The surprisingly strong acceleration in inflation over the past 18 months has been felt in most corners of the globe. Australia has also felt the impact of this global inflation surge, although not quite as intensely as many comparable developed economies.
We have started to see some evidence that this global inflationary pulse may be peaking, though it is still too early to announce a definitive peak. Moreover, even if an inflationary peak is emerging, there is still considerable debate around how much the inflation rate actually fades on both a cyclical (12 month) and structural view (the next 5-10 years).
Domestic Peak? Not Quite Yet
Australia itself saw some tentative evidence of peak inflation last week, although we are reluctant to read too much into this evidence just yet, as it comes from softer data. The new Australian Bureau of Statistics (ABS) monthly consumer price index (CPI) indicator, which covers a ~65% of the broader and more closely watched quarterly CPI, rose by only 0.2% month-on-month (MoM) in October. This rate, which was much weaker than expected (consensus: 0.8%), dragged down the year-on-year (YoY) inflation rate to 6.9%, putting it well below the consensus rate of 7.4% and reversing the pick-up in September 2022 to 7.3%.
While this is encouraging, this monthly data is a new and somewhat experimental series with the more comprehensive quarterly survey likely to be more closely watched by the Reserve Bank of Australia (RBA). In October, the key upward driver of the CPI was automotive fuel, which surged by 7.0% MoM. This is mainly due to the end of the temporary reduction in the fuel excise tax. In contrast, the pace of fruit and vegetable price increases slowed sharply, and travel costs also eased. Although these figures are promising, we would caution that the impact of surging utility charges will not show up until the more comprehensive December-quarter CPI release.
The RBA forecasts that Q4 headline CPI will lift by 2.0% and 8.0% YoY, thus reaching its expected peak. In our view, this still looks like a plausible path for near-term inflation, although last week’s monthly data suggests at least some downside risk and contradicts the views of some commentators, who hold there was upside risk to the RBA’s assumed year-end peak.
While we think headline CPI will peak at ~8% YoY in Q422 (or thereabouts), it appears possible the RBA’s relatively stubborn inflation forecast of 4.75% by the end of 2023 proves too high. A downside surprise on inflation in 2023 may open the door to cash rate cuts before the end of that year. In contrast, the interest rates market is much more hawkish, and is still pricing ongoing RBA hikes to a peak of ~3.8% by around October 2023. Our base case expectation is that the RBA will hike the cash rate by 25bps in both December 2022 and February 2023, taking it to a peak of 3.35%, which remains below money market expectations.
Inflation over the next 12 Months
Plenty of uncertainties still cloud next year’s inflation outlook, let alone the longer-term inflation outlook. Aside from global inflationary influences, such as global energy prices and the state of global supply chains, there are a number of unique domestic uncertainties.
Wages awakening from their slumber?
Foremost among these is the outlook for wage growth, with the RBA's preferred measure, the wage price index (WPI), accelerating sharply to 3.1% in Q3 (after 2.6% in Q2). This was above consensus and has already reached the RBA's forecast for Q422. This wage growth result was the highest since 2012. However, we note that wages had surprised the consensus to the downside in the past 3 quarters. There was evidence of the tight labour market finally translating into rising wage pressure in the private sector (1.2% QoQ, 3.4% YoY). However, this is partly offset by no change in the public sector, which remains benign (0.6% QoQ, 2.4% YoY).
Importantly, the Q3 result reflects the minimum wage decision in June, which increased wages ~5% for ~3M employees, or ~22% of total employees. This should be a significant influence again until next year’s June minimum wage decision. While wages are finally picking up, the 3.1% YoY pace is only in line with the average since 1998. Wages also remain below other comparable economies like NZ (3.7%) and the US (ECI: 5.0%). Furthermore, wages remain below the 3.5%+ pace the RBA requires to sustain the CPI target of 2.5% (assuming ~1% productivity). The RBA is forecasting an extended wage growth peak of 3.9% YoY for both Q423 and Q424.
Upside risk from the federal government’s new IR policy?
There is a degree of risk to these forecasts flowing from next year’s minimum wage decision in June. The RBA would be assuming it does not “match” CPI (in contrast to this year). This is because the Q123 CPI print (at the time of the decision) may be ~7% YoY, which, if implemented as a wage increase, would risk a wage price spiral, potentially nudging the RBA to hike into even more restrictive territory and potentially leading to a recession.
The other wages wild card is the government’s new collective/pattern bargaining legislation, which appears set to pass through the Senate, albeit in modified form. Of course, it is difficult to tell if this legislation will have any discernible wage inflation impact, yet business groups have warned of the inflationary impacts of a return to some form of union-led collective/pattern bargaining. In our base case, we do expect a cooling in the economy to keep wage growth from breaking out to the upside, though wage growth outcomes next year remain a wild card that investors and the RBA will be tracking closely.
Slower demand should help ease inflation pressures
In terms of the impact of a cooling economy on inflation, recent retail sales numbers for October 2022 were weaker than expected, falling 0.2% MoM (consensus: +0.5%). This is the first negative reading since the COVID-impacted year of 2021. However, the retail spending miss came after a run of material upward surprises. There is probably volatility in the data due to COVID-lockdown impacts. Although YoY numbers dropped, spending is still running at a surging 12.5%, after 17.9%.
Once again, this is only tentative evidence of any significant slowdown in demand, with the latest read on business conditions taken in early November suggesting the economy remains robust.
Will the government legislate energy prices lower?
In addition to the potential impact of a cooling economy on inflation, the Federal government’s new energy policy (with recent suggestions of potential energy price caps) may exert some downward pressure on wholesale and retail energy prices (at least for next year). However, the exact form policy action will take still appears far from settled, and it seems unlikely to address longer-term inflationary pressures stemming from the cost of energy.
The RBA: balancing the fight against inflation with housing vulnerability
Finally, house prices and household leverage are also key considerations for RBA monetary policy in balancing the fight against inflation. House prices influence the economy indirectly via confidence and wealth effects. The current picture continues to be one of cooling prices. Australian house prices have now declined for 7 successive months, with prices now 8% below their peak. Sydney and Melbourne are leading the downswing, with prices down 11% and 8%, respectively.
With the RBA almost certain to hike by 25 basis points (bps) this week (to 3.1%), the market’s attention will turn to how close we are to the peak cash rate.
Recent RBA commentary has taken a noticeably less hawkish tone compared to other central banks. We think this is because the RBA is wary of the high levels of leverage in the Australian economy, which are overwhelmingly linked to the housing market. Although it may not focus on this sensitivity in its rhetoric, we feel the RBA is acutely aware of the sensitivity of house prices and household balance sheets to the RBA cash rate. The RBA is likely also weighing up an unusually large expiration of cheap fixed-rate loans over the coming year, with a large number of borrowers set to shift from ~2% fixed rate loans to ~5% variable rates. This will cause an additional crimping of household cash flow next year.
With leverage high, and with policy seemingly pushing past the “neutral zone” toward tightening, the RBA will be very cautious in its incremental hikes. For now, the domestic economy seems to be showing resilience to rate rises, even if house prices are clearly weakening and remain a key source of risk.
Peaking Inflation and a Soft-landing Base Case not without Risks
In summary, domestic inflationary pressures are likely to peak soon but there are still wild cards from a number of global influences, as well as Australia’s unique domestic influences. Global inflation (most particularly in the US) still likely holds the key to the absolute performance of the stock and bond markets. The US’s October inflation print, released in mid-November, provided a welcome surprise to the downside and has helped spark a significant reversal in the fortunes of both equities and bonds. We get another US CPI read on December 13, and rallying markets are becoming more reliant on another dose of good news. However, we think another benign print is more likely than not.
Domestically, we continue to see a path to a soft landing in 2023 against a backdrop of easing inflationary pressures. This should provide additional support to local equity and bond markets, although Australia’s unique risks with regard to housing, a shifting wage setting process and an uncertain outlook for the local energy market are all worth watching as we move into 2023.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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