CPI for Dec ’13 – “higher than expected”

The Consumer Price Index (CPI) for the December 2013 qtr was released last week. According to most media reports, the headline annual number came in “higher than expected”. The CPI is a significant data point because of how it impacts interest rate policy, which is a hot topic at the moment. So now that the Dec 2013 qtr data shows the growth in consumer prices moving into the upper half of the 2-3% band, there is all manner of speculation regarding potential interest increases.

It’s difficult to discuss CPI growth without mentioning monetary policy (interest rates) and the exchange rate. The objective of current RBA monetary policy has been to ‘rebalance’ growth in the economy – to drive growth in non-mining investment to help the economy transition from the resources investment boom. The RBA has lowered its benchmark rate to 1) stimulate greater non-mining investment and 2) break the back of a persistently high $AUD to improve the competitiveness of local manufacturers (and ability to compete with imports locally). The RBA is only just starting to get the lower dollar it has wanted and the dollar needs to presumably remain at this lower level for a while in order to generate the desired results. The problem is that lower dollar is likely to be part of the reason behind the higher annual CPI growth this qtr.

Firstly, a summary of the top line results;-

All Groups CPI (the ‘headline’ number) for December was +0.8% (Dec v Sept ’13 qtr) and +2.7% annual growth (Dec ’13 v Dec ’12). In September 2013, qtrly CPI was +1.2% and annual growth was 2.2%.

The seasonally adjusted CPI for December was +0.9% for the qtr and +2.6% annual growth. In the September qtr the seasonally adjusted CPI was +1.0% and 2.2% annual growth.

Either way you look at it, the result is the same – slightly lower qtrly CPI growth than the prior qtr, but annual growth in CPI moving higher.

The two measures of movements in the core CPI are the trimmed mean and the weighted median – both are used to measure underlying price changes by excluding volatile items. For the December qtr;

Trimmed mean (15% of the smallest & largest price movements are removed or ‘trimmed’) +0.9% for the qtr and +2.6% annual. In the September qtr the trimmed mean grew by +0.7% for the qtr and +2.3% annual.

The weighted median (price change at the 50% percentile by weight of the distribution of price changes) +0.9% for the qtr and +2.6% annual. In the September qtr, the weighted median grew by +0.6% for the qtr and +2.4% annual.

Source: ABS 

Core inflation measures are growing in line with the headline number (qtrly & annually) – which is difficult to see in the above chart. Which means CPI growth is not driven by outlier changes.

Whilst all three measures are well within the RBA’s 2-3% target range, the upward bias is what will have some people concerned. Not that the RBA can or will do anything about the rising CPI. The idea of raising rates at this time would not be good for the Australian economy and goes against the reason why the RBA cut rates in the first place.

During the Jun, Sept and Dec 2011 qtrs the trimmed mean was growing at 2.6%, 2.7% and 2.8% respectively, well into the upper half of the range. This didn’t stop the RBA from commencing cuts to interest rates. CPI growth promptly slowed once interest rate cuts commenced, driven by offsetting low(er) growth in the tradable component.

So far though, interest rate cuts have done little to boost non-mining investment, with the exception of housing finance, which is on its highs again. Unemployment and underemployment continues to grow – which, if it continues, will start to have a greater impact on consumer spending. There are only modest indications that the lower dollar is helping manufacturing. The AIG PMI for Dec ’13 showed that contraction resumed in manufacturing. The latest NAB Business Conditions Survey for Dec highlighted another decline in manufacturing business conditions and makes a special note that many are facing higher purchasing costs as a result of the lower dollar. Capacity utilization remains low in manufacturing (73%), but hasn’t deteriorated further. This low capacity utilisation, together with weak forward orders for manufacturing (-7) suggest little likelihood of capex growth in the near term.

So what are the sources of the growth in the CPI?

The following series measures the change in the contribution, by group, to the CPI.

Source: ABS 

There were four (4) main contributors to CPI growth in the December qtr –

Recreation & Culture (+0.24) – of which domestic travel & accommodation was the majority of the change. Note that there was not a big difference in the contribution between the Sept & Dec qtr (chart above). But the composition of the growth changed in the latest qtr. In the Sept qtr, International travel & accommodation was the bigger contributor to the CPI change. International holiday travel and accommodation continues to be a large contributor (albeit lower than in the Sept qtr) and domestic travel and accommodation has now become a bigger contributor to growth.

Housing (+0.12) – contribution of housing to CPI growth was significantly lower in the Dec qtr due to lower utilities and property rates and charges. There appears to be some seasonality related to utilities price changes (increases happen in the Sept qtr). The contribution of +0.12pts in the Dec qtr was due to changes in rents and the purchase of new dwellings by owner occupiers – both were in line with the increases of the previous qtr.

Alcohol & Tobacco (+0.12) – this was higher in Dec due to a 12.5% increase on cigarettes (from Dec 1 2013 and this price increase will be in effect each year for four years). Alcoholic beverages also saw an increase.

Food & Non-alcoholic Bevs (+0.25) – this was higher in the Dec qtr due to increases in fruit and veg prices.

There were very few categories that off-set these contributions to growth. One category that did not have as big an impact in the Dec qtr, as it did in the Sept qtr was the Transport category, namely, automotive fuels. It was one of the few categories to slightly offset price increases.

Contribution to the CPI over the full year by group;

Source: ABS 

Over the full year, housing, alcohol & tobacco and recreation & culture were the key contributors to CPI change.

Another way to look at the CPI is by looking at the breakdown between tradable and non-tradable 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.

Currency Movements
Before going into this detail, it’s worthwhile reviewing the movements of the AUD over this last period of interest rate cuts.

Depreciation in the AUD has been a major objective for the RBA over the last several years. RBA governor Glenn Stevens, “told the AFR in December that he would prefer the dollar closer to US$0.85c” (AFR, “80c ‘magic spot’ for $A” 25-27 Jan 2014). From the same article, “RBA board member, Heather Ridout says the dollar needs to fall to a “magic spot” between US$0.80 and US$0.85″. Under a FOI request, the RBA released documents on 28^th January 2014 “discussing what the RBA regards as appropriate levels for the exchange rate considering the needs of the economy”.

At the time of writing the Aussie dollar is at US$0.8809.

We started to see the exchange rate fall during the June qtr 2013;-

Source: RBA 

In the June 2013 qtr, the AUD fell by 11%, in the Sept qtr +1.3% and in the Dec qtr fell again by -4.8%. I’ve very simply taken the value of the $AUD at the start and end of the quarters to calculate the change.

On real trade weighted basis, we only started to see the big fall in the currency in the September qtr 2013 – this is the spike down in the latest observation below. This represented 6.6% depreciation.

Source: RBA

From the RBA – “The ‘Real trade-weighted index’ is the average value of the Australian dollar in relation to currencies of Australia’s trading partners adjusted for relative price levels, using core consumer price indices from these countries”. This likely provides a more accurate view of the impact of dollar movements on tradable CPI.

CPI Components – Tradable and Non-tradable

Again, looking at tradable and non-tradable components is another way to gauge the source of pricing pressures in the economy – and may be even more relevant as the AUD continues to fall against the USD.

A brief explanation of the two measures is below;

• 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. The ‘total supply’ of an item is domestic production plus imports
• Non-tradable component – the remaining categories (60% of CPI by weight), mostly services.

This view of the CPI continues to show pockets of pricing pressure in Australia. Annual growth in the non-tradable component of the CPI is running at 3.7%, slightly lower than where it has been. This higher non-tradable component has been offset by the (relatively) lower tradable component since mid-2011. But that situation has been changing recently:-

Source: ABS

Whilst the rate of growth in the non-tradable category has been fairly consistent, the rate of growth in the tradable category has been increasing since the June 2013 qtr. Given the depreciation of the AUD over the last year, it was likely that there would be some impact on price growth in the tradable category.

Looking at the contribution of both categories to the total CPI (annual), it does appear that there has been a shift in the source of price increases.

The contribution data is supplied by the ABS, and the addition of index points (not the index numbers) for both tradable and non-tradable categories sum to the All Groups CPI. The annual change in index points is calculated by subtracting Dec ’13 data from Dec ’12 data.

There aren’t enough qtrs of ‘contribution’ data to establish a long-term trend, but in the short term, there has been a shift in the annual change in contribution. This latest annual change has been the largest and it’s been the first time in a while where the tradable category added to CPI growth (+0.4pts) rather than offset growth in non-tradable categories.

Source: ABS

From an annual perspective, this may be an important shift.

Looking further into each of the categories shows the extent of the shift in the source of pricing pressure. It’s worthwhile reviewing the results of the same analysis for the CPI back in the June 2013 qtr to appreciate the extent of the shift.

Tradable Categories (items whose prices are largely determined on the world market (approx. 40% of CPI by weight), mostly imports)

Source: ABS 

Back in the June qtr, there were 24 tradable categories that had a negative contribution to the CPI (they offset price increases) – that has now reduced to 14 categories (and with lower values). On the flipside, the number of categories adding to CPI growth has increased from 10 to 15 categories. This change in breadth is a subtle shift that has happened behind the scenes, but is reflected in the growth of the trimmed mean and weighted median.

It’s likely that the depreciation in the AUD during this time has contributed to this shift. Categories such as international (and domestic) holiday travel were both larger contributors to CPI growth, mainly in the last two qtrs. The contribution of auto fuel jumped in the Sept qtr. Categories such as motor vehicles and audio visual continue to offset price increases, but to a lesser degree than in the past.

On the other hand, the picture for the non-tradable items looks much the same as it did in the June qtr. There are very few categories that offset growth – most non-tradable categories contributed to CPI growth – 33 out of 40 non-tradable categories.

Source: ABS 

The majority of the price growth still comes from the top few categories. The top six non-tradable categories contribute 53% of the increase. These are purchase of new dwellings by owner occupiers, rents, medical and hospital, domestic holiday travel and accommodation, electricity and property rates and charges. These six (6) categories also represent 41% of the weight of the non-tradable index, so would have a fairly broad impact on households.

Given that the non-tradable category is mostly service based and domestically focused, price growth in this category is sometimes thought to represent growth in labour costs. Whilst Australia does have relatively higher unit labour cost, current wage growth is at a low (wages growing, but at one of the slowest rates). The some of the main categories driving the non-tradable growth higher are not really labour intensive eg new dwelling purchases of owner occupiers, rents and electricity. Lower interest rates are more likely to be the driver of growth in the housing component in this group.

So what are the implications of this CPI report?

1. RBA and interest rates – a worrying feature of the economy is the continued, albeit modest, rise in unemployment and underemployment. Lower interest rates have helped to spur housing, but not non-mining investment. With the dollar only just approaching its “magic spot”, it’s unlikely that the RBA will raise rates at this time. The challenge for the RBA will be to balance low interest rates and CPI growth. At the moment, the scales are tipped in favour of supporting demand through maintaining low interest rates.
2. Real interest rates based on the official cash rate, are now negative. As CPI grows, it will eat further into the returns of savers and those on fixed income. This may act as prompt to seek out higher risk sources of income/return. For a current account deficit country, the worst case scenario is that if CPI does continue to grow, interest rates may have to rise in order to attract capital.
3. The question remains over the ultimate success of interest rates to stimulate non-mining capex and investment. So far, the only lending that has been substantially impacted is housing finance (mostly swapping established dwellings for higher and higher prices), which has not grown the productive capacity of the economy, nor has it improved the labour market.
4. Currency depreciation will have positive and negative impacts on the economy. Whilst it will help exporters and those locally competing with cheaper imports, it will likely increase the cost of inputs into production – the PPI will highlight the extent of this change. We are starting to see the impact of higher prices in tradable categories in the CPI, but at the same time, our manufacturing industry continues to contract. A comparison of unit labour costs among our leading trade partners (excl China) highlights the relatively higher labour costs in Australia (we are one of the highest). A lower dollar is aimed at offsetting that relatively higher cost. Ultimately the RBA may be required to perform some magic in order to keep the AUD in its ideal US$0.80 to $0.85 range. As central banks in emerging markets are finding out, this is not something in their control.

Employment & Output by Industry in Australia

There are four key themes in our business and economic news at the moment. In no particular order;

1. The state of manufacturing in Australia
2. The shift from the mining investment boom to the mining export boom
3. Impact of the strong $A on Aussie business, especially manufacturing, exports and retail
4. The housing market

Are these issues receiving a disproportionate amount of airtime? To what degree is our economic performance really tied to these industries? Frequent and emotionally charged media coverage can influence our perception of just how big some issues really are. So it’s time for some context.

I thought that it would be helpful to post the breakdown of employment & output by industry in Australia to understand the relative size and importance of each sector.

Whether you look at these issues through the lens of employment or output, industries such as manufacturing, mining, retail and housing are important to our economic wellbeing. There are a few surprises too.

Employment by Industry

These first two charts look at total employment by industry (in actual 000’s of persons) and how much that employment has changed over the last year (growth/decline in 000’s of persons).

Source: ABS, 6291 – latest data is Feb 2013

Change in Employment by Industry

Source: ABS, 6291 – latest data is Feb 2013. 

The employment figures have moved a lot over the last three months, but this data will give a good sense of the relative size of employment by industry.

Top five (5) Australian industries by employment; Health Care, Retail Trade, Construction, Manufacturing and Education.

Health Care & Social Assistance – our largest industry by employment size, it accounts for 12% of total employed and was one of the largest gainers in total employed over the last year with +35k persons growth. From an output perspective, it represents approx. 6% of output (gross value added or GVA). Output growth in the sector has also been well above real GDP growth +6.5% (second fastest growth industry behind mining).

Retail Trade – accounts for 10% of total employed, with growth of +12k persons over the last year. From an output perspective, retail trade accounts for a smaller 4% of total GVA/output. Growth in output is just above growth of real GDP at +3.5%. From an aggregate perspective, this isn’t a bad result. Given the issues facing retail and the performance of key retailers, I fully expected to see both employment & output share declining. It’s possible that one or two states could still be keeping the aggregate numbers higher. This will be the focus of another post.

Construction – accounts for approx. 7.3% of total employed and employment in this industry is still growing year on year by +11k persons. The red flag is output – construction is the 4^th largest industry by output/GVA and output is growing well below real GDP at +1.4%. This is possibly a sign of the times with mining investment, & investment generally, slowing down and reduced public sector investment spending.

Manufacturing – The exception to the employment growth story was manufacturing. Currently the 4^th largest industry by employment, manufacturing employment declined year on year at Feb ’13. The decline in manufacturing employment appears much smaller than I would have expected on a year on year basis (-3k persons), given the seemingly constant reports in the media and the poor Performance of Manufacturing Industry (PMI) reports. The most recent PMI reports do point to an improvement in manufacturing – potentially linked to a lower Australian dollar.

Over the last ten years, the number of persons employed in manufacturing as at February has averaged 1.024m. As at Feb 2013, employment in this sector is at 954k, or -7% below the ten year average. Total employed in manufacturing as a share of total employed persons in Australia has consistently declined since the early 80’s;

Source: ABS 

The decline in manufacturing employment share of total employment is not a recent thing (see chart above). This means growth in manufacturing jobs has not kept pace with total employment growth during this entire period. This is evident when you look at the raw numbers of persons employed in manufacturing;

Source: ABS

Between 1984 and the end of 2007 total employed in manufacturing bounced around above one (1) million in a reasonably consistent manner. From the end of 2007 we start to see a pronounced declined in actual total persons employed in manufacturing.

It’s hard to have one blanket reason why employment in manufacturing is falling in Australia –lack of competitiveness (including dollar movements), greater automation of previously labour intensive tasks and/or lower demand (especially post GFC). But even now at 8% of people employed in Australia, manufacturing is still a very important industry. From an output perspective, manufacturing is our 5^th largest industry, accounting for 7% of total GVA/output. But that output declined year on year by -1.4%. Similarly, the share of manufacturing output to total GDP has more than halved since 1974. As a share of exports, manufacturing represents approx. 10% (year to Mar ’13, chain vol, seas adjusted), so again, a reasonably significant amount.

Education – is the 5^th largest industry by total employment, employing just over 900k persons. It’s also been one of the fastest growing in terms of employment growth with +43k persons employed over the last year. From an output perspective, education accounts for approx. 4% of total output/GVA, but growth has been well below real GDP growth at +2%. This is potentially a red flag for future employment in the industry.

Employment has grown on an annual basis in all of the top five industries except manufacturing. From recent posts on employment, we also know that PT employment is growing faster than FT and it’s likely that service-based industries such as retail trade, education and health care could be driving this growth in PT jobs.

What the top 5 industries look like in terms of share of total employment;

Source: ABS

The decline in manufacturing share of employment is clear. The two most significant gainers in employment growth have been in the Construction and Health Care industries.

What’s missing in this list is mining. Whilst the data suggests it’s a small proportion of total employed (2.2%) there are two things to consider. One is that mining is relatively concentrated in two/three key states – WA, QLD & NT. Secondly, the total numbers quoted here under ‘mining’ don’t take into consideration the impact on the support industries such as science, engineering, transport, construction etc. No doubt the mining investment boom has required greater value added resources from other sectors in the economy. As the shift moves from investment to export focus there is likely to be an impact (negative) on employment and wages.

Output by Industry – Share of Real GDP

This set of charts looks at Australian industries by their share of real GDP and their growth in output (as measured by Gross Value Added). This will provide a sense of just how important some industries are to the total output of our economy. When combined with the employment data, we can ascertain the importance by output and employment.

Source: ABS

Change in Output by Industry

Source: ABS 

The top five (5) Australian industries by output – as measured by share of real GDP – mining (adding exploration & support services), financial services, ownership of dwellings, construction and manufacturing. These top five industries accounted for a whopping 41% of total real GDP over the last year.

Mining – is our number one industry with 10% share of real GDP. A recent RBA paper on the Industry Dimensions of the Resources Boom suggests that mining share of output is closer to 18% when the value added of industries that provide inputs to resource extraction and investment, such as business services, construction, transport and manufacturing are included. Output growth is the highest of all industries with growth of 9% (when mining is combined with exploration – exploration is only approx. 0.8% of output). From an export perspective, mining (metal ores & minerals, coal, coke & briquettes, other mineral fuels and metals ex non-monetary gold) represents 66% of total goods exports (for the year to Mar 2013, chain vol, seas adjusted). Despite accounting for such a large share of output and exports, share of employment is much lower at 2% (higher if you include support industries of course). Growth in employment was +6.5k persons over the last year, which still paints a reasonably rosy picture of the state of the mining industry. Most recent figures show a distinct uptick in unemployment in WA and indeed, the employment numbers point to a recent decline in total employed persons in mining;

Source: ABS 

On the back of lower export prices, mining profits have been declining. Major infrastructure & new mining projects have also been cancelled. For the moment, export volumes remain strong although slower growth in the Chinese economy is expected to impact those exports in the future. As the shift moves towards export rather than investment, and in light of falling prices, the focus in the industry will be to minimize costs in order to boost profitability. All these factors could combine to result in slowing exports, reduced investment, lower salaries and less employment associated with mining. This is not a good outlook for our biggest industry by output and exports.

Financial Services – accounts for 9.6% of GVA and has been growing at well above real GDP at +4.3%. Despite that, employment has declined over the last year by -13k persons. The industry accounts for 3.5% of employed persons.

Ownership of dwellings – In the system of National Accounts “owner-occupiers of dwellings, like other owners of dwellings, are regarded as operating businesses that generate a gross operating surplus (GOS). The imputation of a rent to owner-occupied dwellings enables the services provided by dwellings to their owner-occupiers to be treated consistently with the marketed services provided by rented dwellings to their tenants. Owner-occupiers are regarded as receiving rents (from themselves as consumers), paying expenses, and making a net contribution to the value of production which accrues to them as owners. GOS for ownership of dwellings is derived as gross rent (both actual and imputed) less operating expenses (but before the deduction of consumption of fixed capital). An estimate of GOS for dwellings owned by sectors other than households is deducted to obtain GOS for dwellings owned by persons.” (Source: ABS)

So our ownership of dwellings accounted for 7.5% of National output and is growing at just below real GDP at 2.7%. Note that this imputed value doesn’t net out outstanding debt associated with those assets. Ownership of dwellings isn’t an industry that increases the productive capacity of the economy (of course, unless you are building new dwellings etc.) or drive productivity improvements. But it does give you an idea of just how big ownership of dwellings is in our economy. The Australian economy has become more and more reliant on trading established dwellings for greater and greater value, and all the while notching up greater and greater debt within the economy.

According the latest Census data (2011) 67% of households are owner-occupiers;

Source: ABS Census 2011

This is made up of 34.9% who ‘own’ with a mortgage and 32.1% who own their homes outright (for a total of 67%). In the 1996 Census, 66.4% of households were owner occupiers where 25.5% ‘owned’ with a mortgage and a much higher 40.9% owned their home outright. There has been a clear shift to more people owning with a mortgage = greater debt. This does not include any investment property data.

Construction – It’s one of our largest employers as well as one of our largest industries by size of output (see earlier comments). Share of total GVA hasn’t really changed all that much over the last 40 years. Construction has gone from 6.8% share of real GDP in 1974 to 7.2% share in Mar 2013, hitting a peak of 7.5% share in June qtr. 2011. The AIG Construction Outlook is for lower growth in construction. This is already playing out in the most recent output & employment data.

Manufacturing – although still a large proportion of our total output and employment, manufacturing in Australia has been declining in importance for many years, aided in part by the dismantling of various tariffs. If we can’t compete on the world stage (or even our own stage) without subsidies, then should we even be in that that industry? Couldn’t those resources currently tied up in manufacturing be used in more productive endeavours? For an interesting discussion on the importance of manufacturing, see full article here. It suggests that;

“Productivity is the key to national standards of living. Only through productivity growth do we sustainably increase our competitive advantage, capital formation, incomes and employment. Manufacturing accounts for a huge slice of productivity potential in all economies. Without it, any economy will struggle to generate long term high productivity growth. Mechanisation, improved processes, innovation and technical progress are the bread and butter of productivity growth. They simply do not exist to the same extent in services, nor, for the most part, in mining (though the runoff in the boom will be good for the next few years)” (source: www.macrobusiness.com.au)

From an export perspective, manufacturing represents just over 10% of goods exports (for the year to Mar 2013, chain vol, seas adjusted) – made up of machinery, transport equipment and other manufactures. This is only slightly down from its high of 14% in the June 08 qtr. As a share of total goods exports, manufacturing had grown steadily until the GFC. If share of local manufacturing has been declining, then it’s likely that locally made goods are being substituted for imports (for various reasons). Some of the hardest hit local manufactures have been in textiles & clothing;

Source: ABS 

Overall, our top five industries by output do in fact tie in with the central themes of manufacturing, mining and housing. Unfortunately, it’s not all positive. The decline in manufacturing share is prominent, but then so is the growth in share of mining & finance.

Source: ABS 

So there are at least three key industries in Australia that account for a high proportion of output, employment and/or exports – mining, construction and manufacturing. The outlook for these three sectors is not particularly positive;

• Our (re)new(ed) PM, Kevin Rudd has bravely claimed the end of the resources investment boom. What lies ahead for mining is unclear. Exports are forecast to remain strong, but that mostly hinges on what happens to Chinese demand.
• The RBA is looking to construction to fuel the next leg of growth in Australia. But where will that construction investment come from? Housing? Household mortgage debt is already high and this doesn’t improve the productive capacity of the economy anyway. Business? Well, mining investment appears to have peaked and non-mining investment has been flat and is forecast to decline slightly. Public? Public investment is unlikely in the face of government tightening, unless there is a major push behind a stimulus package.
• Manufacturing is the other major industry that accounts for a large share of output and employment. For the moment, it seems that as a country we are happy to continue to let this industry slide despite the potential productivity benefits that could be delivered.