Article written by Scott Haslem. Published in The Australian Financial Review March 12, 2024.
There’s a lot of focus on inflation being sticky, but what does that really mean? Will inflation remain well above central bank targets, preventing interest rates from being cut any time soon? Some are now shifting expectations for RBA rate cuts out into 2025.
It’s true, after falling very nicely through the last few months of last year, progress on inflation in key economies has somewhat stalled. And in the US, underlying measures of inflation have shown some signs of reaccelerating. It’s likely this week's February US inflation print may disappoint too.
This comes at a time when there’s been a lot of focus on “structural” drivers that could lead inflation to be higher on average than during the uber-low period post the global financial crisis.
Persistent below-target inflation underpinned central banks’ arguably flawed adventure to zero rates.
Like global investment company KKR, we believe in a “higher resting heart rate” for inflation ahead, reflecting often talked about pressures associated with population ageing, geopolitically driven supply chain adjustments, the energy transition and falling workforce supply.
In Australia we also have the government unwinding some of the past Hawke-Keating productivity-enhancing industrial relations measures.
What some might find surprising is that most estimates don’t see these forces adding more than about 0.5 per cent to the inflation trend.
UBS has estimated the longer-run outlook for European inflation to be between 0.3 and 0.5 per cent higher than pre-COVID.
Given global central banks want inflation at 2.0 per cent, a rate trending at 2.5 per cent would be a game changer in terms of avoiding another zero-rates adventure.
But it seems unlikely to stand in the way of moderate rate cuts from presently elevated levels.
Inflation has already come down a long way in many economies, and central banks have historically started reversing rate hikes well before inflation reaches their target.
So why aren’t they trimming already? Part of this reflects the extreme difficulty central banks have had forecasting inflation post-GFC.
Inflation continues to surprise. Pre-pandemic it was remarkably low despite a 50-year low in unemployment. Post-pandemic, it was stubbornly high followed by a sudden drop, yet unemployment remains largely unaffected.
It’s almost always a (surprisingly small) rise in unemployment that triggers the RBA (and other central banks) to start reversing rate hikes.
UBS recently showed that the RBA typically makes its first cut only seven months after a trough in unemployment and four months after a rise of 0.2 per cent. Current unemployment of 4.1 per cent is 0.6 per cent above its trough seven months ago … so, we’re in the zone.
But central banks are acting cautiously, likely concerned about exacerbating a still-tight labour market.
Who wants to say, “We need more unemployment”?
That’s why it is good for central banks to have something simple to point to as a reason they’re not in a rush to cut rates. This time around, it seems to be “services inflation”.
US Fed Chairman Jerome Powell recently singled out persistently high services prices as a concern.
Services inflation has also been flagged as part of the reason the European Central Bank “considers its inflation fight unfinished”.
At home, RBA Governor Michele Bullock has noted that “hairdressers and dentists, dining out, sporting and other recreational activities – the prices of all these services are rising strongly”.
While the link between wages growth and services inflation is clear, history reveals the focus on services inflation is backward-looking and somewhat of a red herring.
In the low inflation period from 2002 to pre-pandemic, Australia’s inflation averaged 2.4 per cent, just below the centre of the inflation target.
Over that period, goods inflation almost always ran below the total (averaging 2.0 per cent), while services almost always ran above (at 3.1 per cent).
Moreover, when the RBA cut in 2008, the onset of the GFC, services inflation was 5.8 per cent. In 2011, the RBA cut twice as services inflation accelerated to 4.5 per cent (only a touch below its current 4.6 per cent).
While worrying about services inflation has merit, we shouldn’t get stuck on it.
Sure, in both cases the outlook changed. In particular, unemployment was starting to rise, much as it is now in Australia. This makes unemployment the variable to focus on to figure out the timing of future RBA and other central bank rate cuts. Signs of a softer jobs market are emerging.
Inflation will likely be a bit sticky. And this will mean spending more time at, or a bit above, inflation targets. But not considerably so.
And sticky inflation will still have a meaningful impact on rates, potentially keeping them between 2.5 per cent and 3.5 per cent.
That should mean a boom for fixed-income investors and those harvesting yields in unlisted investments over the next few years.
And it shouldn’t prevent modest cuts to current higher interest rates over the next year either.
