Sluggish inflation numbers push rate hikes further down the road

To some of us who remember the Consumer Price Index (CPI) rising above 10% for much of the late 70s and early 80s, the RBA’s present determination to drive up inflation might seem a little counterintuitive. But, whether it’s an end in itself (inflation encourages spending and investing, since it erodes the value of holding cash) or a symptom of other positive developments (such as falling unemployment and rising wages), most economists agree that a small amount of inflation is a good thing.

The Reserve Bank has used an inflation target of 2-3% to help determine monetary policy for almost three decades, during which time inflation has mostly held below 5%. But while it has been highly successful at keeping a lid on inflation, it has been far less effective at setting a floor in recent year – with only a few exceptions, CPI has scarcely risen above 2% since 2014 despite ultra-low interest rates through the period.

In the wake of the pandemic, the RBA has set a higher bar on inflation, stating that CPI would have to rise “sustainably” to within the 2-3% target range before it would move to increase the cash rate. Setting such a clear objective has given the green light to those looking to borrow and invest on the back of record-low rates. The RBA has also indicated that they don’t expect this moment to arrive until 2024 at the earliest.

So how are we progressing towards that point?

The CPI rose by 0.6% in the March quarter, taking annual inflation to 1.1% year-on-year. Although this is the third increase in a row, we’re still well below the target band and underperformed expectations by 0.3% in March. With a few exceptions, such as jewellery, petrol and vehicle prices (driven by supply bottlenecks), price pressures remained weak across most of the economy, especially in food and housing.

The RBA’s May announcement that it will keep rates on hold confirms this diagnosis, noting that while inflation and wages growth should continue to pick up, improvement is “likely to be only gradual and modest.”

We will see a spike in headline CPI in this June quarter, to around 3.7% year-on-year, as last year’s -1.9% quarterly fall in the CPI drops out, but it is likely to be noise in an underlying trend of slow inflation. As services continue to come back online, spending on goods as a proportion of household income is likely to revert back away from pandemic levels, further taking pressure off goods prices. Both headline and underlying inflation are likely to be below target next year.

Although we expect that the target band will be reached earlier than the RBA has predicted, with the first rate hike coming in late 2023 rather than 2024, we’re still more than two years away from that point. That means the current low-rate environment, with upwards pressure on house prices and keen interest in more speculative asset classes, should persist for some time to come. Strong oversight from regulators will be a need to ensure that we don’t have outbreaks of excessive leverage leading to instability in the financial system over that period and in this regard lending standards with respect to housing loans are likely to be tightened sometime in the next six months.