Inflation, inflation, inflation… it all comes back to inflation.
Special issue
For the past 21 years we have produced “The Big Issues” – a report highlighting the issues to watch over the coming year.
Each year we have identified around 8-10 issues that we thought would dominate economic or financial market attention. And last year was no exception with eight indicators discussed and dissected.
But this year is different…
This year we thought about all the possible issues, but they all seemed to come back to just one – Inflation.
For instance, we could pose the following questions and they all lead back to inflation:
- Where are interest rates going? It depends on inflation?
- Will job markets remain tight? The worry is that wages will rise, leading to higher prices.
- Will supply-chain issues be resolved? The worry is that inflation stays higher for longer.
As always we encourage you to assess the following discussion on your own terms, regularly posing the question “So what”? That way you constantly assess what it all means for you and your business.
So to the first key point…
It’s global
One of the key factors driving inflation rates higher over the past year is Covid-19. More specifically, the fact more and more people caught Covid, causing them to stay home, and therefore prevented businesses from producing the things we want – cars, phones, computers – you name it.
Production was – and still is – being disrupted, but demand (spending) has remained healthy.
In other words, we were hit by a good old fashioned imbalance between supply and demand. Too much demand and not enough supply has pushed up prices for the goods.
In part, this came about because central banks and governments were perhaps too successful at keeping people in jobs and in keeping businesses in business. Interestingly, the unprecedented success that the world’s bio-medical researchers had in producing a vaccine for Covid actually contributed to the supply-chain problems.
And because people kept their jobs and they couldn’t travel, they bought more goods – especially at on-line retailers and other businesses. But the factories, trains, ships, planes and delivery vans have struggled to get the products to where they were supposed to go.
The good news is that supply (production) is catching up with the demand for goods. And demand (spending) is slowing, being checked by higher interest rates (and the higher prices of the goods themselves).
But if we are going to get on top of surging inflation rates, we need to see continued progress over the coming year. Otherwise, central bankers will have to be even more aggressive in lifting interest rates.
The Ukraine war didn’t help…
The inflation problem wasn’t helped by Russia’s invasion of Ukraine in February. Prices for a raft of commodities rose sharply and held at the higher prices for a number of months.
Prices lifted for commodities such as oil, gas, wheat and oilseeds. In fact crude oil posted a gain of 40 percent in the space of seven days.
While bad news for the world’s motorists, as always the double-whammy arrived in the form of higher transport and distribution costs.
The OPEC+ oil cartel could have responded to the initial surge in crude oil prices by lifting production quotas. On March 2, OPEC+ concluded that “current oil market fundamentals and the consensus on its outlook pointed to a well-balanced market” lifting production by just 400,000 barrels per day over April.
Oil prices averaged US$92 a barrel in February and US$108 in March and averaged US$98 in the period since.
Looking ahead, OPEC+ has shown no inclination to pump more oil onto global markets, a move that could stem inflation pressures and reduce the risk of recessions in developed economies.
Investors should keep a close watch on OPEC+ decisions on production quotas and the response to events such as recessions in major economies. Clearly OPEC+ has a key role in alleviating inflation problems and providing the groundwork for central banks to lower interest rates.
The response by global central banks…
During the latter months of 2021 and early months of 2022, the view from a number of central banks was that the spike in inflation would prove temporary.
The US Federal Reserve didn’t start lifting rates until March. But after starting slowly, the Fed has been aggressively lifting rates in the period since.
A similar story in Australia with the Reserve Bank not starting to lift interest rates until May 2022. But the 2.75 percentage points lift in cash rates in six months ranks alongside 1994 as the most aggressive rate hiking cycle on record.
Why the rush? Central banks are worried that the size and speed of the lift in global inflation rates must be met with the same aggression by central banks in quickly moving to tighter policy settings.
The issue now for central banks is judging when the rate hikes should stop. Unless central banks get on top of the inflation problem quickly then the high rates of inflation may become locked in.
But if they lift rates too high, too quickly – and leave rates too high for too long – then economies could face recessions.
The US Federal Reserve got a positive surprise on November 10 when the October consumer price index results printed well below forecasts.
But clearly, 2023 is going to be a long year mixed with successes and setbacks. Central Banks will have to be vigilant with their actions and verbal commitment to push inflation down to levels closer to 2-3 per cent.
What is the ‘normal’ or neutral rate?
Central banks generally say that they don’t know for certain where the ‘normal’ or neutral policy rate sits. That is, the level of interest rates that neither speeds up nor slows down the economy.
The Reserve Bank is apparently working on a ‘neutral’ cash rate near 2.5 per cent. At the current cash rate of 2.85 per cent, the RBA believes that rates are close to where they need to be to appropriately slow the economy to a sustainable growth path as opposed to ‘crunching’ the economy.
Commonwealth Bank Group economists believe the ‘normal’ rate is closer to 1.5 per cent. The level of debt taken on by home borrowers as well as significant upcoming fixed rate home loan maturities, should lead to a sharp slowdown of consumer spending in 2023.
The US Federal Reserve has lifted the federal funds rate to 4 per cent and shows few signs that the ‘pause’ level for rates is close by.
At some point central banks need to refrain for lifting rates to judge its impact on the economy. Finding that ‘sweet spot’ for cash rates will be the key to getting on top of inflation and not sending economies into recession.
Inflation expectations: The key battleground
Many in the community must be asking “What’s the rush?” Why are rates being lifted so quickly and so aggressively? It gets down to the fact that our economy recovered so quickly from the pandemic-driven slowly. And it has been a somewhat similar story in other countries, although arguably our improvement has been stronger and faster.
Effectively, central banks and governments were successful in keeping economies moving. And the development of a vaccine in super-quick time was also a key factor in the recovery, and then the emergence, of supply-chain difficulties.
So central banks had to quickly get interest rates back to normal. But that is only part of the story. If central banks dragged their heels, then there was a greater chance of inflation getting locked in at higher levels.
If businesses and landlords see that inflation is 7 per cent and then lift prices and rents accordingly then there is a greater risk that inflation gets locked in near 7 per cent.
Central banks must not just lift rates to slow down the economy, but they must constantly warn that they will do what it takes to get inflation back to desired levels. In Australia, that is 2-3 per cent. In the US, it is 2 per cent.
In 2023, all eyes will be on inflation readings, but also they will be very much focussed on surveys or financial market indicators of inflation expectations. If inflation rates and expectations of inflation stay stubbornly high, the central banks will lift rates even higher, raising the risk of recessions occurring.
And then there is the tight job market…
Before the pandemic – back in December 2019 – the jobless rate sat an 8-year low of 5 per cent. In the pandemic, the jobless rate quickly rose, hitting a 22-year high of 7.5 per cent in July 2020. But then the massive stimulus kicked in, especially JobKeeper. And the vaccine enabled economies like Australia to re-open.
By June 2021 the jobless rate had returned to 5 per cent. And it didn’t stop there, quickly falling to 4 per cent in the next eight months and then hitting 48-year lows of 3.4 per cent in July and October 2022.
The tight job market is a reflection of the cyclical strength of the economy, absence of migration and people leaving jobs voluntarily (such as the “great retirement”). However there is also a key broader structural issue – the ageing of the population.
In the US, UK and Australia, unemployment is near the lowest levels since 1974. The ‘baby boomers’ cohort continues to leave the job market, with another 5-7 years before the process peaks. The problem is that other generations such as GenX, GenY and Millennials are not filling the void left by the ‘baby boomers’.
The generational transition provides a complication for governments and central banks. But Australia is looking to alleviate the shortfall of workers by upping the 2022/23 migration program to 195,000 visa places. The question is – in the ‘living with Covid’ world – will the workers come?
The good news element of the structurally-tight job market is that aggressive rate hikes may not lead to soaring unemployment rates. Economies may slow, not slump, but still cause inflation rates to ease.
And higher wages…
Central banks are rightly concerned that high rates of inflation can become ‘locked in’ via a change in inflationary expectations. That is, the higher the rate of inflation, and the longer that it remains above the inflation goal, the greater chance that it will become accepted.
One of the other great fears associated with high rates of inflation is a ‘wage-price’ spiral. For instance a supply shock like the supply-chain issue that pushes annual inflation to 7 per cent. Unions and other employee groups then press for a wage increase above 7 per cent on the fear that their standard of living could be de-graded.
The 7 per cent wage growth then fuels ‘demand-driven’ inflation by forcing up prices even further on goods in short-supply. As a consequence, the inflation rate may rise to 8 per cent or higher, sparking fresh wage claims.
So far, Australia has not experienced significant, economy-wide agitation for higher wages in response to headline inflation rates above 7 per cent. But the longer that inflation rates stay high, the greater the fear by employees that they are falling behind, or they would be likely to fall behind in the near future.
Couldn’t happen in Australia? In March quarter 1975 the annual inflation rate stood at 17.6 per cent. In the previous quarter the average wage (male wage at that time) hit a stunning annual growth rate of 28.3 per cent before easing to 26.9 per cent in the March quarter.
It took the recession of 1990/91 to bring the inflation rate down to around 2 per cent. In fact in September quarter 1992, annual inflation stood at 0.8 per cent with wage growth at 3.1 per cent.
Will this indeed be one of the frequently-discussed issues of 2023? It really depends how quickly inflation rates respond to rate hikes and ‘jawboning’ (open mouth operations) to quickly bring down the inflation rate to ‘normal’ levels.
And finally…complications
In theory, central banks should be successful in reducing inflation rates to target levels. In Australia, that is the goal of reducing annual inflation to a 2-3 per cent range. That is a flexible range. The goal is a medium-term goal – to be achieved on average over time. Inflation can undershoot and overshoot the range but should be broadly in the range on average over time.
The US Federal Reserve wants to get inflation back to near 2 per cent. And other central banks have broadly similar goals with a few tweaks thrown in.
But what if a new issue came around that complicated the goal of getting inflation effectively ‘back to normal’. As with most things, businesses, governments, central banks and investors must have contingency plans.
What happens if Covid re-appears – indeed the discussion at present is that a fourth wave of the virus is taking hold. In the ‘living with Covid’ world, that means treating it like a cold. If you can go to work, then good. If not, you take a few days off.
But if new strains become deadly, that complicates the situation. Do you bring back restrictions on movement, work, sport, hospitals and crowded areas more generally? How does monetary policy respond? Inflation is high – do you stimulate or constrain growth of economies?
This introduces the element of stagflation – slow economic growth and relatively high inflation – last seen in the 1970s. Can you have both economic growth and low inflation in a world where supply is again restrained but where the starting point is generationally-high inflation and still relatively low interest rates?
It is a scenario that no one wants to see played out.
Rewind: The Big Issues for 2022
As we noted at the start of this report, we have been producing the Big Issues report annually for the past 21 years.
It is interesting – and perhaps even instructive – to rewind over the past year and assess what we had on the radar in December 2021.
Looking ahead into 2022, we highlighted eight issues. And the first issue was “Living with COVID-19”.
And while that was a key focal point in 2022, if we had our time over we would selected “Inflation” as issue number one. Inflation was issue number seven on last year’s list, but clearly it became a global concern very quickly. The implications have spread across the globe. Supply-chain issues became dinner party conversation and a new war between Russia and Ukraine sent commodity prices soaring.
Issue number two for 2022 was “Winding back stimulus” and indeed that quickly became a key consideration as inflation took over, and it became clear that the price hikes were unlikely to prove transitory.
Issue number three was “Regional Renaissance” and it attracted plenty of discussion, especially in the context of “Living with Covid” as people decided the new lifestyle that would work for them.
“China” has never been too far away from the top of our Big Issues reports. And in 2022 there was much discussion about the ‘zero Covid’ policy adopted by China that has led to sharply slower economic growth. Again, the implications of its policy has been widespread, with knock-on effects across companies and continents.
Numbers five and six on last year’s Big Issues list were “Climate Change” and “Jobless Rate: How low can it go?” Climate Change will always be a focal point while there are problems to be solved – so that issue is ongoing – especially with Australia’s east coast hit by persistent flooding.
But in terms of the jobless rate, it fell from 4.2 per cent to a 48-year low of 3.4 per cent in July and then again in October. So, quickly the discussion has progressed to whether “full employment” has been achieved. And as we’ve discussed in this year’s report, the discussion is on-going.
As mentioned, issue number seven for 2022 was “Inflation: Just transitory?” The question did the rounds in the early couple of months of the year. But it was then replaced by questions about how high could inflation lift and how quickly interest rates needed to rise to get it under control.
Finally “Migration” was heard more and more as the jobless rate fell and supply-chain issues abounded. On September 2, 2022 the new government did announce that the planning level for the 2022/23 permanent Migration Program would increase to 195,000 places.
“Migration” was even included in the economic forecasts for the October 2022 budget with the government forecasting net overseas migration of 235,000 for both this 2022/23 year and the following year.
Last year we also highlighted a raft of topics we called “Talking Points”. Indeed the issues popped up over 2022, although for some, just for brief periods of time.
The purpose of Big Issues is to highlight topics or themes that could have implications for businesses, budgets and investments. Still, there will always the ‘X-factors’, highlighting the need to be alert as well as agile.