian economy – September 2014

Not long ago, I wrote a post arguing why I thought GDP growth was too low. I outlined several reasons in support of this argument: 1) that the pool of unemployed persons has been growing for a duration similar to that of the early 90’s recession and 2) real income per capita was no longer growing. The recent release of Q3 2014 CPI data provides some further evidence supporting this argument. Where aggregate demand is growing faster than its potential rate, demand for resources generally places upward pressure on prices and unemployment declines. The release of Q3 CPI shows that consumer price growth in Australia has started to slow, with growth of core inflation now in the middle of the RBA range of between 2 and 3%. Over the last few quarters, annual CPI growth was at the upper end of the RBA band which seemed at odds with the idea that growth in Australia was too low. There were in fact suggestions that the RBA would need to hike rates. But quarterly CPI growth and other price measures such as wages, commodity prices and Terms of Trade (ToT) have been pointing to an easing in the level of price growth across the economy. Whilst a rate of core CPI right in the middle of the RBA range doesn’t sound like a problem, it’s in combination with indicators such as unemployment growth and income stagnation that point to this as another symptom of a bigger/broader issue.

This situation is not limited to Australia. Globally, price pressures have been easing, with growing concerns of emerging deflation throughout Europe, US, UK and China according to data recently published by The Economist (25th Oct 2014). It’s difficult to pinpoint just one reason for this phenomenon, but slowing global growth is a good starting point. For Australia, the reversal of the ToT boom has been a fairly significant factor associated with slower income growth, growing unemployment and now slowing price growth.

Highlights of CPI Quarter 3 2014

The Sept quarter CPI growth was 0.5%, the same rate of growth in the previous quarter. Quarterly growth at 0.5% is just below the average for Sept CPI growth over the last 10 years of +0.8%.

The quarterly growth trend has been slowing throughout the last four quarters:-

Source: ABS

The annual rate of growth slowed significantly in the Sept quarter from 3% to 2.2% (seasonally adjusted). This large slow-down in annual growth is partly the result of the shift to a higher base used to calculate growth – Sept 2013 quarterly growth was relatively strong at +1.2% (see chart above). That said, the quarterly growth since Sept 13 has been slowing, resulting in annual CPI growth closer to 2% – at the lower end of the RBA range – and reaching this point in a relatively short period of time.

The measures of core CPI growth provide a better guide as to the underlying price growth. Growth in measures of ‘core’ CPI, the trimmed mean and weighted median, eased somewhat in Sept and remain in the middle of the RBA range. The trimmed mean view of consumer prices is the main focus for RBA assessment.

Source: ABS

For the Sep 2014 qtr;

  • Trimmed mean (15% of the smallest & largest price movements are removed or ‘trimmed’) +0.4% quarter on quarter and +2.5% year on year (a slowing of the annual rate)
  • Weighted median (price change at the 50% percentile by weight of the distribution of price changes) +0.6% quarter on quarter and +2.6% year on year (no change in the annual rate)

The biggest contributors to quarterly CPI growth was in Food and Housing categories:-

Source: ABS

The biggest price pressures under Housing were Purchase of New Dwellings and Property Rates and Charges. Both offset the large -0.14 % pts decline in Utilities (Electricity) that also fall under this category.

There was one single significant contribution to growth in Food CPI and that was in the Fruit category.

The big turnaround for the quarter was the slow-down in Health costs, from +0.17% pts last quarter to -0.1% pts this quarter.

Overall, CPI growth is slowing, but for the most part is sitting right in the middle of the RBA range. Based on this, it’s unlikely that there will be pressure to raise rates.

But there is a broader context to this CPI report…

Back in Sept 2012, Assistant RBA Governor, Christopher Kent, gave a speech to the Structural Change and the Rise of Asia Conference titled Implications for the Australian Economy of Strong Growth in Asia. This speech laid out the broad set of factors effecting the Australian economy, namely the impact of economic growth in Asia (China) on driving our Mining boom. The most visible impacts in Australia were the rise in the ToT, an appreciating exchange rate and the growth or “reallocation of productive factors” to resources and resources related industries.

It’s relevant to revisit some of the points of this speech as they relate to the impact on prices and growth now that the positive ‘shock’ to the ToT has started to reverse and the economy has commenced the transition from phase II (investment) to phase III (production and export) of the boom.

“The positive shock to the terms of trade, resulting from a rise in commodity prices, increases income accruing to the resource sector and increases that sector’s demand for productive inputs. Both of these exert a measure of inflationary pressure.” Christopher Kent, RBA Assistant Governor, 19th Sept 2012

“Domestic inflationary pressures, associated with higher wages and incomes, will lead to higher inflation for non-tradable goods and services but, at the same time, the gradual pass through of the initial exchange rate appreciation will lead to lower inflation for tradable goods and services (whose prices in foreign currency terms depend to a significant extent on global considerations). In this way, the appreciation of the exchange rate helps to offset the inflationary impulse from the terms of trade shock, and assists in maintaining inflation in line with the inflation target.” Christopher Kent, RBA Assistant Governor, 19th Sept 2012

We’ve seen all of this happen in the Australian economy.

Firstly, the rise in the ToT generated higher income growth.

Source: ABS

Once the ToT started to appreciate, real GDI started to grow much faster than real GDP – the difference being the impact of the ToT. The ToT peaked during Sept qtr 2011 and is now 21% below that peak. While the ToT did peak, it is still well above its historical levels for the moment – but income growth has stalled nonetheless. More on this later.

Secondly, the exchange rate did appreciate during the investment phase of the boom.

Source: RBA

The real AUD TWI appreciated during the years between 2000 and 2011, with the exception of 2008/9 (GFC). Growth in the exchange rate started to slow from June 2011 but importantly, remained elevated until it peaked in March 2013. Since then, the real AUD TWI has fallen by 7%.

Finally, there was greater inflationary pressure in the non-tradable sector than the tradable sector (see definitions and detail of each here) during the period of the investment phase of the Mining boom.

Source: ABS

It’s hard to look at this chart and ascertain a ‘neat’ relationship between exchange rate changes and annual tradable inflation. The range for tradable CPI growth has been between +4% and -2% during this time, but has generally been lower than non-tradable inflation growth. This can be shown more clearly by reproducing one of the charts from the RBA speech – the ratio of non-tradable CPI to tradable CPI.

This first chart is from the RBA speech as it provides the historical context. The second chart is updated using the latest data (with as much history as available from the ABS).

This first chart reinforces that since the start of the ToT boom, non-tradable inflation has grown much faster than tradable.

The updated data show a fairly important change in that trend – non-tradable CPI growth started to slow from March 2013:-

Source: ABS, The Macroeconomic Project

This is an unusually long period of no change in this ratio, given the growth in non-tradable CPI during recent history. Prices are still growing, but at a slower rate and this is could be an important indicator of slower demand in the domestic economy.

Since June 2013, non-tradable CPI has started to contribute less to total CPI growth. In Sept 2014, non-tradable CPI made its lowest contribution to total CPI growth (contribution data is only available back to June 2012). Since June 2012, tradable CPI also started to have an increasingly positive contribution to CPI growth, but it too made a smaller contribution to CPI growth in the recent quarter. Both tradable and non-tradable CPI slowed in the latest quarter:-

Source: ABS

There are 47 categories classified as ‘tradable’ – which contributed +0.76% pts to CPI growth. In over half of those categories (26), prices are either flat or declining (YoY -0.39% pts), 17 categories contributed +0.31% pts and the top 4 categories contributed the bulk of the price growth +0.86% pts. The categories were Tobacco, Fruit, Vegetables and International Holiday & Travel. The increase in Tobacco prices is due to an excise increase.

By contrast, there are 40 categories classified as non-tradable, which contributed 1.58% pts to overall CPI growth. In only 12 out of 40 categories are prices flat or declining, contributing -0.26% pts to overall growth. The bulk of the growth in non-tradable CPI comes from the ‘middle’ 24 categories which contributed +0.94% pts. The top 4 non-tradable categories still punched above their weight adding +0.87% pts. The top 4 categories are (in order) Purchase of New Dwellings, Medical & Hospital Services, Rents and Other Services in respect of Motor Vehicles.

There is broader pressure i.e. more categories contributing to CPI growth, in the non-tradable sector and our housing market (new dwellings anyway) is driving one of the biggest parts of that growth.

This brings us to the present day – and we are now seeing the opposite effects take place as the ToT boom reverses.

As mentioned earlier, the ToT has declined by 21% from its peak and the most important thing about this in relation to the CPI is the impact on income growth. The most accurate representation of the income effect is to look at Real Net National Disposable Income (NNDI) per capita. During the ToT boom (2000-2011), growth averaged 2.9% (not including the GFC). Since the ToT peaked in Sept 2011, income growth has averaged 0%.

Source: ABS

In per capita dollar terms, real NNDI has declined by -2.6% since its peak in Sept 2011 (ToT peaked at the same time). This isn’t a huge drop (the chart above measures growth not the per capita value) and the decline is not a short and deep correction that you would see associated with a recession, but rather, income growth has stagnated (at best) over a somewhat extended period of time. Unfortunately, further declines in commodity prices are expected and this is likely to maintain pressure on income growth. If National income growth remains low, it’s likely that CPI growth, especially non-tradable CPI, will continue to slow.

Unfortunately, the exchange rate stayed high during the initial falls in commodity prices and the ToT (the ToT started falling from Sept 2011 and the real AUD TWI only started to decline from March 2013). Elsewhere in the economy, it’s likely that the final stages of the Mining investment phase, a continued housing boom (which requires some funding from overseas markets to maintain loan growth) and relatively higher interest rates in Australia since the GFC have kept the exchange rate higher than expected. This has placed some local non-resources industries and the resources sector (due to falling commodity prices and the scramble to cut costs) at a disadvantage. So far the real AUD TWI has only fallen by 7% and the AUD/USD has fallen by 20% but remains above the level that the RBA deems as its ‘magic spot’ of between US$0.80 and US$0.85 (SMH, IMF: Australian dollar should trade at ‘low US80¢'” 25-27 Jan 2014).

This is not a recessionary period and total output has not declined, but activity/growth has slowed. For the moment, income growth per capita has stopped, unemployment continues to rise and price pressures are starting to ease in the domestic economy as our ToT boom reverses and global growth remains low. This situation is likely to continue, if not become worse, as further falls in our ToT are expected. From a policy perspective, it’s unlikely, given this environment, that the RBA will increase interest rates in the short-term. Depending on the size/severity of changes in the ToT, it would be more likely that the next move in the official cash rate will be down.

The huge elephant in the room remains the ongoing strength of the Australian housing market.

 

 

Australian CPI for Q2 2013

The latest CPI figures for the June 2013 quarter were released by the ABS last week. The headline growth figures were slightly lower than reported in the previous quarter;

  • All groups CPI grew by 0.4% for the June 2013 qtr. (versus 0.4% in the Mar 2013 qtr.) and by 2.4% year on year
    • Growth in the previous qtr. Mar 2013 was 0.4% and 2.5% year on year
  • On a seasonally adjusted basis, all groups CPI grew by +0.5% (versus +0.1% in the Mar 2013 qtr.) and by 2.3% year on year
    • Seasonally adjusted growth in the CPI in the previous qtr. Mar 2013 was 0.1% and 2.5% year on year

Source: ABS 

Whilst the headline figures are reported in the media, there are two other measures of inflation that are reviewed by the RBA – the weighted median and the trimmed mean. The CPI is made up of a basket of household goods & services. Prices of items in that basket are sometimes subject to short term volatility eg; fruit & veg, which can distort the view of the underlying inflation trend. The trimmed mean and the weighted median are measures used to ascertain the underlying inflation trends. For the June 2013 qtr;

  • Trimmed mean (15% of the smallest & largest price movements are removed or ‘trimmed’) +0.5% quarter on quarter and +2.2% year on year
  • Weighted median (price change at the 50% percentile by weight of the distribution of price changes) +0.7% quarter on quarter and +2.6% year on year

Interesting that this month, the two measures of underlying inflation are moving to either side of the spectrum (red & green lines in the chart above). The trimmed mean is pointing to reduced price pressures and sitting at the lower end of the RBA’s 2-3% target range and the weighted median shows a stronger uptick in core inflation and continued rise in the trend (let’s see that little nugget raised in the media). So what does that mean? I read an interesting post that deals with this very issue. Coincidently, it was the only other post to raise the issue of the difference between the two measures of underlying inflation in the data released by the ABS. Basically, the trimmed mean is the better of the two measures and this is what the RBA prefers to look at as a guide to underlying inflation. The RBA paper covering this issue can be viewed here.

Based on the trimmed mean, inflationary pressures in the economy continue to weaken. In its own words, the RBA makes the link between weakening aggregate demand and reduced pricing pressure. This, together with a raft of other weak economic data, will likely pave the way for further interest rate cuts.

The main contributors to CPI changes during the June 2013 quarter were housing, health, clothing & footwear and alcohol & tobacco.

Source: ABS 

Over the full year to June 2013, housing, health and alcohol & tobacco were the main contributors to CPI change.

Source: ABS 

From these two charts it’s clear that housing (purchase of owner occupied dwellings, rents & utilities) & health care continue to be a source of price pressure in the economy (as well as alcohol & tobacco). The June qtr. reading on clothing & footwear is quite different to the annual trend – possibly due to a weaker $AUD? The impact of movements in the dollar is yet to be fully seen in the CPI.

We can gain further insight into the CPI by looking at the breakdown between tradeable and non-tradeable items/categories. This provides some insight as to the extent to which price changes are attributable to domestic factors (changes in labour costs, productivity) or international factors such as exchange rate movements or changes in supply and demand in overseas markets. Again, this is another way to gauge the source of pricing pressures in the economy. A brief explanation of the two measures is below;

  • Tradeable component – items whose prices are largely determined on the world market (approx. 40% of CPI by weight). Items are classified as ‘tradable’ if imports or exports represent at least 10% of supply of an item. The ‘total supply’ of an item is domestic production plus imports
  • Non-tradeable component – the remaining categories (60% of CPI by weight)

What I think is interesting about this view of the CPI is that it shows some pockets of pricing pressure in Australia. Annual growth in the non-tradable component is now running at 4.3%.

Source: ABS

This high level of non-tradeable inflation is off-set by the very low print (and continued decline) within the tradeable categories of -0.7% year on year. I’ve broken down each of the categories into their smaller component parts to get an understanding of which categories are driving price changes.

Tradeable – those items whose prices are largely determined on the world market (approx. 40% of CPI by weight). There are 47 sub categories in the tradeable group.

Source: ABS 

This is the contribution to CPI year on year which gives you exactly that – how each sub category contributes to the total growth in prices. An important point is that not all categories are weighted the same. In the case of tradeables, auto fuel, motor vehicles, tobacco and international travel and accommodation are the four largest categories, accounting for 30% by weight. Auto fuel and motor vehicles have been the major contributors to price declines over the last year (the largest by weight, but not the largest % change in prices). In the audio visual category, which is only 3% of the tradeable index, prices are down -12% year on year – one of the largest price decreases.

The question now is what impact does the recent decline in the $AUD have on these categories (given they are import/export exposed)? No doubt cars & auto fuel will likely see price increases as a result of a weakening $AUD. A good example is Qantas now increasing its fuel levy and airfares as a result of lower dollar and higher fuel charges (based in USD). The question is, to what degree will the other categories be impacted by a weaker $AUD? Tradeables are more likely (than non-tradeable) to be a larger source of price pressure as the $AUD weakens and this should become evident in the next quarter of data. But there are also competitive factors at work that could see prices, such as food, remain subdued. As long as the major retailers continue to battle it out for market share and sales (with subdued demand), prices may remain lower, possibly squeezing the margins of manufacturers/distributors further (via higher import costs). Higher prices (via imports) may result in decreased spending, especially in the more discretionary categories.

Non-tradeable – the remaining categories (60% of CPI by weight). As mentioned earlier, non-tradeable have been the key driver of price pressure in Australia.

Source: ABS 

The top four categories by weight are new dwelling purchases by owner occupiers, rents, medical and electricity. They account for 35% of the non-tradeable price index. It just so happens that electricity and medical also recorded the highest % price increase year on year. Rents and dwellings are growing above the average as well, which is driving the higher contribution of these two categories. But it’s the overall distribution of price growth that is also impacting non-tradeable inflation; 55% of the non-tradeable categories are growing faster than the average, but these 22 categories represent 64% of the index by weight. I would argue that it’s not higher labour charges that are responsible for the higher prices of the top four categories. Pricing pressure in these four categories is likely to remain, especially as the RBA cuts interest rates and irrespective of movements in the $AUD.

The policy response expected by the RBA is to continue to lower interest rates. Prices, overall, are edging lower, suggesting weakening aggregate demand. Will lower interest rates be enough to stimulate demand?

There are several points about the impact of lower interest rates:

1) The recent spate of interest rate cuts has started to break the back of the persistently high $AUD. Whilst good for exports (and local manufacturers and employment), it will increase the price of imports – I’d expect to see greater impact of a lower $AUD in the tradeable categories. As mentioned earlier, in an environment of subdued demand, there could be greater margin pressure placed on businesses that feel they cannot pass though price increases without seeing a fall in sales.

2) Lower interest burden on mortgage holders – this will reduce pressure on disposable income, affecting approx. 34% of households that have a mortgage (and countless others with interest-only investment property loans). Conversely, there are households (the number unknown) that also rely on interest income. A cut in rates will reduce the income of these households (and the savings rate has been going up). You would hope that it would balance out in the economy as a net increase in disposable income (it’s unclear that’s what will happen) leading to an increase in aggregate demand.

3) It’s likely that this cycle of rate cuts has kept demand for housing finance and hence real estate prices high (mostly via investors). This impacts all home owners by maintaining prices. But this will continue to keep the non-tradeable price growth high as well (new dwellings and rents are large components of the non-tradeable price increase). High levels of domestic household mortgage debt and deteriorating employment will act as headwinds to greater growth in house prices.

4) Lower interest rates have not yet appeared to stimulate investment spending in most quarters of the economy – this is one to keep an eye on.

Inflation in Australia – March 2013 Quarter

Last week the ABS released its quarterly CPI series for March 2013. Across various measures, inflation looks to be within the RBA’s range of 2-3%:-

Source: ABS 6401.06

The headline inflation figure (ALL Groups CPI) rose +0.4% (or +0.1% seasonally adjusted) quarter on quarter and +2.5% year on year. The RBA, in assessing its interest rate policy, looks mostly at the trimmed mean and the weighted median in order to understand ‘underlying’ price pressures;

  • Trimmed mean (15% of the smallest & largest price movements are removed) +0.3% quarter on quarter and +2.2% year on year.
  • Weighted media (price change at the 50% percentile by weight of the distribution of price changes) +0.5% quarter on quarter and +2.6% year on year.

Since mid-2008, the trend in the underlying inflation rate suggests that price pressures have been abating and we are appear to be moving more into the lower end of the RBA’s range (compared to where we were at the start of 2010).

Another way to look at the CPI series is to look at tradable v non-tradable items. This helps us to understand the extent to which price changes are attributable to domestic factors (changes in labour costs, productivity) or international factors such as exchange rate movements or changes in supply and demand in overseas markets.

  • Tradable component – items whose prices are largely determined on the world market (approx. 40% of CPI by weight). Items are classified as ‘tradable’ if imports or exports represent at least 10% of supply of an item.
  • Non-tradable component – the remaining categories (60% of CPI by weight).
  • The ‘total supply’ of an item is domestic production plus imports.

Source: ABS 6401.06

Price pressure in Australia appears to be driven by ‘non-tradable’ items. Over the last ten years, the non-tradable component of CPI has been running at an average growth of +3.8% – well above the RBA’s range. These are items in the CPI whose prices are largely attributable to domestic factors – so changes in labour, productivity, profits. Does this mean we are experiencing wage inflation? There are potentially factors other than wages driving these costs.

Delving into the detail of the non-tradables segment, its not the ‘labour-intensive’ categories contributing to price growth:-

Source: ABS 6401.11

The top four items (electricity, medical and hospital services, rents and new dwelling purchases by owner occupiers) account for 45% of the total non-tradable contribution to total CPI (of the last year). It’s very hard to see what might be driving these price changes without delving into each and every product/service category. Prices of two of the top four items (rents & housing) will be determined by returns or market prices. Electricity prices may have been impacted by carbon taxes (a one-off), although electricity prices have been rising since before then on the back on growing demand. My point is that labour prices may not be the driving force behind all of these price changes.

What is this data telling us about prices here in Australia? The average contribution of all other non-tradable categories (90%) is 1.5 index points each – this is not very high. If a household is exposed to each of these product or service categories, then the costs do add up. Most households would be experiencing the impact of electricity changes, but not all households are renters. If you are renter, you won’t be exposed to purchasing an owner occupied dwelling. Households won’t be exposed to each and every category. Some of these categories are discretionary, some are not.

If it is wages driving some of these costs, then somehow, that cost is being off-set or margins are being reduced. Look at the lowest ranking categories above – household staples of eggs, milk, bread and breakfast cereal. These are categories with high household penetration – yet there has been a slight deflationary trend in these prices over the last year. On the bright side, this could be due to improvements in productivity and those savings are being passed onto the retailer and then onto the consumer (although this is not likely in my experience).

I think this data supports the assertion that across most categories, pricing pressure in Australia is low. The exceptions are housing, electricity & medical services.

Looking more broadly at ALL the CPI categories, it may not be surprising to find that housing was the major contributing category to the total CPI change in the March quarter. This category includes rents, new dwelling purchases by owner occupiers, maintenance and repair and property rates and charges. In second place was education, possibly due to the start of the new school year (seasonality).

Source: ABS 6401.11

During the quarter, quite a few categories experienced price falls. Food (mainly fruit and vegetables) & non-alcoholic beverage prices have fallen. In the more discretionary categories such as clothing footwear, furnishings & household equipment, price pressures have also abated. Some of these categories have started to experience a rebound in retail sales (clothing & footwear), possibly as a result of price declines. There has been the assertion that, rather than discounting, these price changes are as a result of ‘convergence’ with global prices. If this is so, then we can expect to see growing margins.

Contrast these more short-term changes with the annual contribution to CPI by group (the same chart on an annual basis);

Source: ABS 6401.11 

On an annual basis, housing, utilities and health are the major contributors to inflation in Australia. But note that there are more categories overall making a positive contribution to inflation, albeit modestly.

Across all the major measures, inflation is still within the acceptable range in Australia.