Analysis: Risk of Low Inflation for Longer from RBA’s Flexible Inflation Stance

• Published on
• 30 Oct 2019, 07:18 AM

By Sophia Rodrigues

Flexibility in meeting the inflation target is a good thing except that too much of anything, including flexibility, may be a bad thing. And that’s exactly what is happening with the Reserve Bank of Australia which has been following a flexible inflation targeting regime.

The biggest threat to Australia’s inflation outlook is inflation itself, or more specifically, past inflation. So allowing inflation to remain below the target band for too long means the threat is increasing. The sooner the RBA recognizes this and seeks to get inflation back in to the target band faster, the less work it would have to do on the monetary policy front – conventional or unconventional.

The risk increases because within the RBA’s forecast horizon there are two key headwinds to inflation.

HOUSING GROUP A WORRY

Data published by the Australian Bureau of Statistics earlier Wednesday showed headline CPI rose 1.7% y/y in Q3, slightly faster than 1.6% in Q2 but remained below the RBA’s target band for 18 out of the last 20 quarters.

The 0.5% q/q rise in headline CPI was due to a 6.1% q/q rise in travel and accommodation, a 3.4% rise in tobacco, a 2.5% rise in property rates and charges, and a 2.5% rise in child care.

But there were some concerning details in the data. The most important one was the housing group which rose 0.3% q/q, making it the slowest Q3 rise since 1998.

Significantly, the data showed how the lower inflationary environment of the past few years is impacting the housing group which has the biggest weighting in the CPI of around 23%.

For the third straight year, the annual change in property rates and charges showed a modest gain, rising just 2.3%, compared to historical increases over 4.0%. The modest rise is due to a lower inflationary environment, and rate caps in some capital cities which again, is a reflection of low past inflation.

Housing rent rose just 0.4% y/y in Q3 for the third straight quarter, and posted less than 1.0% gain for 15 quarters in a row. There is a risk of a further slowdown in rental growth, that could make Q4 the slowest y/y rise on record. Low past inflation is one of the factors contributing to slowing rents.

TOBACCO A KEY RISK

Perhaps one of the biggest risks to inflation is expected to come after 2020 from tobacco prices which has around 3% weight in the CPI basket and has been the single largest contributor to headline inflation for some time due to increases in excise duty. Specifically, this component alone has risen at an average rate of around 14% since 2015.

Deputy Governor Guy Debelle first discussed the tobacco contribution to CPI in a speech last year, pointing to the fact that the excise regime is set to end in 2020.

If the regime is not extended, it would have a significant impact on headline CPI, and is one of the biggest risks to inflation outlook. If headline slows, there is a risk of further slowing in the housing group, and other components of the CPI that bear a close relationship to past inflation.

WAGE GROWTH COULD SLOW

Another risk to inflation is likely to come indirectly from the possibility that wage growth could slow from 2021 when the general superannuation guarantee rate is scheduled to rise to 10% from 9.5%, and every year after that until it reaches 12% in 2025.

Employers are likely to give a small increase in wages to compensate for the higher contribution to superannuation they have to make.

The RBA has repeatedly said an acceleration in wage growth is important for inflation to be consistent with the target band. Any slowing in wage growth is not just a risk to inflation but household income and consumption, and thus to monetary policy.

The RBA is likely to have factored these risks into the forecasts made in August, but given how past inflation feeds into future inflation, it may have to rethink whether it has given them enough weightage. Importantly, it may have to consider how long it can retain flexibility with inflation targeting.

--Email: sophia@centralbankintel.com