Ahead of next week’s latest inflation figures, the new governor of the Reserve Bank, Philip Lowe, gave his first speech on the topic of inflation and monetary policy. And while he remains concerned about entrenched low inflation, there seems little likelihood of lower interest rates in the near future.
Australia, like many other nations, is experiencing very low inflation growth. Because major economies throughout the world are intricately linked, high or low levels of inflation invariably occur at the same time across all nations:
Inflation across the OECD has for most of the last 20 years been relatively low, however most nations are currently experienced levels of inflation that are even below their 20 year average:
That doesn’t mean we are purely hostage to international forces, but they certainly play a role. Lowe highlighted this in his speech when he spoke of the reasons for our current low rate of inflation growth.
He noted that the fall in oil prices over the past two years has seen “the price of petrol in Australia has declined by around 20%” over the past two years. That alone “has lowered the year-ended rate of headline inflation by almost 0.4 percentage points over each of these years”. House prices by contrast increased the inflation rate by almost 0.4 percentage points:
Given that Australia’s national income is also very dependent upon commodity prices, the decline in oil and iron ore and (prior to the middle of the year) coal prices has seen our national income also struggle to grow.
But the greater interconnectedness of Australia with the rest of the world is also reflected in greater competition – and with that comes competition not just for lower prices, but also over labour costs.
Lowe noted that “increased competition has forced existing retailers to find efficiencies to lower their cost bases and, in turn, their prices.”
One major factor according to Lowe, is the increase in underemployment compared to unemployment (something I have recently noted) and that “that many of the people finding work recently have been employed in part-time jobs and report that they would like to work more hours”.
So combine low prices from abroad, increased competitiveness and an increase in the spare capacity of the employment sector and we have our current low inflation level.
It is worth noting that the current low level of inflation is not completely unusual. The RBA targets inflation between 2% and 3%, and while it has now been nearly two years since it was within that range, for two and a half years in the late 1990s inflation was also below 2%:
But there are a few differences between now and then.
One of the most obvious is that our economy is growing a lot slower than it was then. From September 1997 to December 1999, Australian GDP grew annually, on average, by 4.6% compared to just 2.6% in the period since December 2014 when inflation has been below 2%.
More marked is the difference between the growth of nominal GDP. Back then nominal GDP was regularly growing faster than 5%, whereas it is now four years since Australia experienced that level of growth:
The other big difference is the level of interest rates.
In December 1998, when the RBA cut rates to “offer some additional support to growth through the adoption of a more accommodative monetary policy stance”, it was cutting the cash rate from 5% to 4.75%:
At that time, the “real cash rate” was 3.25% (ie the cash rate was 3.35% point above the inflation rate). At the moment, the cash rate of 1.5% is just 0.5 percentage points above the CPI and remains 0.5 percentage points below the bottom of the RBA inflation target band of 2%.
It’s one of the reasons why, even though Lowe is concerned about entrenched low inflation expectations, that interest rates are unlikely to be cut, even if the next inflation figure out next week shows inflation to be below 2%.
Another reason is that Lowe is somewhat bullish that things are improving. He believes the bottom has likely been reached on low wages growth, and also that “domestic demand is expected to strengthen gradually” coupled with improvement in commodity prices.
As a result, the market has pretty much given up on the likelihood of another rate cut, whereas a month ago there looked to be around an 80% chance of another cut by this time next year:
Lowe’s speech also suggests a pretty smooth transition from the governorship of Glenn Stevens. Stevens, towards the end of his term, was rather clear about the declining ability of lower interest rates to stimulate growth.
Since Lowe has taken over, he has suggested both in his speech this week and his appearance before the House of Representatives economics committee, that he agrees with this position.
We have interest rates now at record lows, but unless something unexpected occurs, it would seem the RBA is not about to break that record any time soon.