Dear RBA, DON’T RAISE INTEREST RATES
We will have the inflation figure today and it will explode. The central bank should see clearly. Why?
Because there is a growing deflationary shock globally as Europe is rocked by war and an energy shock. China is rocked by a real estate and COVID shock. And the US is rocked by an inflation and interest rate shock.
A global recession is on the way and it will automatically deflate prices, likely sending them deep negative into 2023 in a repeat of what happened in the great Spanish post-fly deflation of 1920/21. Stock markets are starting to take this into account, and it’s happening faster than anyone thinks.
If so, then there is no commodity investment boom in Australia. There is already enough tightening built into the fixed interest rate reset to drive home prices down 10%. And the RBA should instead worry about the unraveling of pandemic distortions as supply-side tensions collapse in excess.
Australia is a quarter or two behind in this global cycle, so we’re lucky we don’t have to repeat the mistakes of others.
Below is UBS on how this is playing out in the US even before we see the Fed hikes coming quickly to bring the lot down.
For several months, the media has been reporting breathlessly (and repeatedly) that the latest consumer price inflation data from developed economies is the highest in decades. As the trend of the year-over-year inflation rate has increased, the stories can be recycled month after month, as inflation has always been found to be higher. Economists, however, see inflation falling in the second half of this year – peaks in consumer price inflation will occur at different times in different economies, but the downward trend in inflation is a call with high conviction. Economists have three reasons to be confident.
(Some) Prices are already falling
The story of inflation last year was simple. In developed economies, there was an extraordinary increase in the demand for goods – in the United States, the demand for durable goods rose unprecedentedly since the end of wartime rationing in 1946. Consumers had taxable incomes supported when lockdowns prevented spending – and as restrictions were lifted they rushed to spend. Supply also increased, but since the surge in supply could not keep up with the surge in demand, there was an imbalance. The result was a mixture of shortages and price inflation.
Economists knew that the economies linked to the pandemic could not last and therefore the surge in demand could not last, which is why inflation was described as transitory. And, indeed, the surge in demand did not last (fading first in the US, then elsewhere). The resulting inflation proved to be transitory. The imbalance between supply and demand has narrowed and in some areas markets may even have to consider oversupply at some point. The result is that inflation rates for products affected by the imbalance of supply and demand begin to fall as demand slows. For some products, inflation turns into pure and simple deflation.
Falling inflation and outright deflation in developed economies can be seen in exactly the areas where demand rose and then fell. Used cars and televisions saw unusual price increases last year, and now prices are plummeting.
Inflation can also be self-defeating – higher prices reduce demand, causing prices to fall. American households have recently paid higher prices for fuel, which means they have less money to spend on other items. Low-income households in particular have had to cut back on other spending, and this slowdown in demand is relevant for non-energy prices. Thus, in March, prices in American fast food restaurants experienced their largest monthly decline in twenty years (although prices are still higher than a year ago).
Base effects start comparing normal to normal
It’s always useful to remember that inflation is all about price change – and so a year-on-year rate of inflation tells us something about price pressures today, but also on price pressures a year ago.
During the first quarter of 2022, the year-over-year inflation rate compared a normal economy (more or less) to the containment economy of the first quarter of 2021. Inevitably, the shift from “containment” to “normal” will imply a large variation in prices. As we move into the second quarter, the comparison will change. First, we will compare normal in 2022 with reopening in 2021. Later, we will compare normal in 2022 with normal in 2021. At the time the comparison is “normal” to “normal”, the price change should be fairly discreet.
Prices normally go up – falling prices are relatively unusual. If prices rise faster, inflation rates (the change in prices) will increase. If prices rise more slowly, inflation rates will slow. Thus, the rise in oil prices this year should bring down the inflation rate. In the year ending March 2022, crude oil prices rose 77%, driving headline inflation higher. As long as the price of oil increases by less than 77% over the next 12 months (meaning a Brent crude oil price level below USD 205), oil will contribute less to the future headline inflation rate.
Wage costs are not exploding
Labor costs are the most important component of an inflation basket. In developed economies, processing, packaging, distributing and advertising everything we buy is very labor intensive. If wage costs increase at an increasingly rapid rate, it will be difficult for inflation to come down.
Wages are not the same as labor costs. If people work harder, they can be paid more without causing inflation. And that is what is happening.
In many developed economies, economic output (GDP) is near or above pre-pandemic levels. But employment is below pre-pandemic levels. In other words, fewer people work harder to produce more stuff. Paying fewer people with higher wages if they make more does not increase labor costs.
It is also important to distinguish between one-off corrections in wage costs and a continuous increase in wages. For example, the increase in demand for goods (rather than services) and the growing share of online retailing have increased the demand for delivery drivers. When there is a sudden increase in the demand for labour, wages will rise until enough people are attracted to the jobs. This is one of the reasons that the salaries of delivery drivers have increased. However, once wages are high enough to attract enough workers, wages need not continue to rise at the same rate – a one-time increase in demand is met by a sharp rise in wage costs, then more normal behavior. .
The pandemic has been an extraordinary economic shock, as has the magnitude of the political response. It produced extraordinary inflation as a result. Indeed, given the pent-up demand created by pandemic-related spending limits and exceptional income support, perhaps one of the biggest surprises is that inflation has been as subdued as it is. been.
As the world moves further and further away from the pandemic, it moves further and further away from the extraordinary economic consequences. Demand is normalizing and companies that had pricing power when demand was incredibly high find that they no longer have the same pricing power now that demand is low. We looked at past prices as much as current prices, with year-over-year comparisons forcing us to backtrack on blockages. In the next quarter, we will finally leave the lock-ups behind us as the retrospective comparisons come to an end. And finally, there is no evidence of the appearance of second-round effects of inflation – a labor cost/price spiral (which would be a very worrying signal for inflation) is notoriously absent.
Economists are rightly convinced that inflation will fall.
What is less certain is how far inflation will go.