Introduction to Inflation
The economy was shaken on Wednesday after the Bureau of Statistics released its new monthly Consumer Price Index (CPI) data. The data showed that inflation is not behaving as expected. Headline inflation came in at 3.8 per cent, while underlying or core inflation was at 3.3 per cent. This is higher than the Reserve Bank’s target range of between 2 and 3 per cent.
What is Happening with Inflation?
The Reserve Bank wants inflation to be "sustainably" within its target range, and ideally at the midpoint of that range (2.5 per cent). However, inflation had seemingly settled slightly above that midpoint earlier this year, but it appears to have been a mirage. The cost of electricity was a significant factor in rising inflation, with a 37.1 per cent increase in the 12 months to October. Rents also rose 4.2 per cent in the 12 months to October, following a 3.8 per cent rise in the 12 months to September.
An Economy Bursting?
To understand the inflation frustration, we need to get a bit abstract. The Reserve Bank says it doesn’t know for sure, but it believes aggregate demand in the economy exceeds aggregate supply. Economics textbooks tell us that when demand exceeds supply, prices rise. Independent economist Chris Richardson says, "Inflation is back because, even though the Australian economy isn’t travelling fast, its clapped-out engine is already moving faster than we can safely travel." He takes the engine analogy further, "With our engine clogged by poor productivity, we’re already back where we were a while ago — with inflation bouncing as too much money chases too little stuff."
Interest Rate Antidote
If the economy won’t expand to absorb the higher demand, guess what … demand needs to fall. Cue the potential need for what was unthinkable just a month ago: an RBA rate hike. This week saw several investment banks and commercial banks forecast the next move by the central bank would be to hike interest rates. The NAB said, "With growing evidence that the economy is close to bumping up against capacity constraints, we are confident in calling the RBA easing cycle as over." Barrenjoey sees an "uncomfortable persistence" to housing inflation, and services inflation, which makes it difficult to see trimmed mean inflation moving sustainably to 2.5 per cent.
Mortgage Borrowers Pay the Price
A quarter of a percentage point interest rate increase adds roughly $75 to monthly repayments on a standard variable loan with a $750,000 balance, over a 25-year term. This is a straightforward way of reducing the purchasing power of, and demand from, millions of Australian households. The alternative is to boost productivity, providing the economy with breathing room to grow and expand. The price for the nation’s ongoing poor levels of productivity is being paid, in large part, by mortgage borrowers.
Conclusion
In conclusion, the recent CPI data release has shown that inflation is not behaving as expected, and the Reserve Bank may need to consider a rate hike to control it. The economy is facing capacity constraints, and demand needs to fall to prevent further inflation. Mortgage borrowers will pay the price for the nation’s poor productivity levels. It is essential for the economy to boost productivity to provide breathing room for growth and expansion.
