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The ABS have released their quarterly measure of inflation pressures for the second quarter this year; and it contains no surprises. Inflation remains muted (+0.4% q/q and +2.1% y/y) with “core” inflation somewhat lower at +0.5% q/q and just +1.9% y/y. This result is very much as the markets had been expecting and is unlikely to see any change in the RBA’s current stance with regard to interest rates; i.e. no change in the foreseeable future.
Inflation affects us all. It shapes our decisions and is a key consideration for politicians, businesses and policy makers alike; but it’s often poorly understood by the general public. In recent months I’ve been asked by a number of clients and readers questions relating to inflation so I figured now might be a good time to hopefully answer some of those questions with an article on the subject.
The most commonly used and reported measure of prices in Australia is the Consumer Price Index (CPI). This index is calculated by the Australian Bureau of Statistics (ABS) each quarter; for the most recent June quarter CPI currently sits at +2.1% y/y
The index is calculated by comparing the prices of a basket of goods and services which account for a large proportion of expenditure of what is called the “CPI population group”. What this means is that the index looks at the expenditure patterns of metropolitan households (i.e. those in the 8 capital cities). The composition of the basket is unlikely to accurately match the expenditure patterns of more regional consumers.
The basket itself is comprised of 86 expenditure classes which in turn are grouped into 11 groups.
| Expenditure Group |
% |
| Food & non-alcoholic drink |
16.1 |
| Alcohol & tobacco |
7.1 |
| Clothing & footwear |
3.6 |
| Housing |
22.7 |
| Furnishings, h’hold equipment & services |
9.4 |
| Health |
5.4 |
| Transport |
10.3 |
| Communications |
2.7 |
| Recreation & culture |
12.7 |
| Education |
4.3 |
| Insurance & financial services |
5.8 |
Every 6 years the weightings are adjusted to take account of changing expenditure patterns; these most recent weightings are the 17th series and have been in place since November 2017.
As an aside it is perhaps worth noting one interesting fact about the composition of the national CPI data. Given the amount of political comment regarding electricity prices we should note that electricity (which sits within the “housing” group) accounts for just under 2.2% of total expenditure. This is a little less than the amount spent on tobacco, and less than half the amount spent on alcohol. Of course, this will vary from household to household but puts into some perspective the commentary about “cost of living” pressures from electricity price rises.
Of particular interest are two data series (trimmed mean and weighted median) within the ABS inflation data. It is these series that the RBA use when considering inflation and they are often referred to as “core” inflation.
The RBA has a duty within its charter to maintain price stability and, to achieve this statutory requirement, has an ‘inflation target’. It seeks to keep consumer price inflation in the economy to 2–3%, on average, over the medium term. The measure that they use to determine that target is a combination of the trimmed mean and weighted median. It is important therefore that we consider what these two measures are and why the RBA prefers them to the CPI.
Despite the CPI being seasonally adjusted there is no doubt that price variability can be extreme in some expenditure classes at various times and that much of this variability may not be seasonal. For example, a natural disaster might result in a dramatic increase in the price of a particular agricultural product while declines in the international price of crude oil might result in sudden and large drops in the price of petrol.
In order to remove the impact of these outlying price changes the ABS ranks the seasonally adjusted quarterly price changes and then excludes those at the top and bottom of the list. In the case of the trimmed mean the top and bottom 15% of outliers are removed (i.e. trimmed mean considers the middle 70% of items) while the weighted median looks at the middle 50% (and excludes the top and bottom 25%). In this way the RBA hopes that their preferred inflation gauge is less subject to sharp, but short-lived and perhaps non-seasonal, price variability. This approach makes sense when we consider that the RBA are tasked with adjusting monetary policy to maintain inflation with a 2-3% target range over the medium term (i.e. throughout an economic cycle).
As the chart demonstrates, both trimmed mean and weighted median are slightly below the headline CPI number, currently sitting at 1.9% y/y. While CPI is now within (just) the RBA target range, core inflation remains below.
We can look deeper into the information on prices to understand better why that might be. Inflation data can be further segregated by looking at those items for which the price is determined on international markets, and therefore impacted by currency fluctuations (so called “tradables”) and those for which prices are largely determined locally (“non-tradables”). By considering these two groups we can see the impact of changes in the value of the Australian $ on the prices of imported goods. What the chart below makes abundantly clear is that in previous years the strength of the A$, tied with the downward pressure on production costs globally caused by the rise of China as a producer, has kept Tradables inflation at much lower levels than Non-tradables. We can also see that the recent small pick-up in inflation is being driven primarily by a return to positive moves in Tradables inflation rather than domestic, Non-tradables pressure. This in turn is coming from the slight decline in the value of the A$ which will be putting some upward pressure on prices of imported goods coming into the country. Continued declines in the value of the A$ (which are generally anticipated as US interest rates continue to rise while those in Australia remain unchanged) is likely to see that trend continue with further upward pressure coming from Tradables in coming quarters.
Before we leave the topic of inflation I wanted to spend a few moments taking a look at an interesting (and somewhat contentious) topic; the relationship between inflation and unemployment.
Some economics suggest that as an economy approaches “full employment” there are likely to be inflationary pressures coming to bear as the demand for labour outstrips supply and wages are pushed higher. It is worth noting that “full employment” does not equate to “no employment” but rather that level of unemployment that is generally consistent with a stable rate of inflation; what is known in economic jargon as NAIRU (Non-Accelerating Inflation Rate of Unemployment). Precisely what this level is varies over time and from economy to economy but in Australia (and according to Treasury macro-economic models) the current NAIRU lies somewhere between 4.5% and 5.0%.
The relationship between unemployment and inflation can be plotted on what is known as the Phillips Curve.
Since there is always going to be a lag between the build-up of wage pressures, caused by low unemployment, and prices we consider the effect of unemployment rates on price levels with a 12-month lag (i.e. we compare the level of unemployment in Dec 2015 with inflation in Dec 2016). If we plot this relationship the results are quite interesting. Although the relationship can be “messy” at times, there does appear to be some correlation between the two data sets, particularly if we ignore very high levels of unemployment.
As we can see, there is a clear suggestion that inflation starts to accelerate as the unemployment rate falls below about 5%. It also appears that the RBA’s upper target band of 3% is almost precisely the level at which the Phillips Curve breaks below the 5% unemployment rate.
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