Australia’s consumer price index (CPI) lifted 1.9% in the December quarter, taking the annual headline rate to 7.8%. This was above the consensus estimate of 7.5%.
This represents Australia’s highest headline inflation rate since the March quarter 1990. While the headline result was just below the Reserve Bank of Australia’s (RBA) forecast for an 8% rise, the acceleration in the RBA’s preferred “trimmed mean” measure of underlying inflation to 6.9% YoY (its highest since 1988), against RBA expectations for a rise to 6.5%, has put the interest rate markets back on edge.
Where Is Australia’s Inflation Surge Coming from?
The most significant quarterly jumps in the December quarter came from domestic holiday travel and accommodation (+13.3%) and international holiday travel and accommodation (+7.6%), as well as electricity costs (+8%). On a year-on-year basis, the strongest price growth is evident in food, housing costs (particularly construction costs) and recreation (particularly travel costs).
However, what is starkly evident in the inflation figures is the shear breath of the inflationary pulse. 88% of CPI categories are growing above the RBA’s 2.5% target inflation rate, with 60% above 5%.
In spite of the breadth in the current inflation pulse, we do not believe that inflation will become ingrained in the system 1970s style. We see a combination of slower consumer demand in response to rising rates and the lagged impact of easing global inflation pressures as likely to take the heat out of inflation as we move through 2023. A more normal year in terms of weather should also help bring food inflation down.
While our base case is for a significant drop in inflation, the breadth of the inflation surge does raise risks to the outlook and should keep the RBA on the front foot for a while yet.
Why Is Australia Bucking Inflation Trends?
High inflation was very much a global problem in 2022, but the acceleration in Australian inflation in the final quarter contrasts with clear signs of a peak in US inflation and tentative signs of inflation easing in Europe.
Despite the divergence from the US/global inflation cycle, we see Q422 as the inflation peak for Australia.
Global inflationary pressures such as supply chain disruptions are clearly receding. This global disinflation should increasingly flow through to Australian inflation this year, despite the decoupling evident in Q4.
Last year’s AU$ weakness is now reversing, which should also help alleviate inflationary pressure as we move through the year. The significant local weather impacts on food prices in 2022 are also now showing signs of fading.
However, while Q422 is likely to represent the peak for Australian inflation, the pace of moderation is likely to be slower than the deceleration we are now seeing in the US.
There are a number of drivers behind this somewhat divergent profile in terms of the timing of the inflation peaking and the pace of moderation. The US consumer slowdown is (at this stage) more advanced. In contrast to the US economy, where wage pressures are finally appearing to ease, Australian wage growth is likely to pick up further in 2023. December quarter wage data will be released on February 22, 2023.
While Australian Bureau of Statistics (ABS) wage data for Q1 and Q2 will be closely watched, one additional risk on the local inflation front is the minimum wage decision, which is scheduled to be made in June this year.
With the RBA forecasting a still very high inflation rate of 6.3% in the year to June 30, many businesses and the RBA itself will be anxious about the minimum wage outcome.
Last year, the Fair Work Commission delivered a 5.2% increase in the minimum wage, in line with the prevailing rate of inflation. This lifted wages for 184,000 workers. In addition, the commission granted a 4.6% increase for about 2.6 million workers on higher awards.
There is a risk of an “inflationary” outcome of ~+6%, given the government’s pledge that workers’ wages will not go backwards relative to inflation.
The RBA will clearly be hoping for a more moderate outcome to help contain inflationary pressures and not force it into ratcheting up the cash rate further in the second half.
How will the RBA React to the Inflation Surge?
We believe the RBA is likely to instigate another 0.5 percentage points of rate rises in coming months, lifting its target cash rate to 3.6%. This includes an almost certain 25 basis points (bps) hike this week ,with another 25 bps hike likely in either March, April or May.
While we see a 3.6% cash rate as the likely peak, the futures market has shifted to price an additional 25 bps hike into the Q3 peak, implying a peak rate of ~3.8%.
The futures market pricing for peak rates has been somewhat volatile in recent months. Peak futures pricing got as high as 4.2% last year, before coming back to a ~3.6% peak in January this year. The higher-than-expected inflation reading released in mid-January saw the futures market reinstate another rate hike for a 3.8% peak.
A key consideration in our lower expected peak is the so-called “fixed rate cliff” that is looming this year. As a result of the very low fixed rates on offer in the second half of 2020 and 2021 (spurred on by cheap RBA funding), there are an unusually large number of fixed rate loans set to expire this year. Many mortgage holders will see their mortgage interest rates jump from ~2% to ~5-6%.
The RBA will be aware of this dynamic over and above the usual lagged impact of its hiking cycle.
The RBA has also seemingly done most of its modelling around a 3.6% peak in its discussion of household cash flow position in 2023. Hence, we think the bar to move above 3.6% is fairly high, albeit not insurmountable.
Potential for a Soft Landing is still Good
While Australia’s 30-year high in inflation poses a risk for the 2023 outlook, we see these risks as manageable and not without offsets.
As discussed, we do expect inflation will subside this year beginning in Q1. This deceleration should continue through 2023 (to 3-4%) and 2024 (to 2-3%).
The RBA will almost certainly raise rates at least twice more in coming months but we think the RBA will be reluctant to make rates “ultra tight”.
We expect the economy to slow materially from an above trend pace to a below trend pace. However, a starting point of very low unemployment, still elevated savings balances in the consumer sector and growth tailwinds from general migration and China’s reopening will help Australia from sliding into recession. A softish landing will aid the local stock market, but the focus on resilient earnings should intensify in coming months as growth slows.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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