Inflation is sinking ever lower. Now that it’s official what’s the RBA going to do?

Lower petrol prices and an electricity rebate have contributed to a further fall in the quarterly measure of inflation^[1], the Consumer Price Index.

The rate in the September quarter dropped to 2.8%, putting it for the first time within the Reserve Bank’s target range^[2] of two-point-something since the March quarter of 2020.

The fall was broadly in keeping with market expectations, and keeps low the likelihood of an interest rate cut this year. The next Reserve Bank meeting is scheduled for Tuesday.

The bank pays more attention to the long-running quarterly measure of the CPI than the more volatile monthly version^[3] which already dropped into its target range in August.

The monthly measure^[4] dropped further, to 2.1%, in September.

The quarterly CPI is also more important because it is included in all sorts of workplace and other contracts and indexation formulas.

The main reason for the fall in inflation was the electricity rebates announced in the federal budget and by some states.

Also helping were the falls in petrol prices, mainly reflecting declines in global oil prices. Cheaper or free public transport in Brisbane, Canberra, Hobart and Darwin also contributed.

Preventing a larger fall were the continuing strong growth in insurance costs and rent. The rise in insurance costs reflects a series of extreme weather events such as bushfires and floods. It is a way in which climate change is exacerbating inflation.

Contrary to what many people think, the increase in rents is not due to landlords passing on higher interest rates. Landlords may want to do this but they are only able if vacancy rates are low, otherwise tenants just move elsewhere.

History shows it is low vacancy rates that drive up rent regardless of the level of interest rates. The inability of landlords to pass on interest rate increases has been confirmed by a study just published^[5] by the Reserve Bank using tax return data.

It showed that only three cents of every dollar in extra interest costs is passed on.

The fall in inflation to a rate significantly below the 4% at which wages are increasing^[6] means that the cost of living crisis^[7] is abating, although not yet over.

The dramatically lower inflation rate puts Australia in a comparable position to the United States^[8], whose inflation rate is 2.4%, the United Kingdom^[9], whose inflation rate is 1.7% and New Zealand^[10] where it is 2.2%.

The US, UK and New Zealand all have inflation targets (or midpoints) of 2%, so inflation is now only slightly above the target in the US and New Zealand. It is actually below it in the UK. In response all three have cut their key policy interest rates.

Yet it is unlikely that the Reserve Bank will follow their lead until next year, despite growing pressure.

One reason is that, even after their cuts, interest rates in our three peers are still higher than in Australia, at around 4.75% to 5%.

But more importantly, the Bank has stressed recently that it pays more attention to the “underlying” rate of inflation, which looks through temporary measures such as the electricity subsidies. The Bank will only cut interest rates when they are “confident that inflation was moving sustainably towards the target range”^[11].

The bank’s preferred measure of underlying inflation, the so-called trimmed mean^[12], has also fallen.

But at 3.5%, it is still above the target. A positive aspect is that it has reached 3.5% ahead of the Bank’s most recent forecast^[13] which had 3.5% only being reached by the end of 2024.

Monetary policy, however, has in Milton Friedman^[14]’s famous words “long and variable lags”^[15].

As the then future governor Glenn Stevens remarked^[16] back in 1999, “the long lags associated with the full impact of monetary policy changes mean that policy changes today must be made with a view not just to what is happening now, but what is likely to be happening in a year’s time and even beyond then”.

In other words we want to drive by looking ahead rather than just at the rear view mirror. The Bank is like a footballer who needs to head to where the ball will be rather than where it is now.

There is therefore a risk that if the Reserve Bank keeps interest rates high until inflation reaches the middle of the target, it will be too late to prevent the economy slowing too much and inflation will undershoot the target. This would likely be associated with unnecessarily high unemployment.

That is why the Reserve Bank board faces a difficult balancing act in taking its decisions.

References

1. ^{^} quarterly measure of inflation (www.abs.gov.au)
2. ^{^} target range (www.rba.gov.au)
3. ^{^} volatile monthly version (theconversation.com)
4. ^{^} monthly measure (www.abs.gov.au)
5. ^{^} study just published (www.rba.gov.au)
6. ^{^} wages are increasing (www.abs.gov.au)
7. ^{^} cost of living crisis (www.theguardian.com)
8. ^{^} United States (www.bls.gov)
9. ^{^} United Kingdom (www.ft.com)
10. ^{^} New Zealand (www.rbnz.govt.nz)
11. ^{^} “confident that inflation was moving sustainably towards the target range” (www.rba.gov.au)
12. ^{^} trimmed mean (www.rba.gov.au)
13. ^{^} Bank’s most recent forecast (www.rba.gov.au)
14. ^{^} Milton Friedman (www.nobelprize.org)
15. ^{^} “long and variable lags” (www.journals.uchicago.edu)
16. ^{^} remarked (www.rba.gov.au)