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Inflation continues to moderate
As has been the case in the United States,
Australia’s inflation rate has continued to pull
back from the recent peak reached after a period
of sharp increase. The Consumer Price Index (CPI)
rose by 0.8% in the 3 months to June, which was
0.6% below the increase recorded in the March
quarter. In annual terms, Australia’s inflation rate
dropped from 7.0% to 6.0%. The recent peak of
7.8% recorded in December 2022 was the highest
annual rate recorded since March 1990.
The June quarter CPI result was impacted by a
lower rate of increase for several categories of
goods, whereas service categories, being more
influenced by wage levels, continued to push
higher. Automotive fuel (down 0.7%) was one key
goods category to show price decline, with the
price of motor vehicles also declining. Both motor
vehicles and automotive fuel had previously
recorded sharp increases due to supply
constraints prevailing as economies reopened
after the COVID-19 crisis. Elsewhere, a 0.7% fall
in telecommunication equipment and services
contributed to the lower rate of CPI growth; as
did pharmaceutical products, which fell 1.0% due
to an increase in the proportion of purchases
qualifying for the Pharmaceutical Benefits
Scheme (PBS).
Partially offsetting the above areas of price
reduction was a higher rate of increase in the
price of some services. Housing rents (up 2.5%)
continued to make a major contribution to
inflation and have now risen by 6.7% over the
past year. Also notable was a 5.3% quarterly
increase in house, contents and motor vehicle
insurance, whilst prices for restaurant meals &
takeaway food rose 1.7% over the quarter.
The chart below shows the actual “headline”
inflation rate along with the “underlying” rate of
inflation. This underlying measure of inflation
removes seasonal factors, outliers, and more
volatile components of the CPI, to measure the
core rate of price increase. The “underlying” rate
has become a more important area of focus for
policy markers over the past 3 years as the COVID
crisis and global energy shortages have created
significant temporary influences on the CPI
calculation. As the chart demonstrates, the
underlying measure of inflation is less volatile
than the “headline” unadjusted CPI measure.
Source: Australian Bureau of Statistics 6401
The chart highlights that the underlying rate of
inflation steadily declined between 2008 and
2020. It has, however, recently increased sharply
and is currently calculated to be 5.7%. This
underlying rate of inflation remains well above
the Reserve Bank’s longer-term average target
range of 2% to 3%.
Australia’s experience with inflation following the
COVID-19 crisis is consistent with that of most
developed economies around the globe. Supply
constraints (due to the lower production in
lockdowns and subsequently the War in Ukraine)
combined with the sharp increase in demand
upon economic reopening (supported by both
expansionary monetary and fiscal policy) saw
goods prices rise sharply. Goods inflation has now
started to subside around the globe; however, it
remains to be seen how quickly inflation can
return to target levels. Much will depend on the
persistence of services inflation and the extent to
which higher wages growth underpins prices for
the service items.
Q1: Discuss the factors that have contributed to
Australia’s inflation rate falling from recent peak
levels.
July 2023 Volume 30 Issue 7
(ISSN Digital 2208-0325)
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RBA pauses interest rate increases
The recent moderation in inflation is likely to
have been a key factor in the Reserve Bank (RBA)
pausing its program of interest rates increases.
Following both the July and August Board
meetings, the RBA maintained its cash interest
rate target at 4.1%. This pause in policy
tightening follows 12 interest rate increases since
May 2022 when the cash rate was at its
“emergency setting” of just 0.10%.
Source: RBA
With both inflation and consumer spending
showing signs of softening, the significant
tightening of monetary policy that has already
taken place may now be having the desired
effect. The RBA now expects inflation to fall to
3.25% by the end of 2024 and be back within the
target 2% to 3% range by late 2025.
However, despite the evidence of weakening
demand and lower forecasted inflation, the
central bank has stopped short of indicating that
the higher interest rate cycle is complete and has
suggested that further tightening may be
necessary. Following the Board meeting in early
August, the RBA emphasised the degree of
uncertainty in its policy outlook as follows:
“There are though significant uncertainties. Services
price inflation has been surprisingly persistent
overseas and the same could occur in Australia. There
are also uncertainties regarding the lags in the
operation of monetary policy and how firms’ pricing
decisions and wages will respond to the slowing in the
economy at a time when the labour market remains
tight. The outlook for household consumption is also
an ongoing source of uncertainty. Many households
are experiencing a painful squeeze on their finances,
while some are benefiting from rising housing prices,
substantial savings buffers and higher interest income.
In aggregate, consumption growth has slowed
substantially due to the combination of cost-of-living
pressures and higher interest rates.”
Q2: Evaluate the rationale for the RBA’s recent
decision to leave the cash rate unchanged at 4.10%.
Q3: Describe the changes in economic conditions that
would be likely to result in the RBA re-commencing its
program of lifting interest rates.
Business investment at risk from higher
interest rates
Although much of the focus of the impact of
higher interest rates is centered on the
household sector and housing industry,
businesses more broadly are impacted by higher
interest rates. One of the transmission
mechanisms by which higher interest rates effect
the real economy, is via business investment
decisions. If interest rates are higher, the cost of
business borrowing increases, making business
investment spending less viable.
Business investment refers to the purchase by
businesses of items used in the production
process e.g. machinery, computers, the
construction of new factories etc. Business
investment also includes research and
development spending. After declining sharply
during the COVID crisis, business investment has
recovered and has been surprisingly resilient in
the recent period of higher interest rates. Private
sector capital expenditure (business investment)
was 6.6% higher in the year to March 2023, in
real (after inflation) terms.
Despite the recent increase though, real business
investment is currently some 14% below the level
recorded in 2012, when the mining sector was at
the peak of its expansion. In comparison, the size
of the Australian economy has grown by 27%
over the same period. The mining boom
coincided with record high business investment
spending as capital expenditure was required to
develop and expand mines and supporting
infrastructure.
As indicated on the chart below, business
investment spending is now above pre COVID
period levels but has shown very little real
growth over the recent years. Over the 5 years to
March 2023, business investment has averaged
an annual increase of just 1.8%. Somewhat
surprisingly, the period of unusually low interest
rates for much of this period did not appear to
materially stimulate new business investment
spending.
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Source: Australian Bureau of Statistics 5206.
The peak in mining sector investment followed a
period of strong growth in commodity (e.g. iron
ore) prices, which encouraged mining firms to
expand their productive capacity via capital
expenditure. However, this expansion in capacity
was followed by a period of falling commodity
prices, which is likely to have accelerated the
decline in new investment. This decline in mining
sector investment was not matched by any
material pickup in non-mining sector investment
for most of the past decade. Although, it should
be noted that over the most recent 12 months,
both mining and non-mining sector investment
has increased - the former likely to be attributed
to a sharp increase in various commodity prices.
It is possible that the lack of apparent
relationship between interest rates and business
investment levels could be due to significant time
lags between when decisions are made and when
investment expenditure actually takes place.
Potentially, therefore, the current period of
higher interest rates will still ultimately restrict
growth in business investment.
Q4: Describe how an increase in the level of interest
rates may impact on business investment spending
plans.
Q5: Explain why business investment was so high in the
period around 2012.
Productivity in decline
Any softening in business investment from
current relatively modest levels may be a
negative influence on future rates of economic
growth. The objective of business investment is
to expand the capacity to produce. Therefore,
less investment spending will ultimately lead to
less capacity to support economic growth.
Business investment is also seen as a necessary
path to increasing productivity and ultimately
higher living standards.
Relatively lower levels of business investment
over the past decade have coincided with a
period of low productivity growth. Labour
productivity is a measure of output per unit of
labour and is sometimes referred to as the
efficiency of labour. A common measure of
productivity is to divide the level of GDP by the
number of hours worked across the economy in
each period.
Recent National Accounts data suggests there has
been no improvement in the rate of labour
productivity of late. Over the year to March, the
level of GDP per hour worked across the
economy fell by 4.5%. This is the weakest
productivity result recorded for more than 40
years and could be at least somewhat reflective
of subdued business investment spending over
most of the past decade. Additionally, the impact
of the COVID crisis has been highly disruptive on
production processes and could have made
productivity growth more difficult.
Productivity growth rates in recent years have
been below the peak levels reached in the second
half of the 1990s. The average annual growth
rate in productivity in the 8 years to March 2023
has been just 0.4%, which is 2.4% per annum
below the growth rate achieved between 1995
and 2000. The chart highlights that there was also
a strong lift in productivity between 2010 and
2015. This improvement could reflect the impact
of the large capital expenditure that took place in
the mining industry, which peaked in 2012.
The lack of productivity growth in recent years
could be one factor contributing the low rates of
real wages growth experienced across the
Australian economy. With low rates of growth in
output per worker, employers have less capacity
to fund higher rates of real wage increase.
Source: Plain English Economics. Australian Bureau of Statistics.
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It is interesting to note that two of the periods of
highest productivity acceleration, i.e. the early
1980s and late 1990s, coincided with relatively
active economic reform. Reform brought about
by Governments took place in areas such as
financial industry deregulation, labour market
reform, the privatisation of various Government
enterprises and the removal of trade barriers.
Q6: Define the term “Labour Productivity
Q7: Explain the possible impact on future rates of
economic growth of the low rates of business
investment recorded in Australia over recent years.
China drops tariffs on Australian barley
China has announced that it will remove tariffs
that have been put in place on barley imported
from Australia. This follows a protracted dispute
between the two nations that began in May 2020
when China imposed the 80% barley tariff. The
tariff on barley was in response to Chinese
allegations that Australian producers “dumped”
barley on global markets between 2014 and
2016. Similar allegations were made against the
Australian wine industry when tariffs were
introduced by China on Australian wine exports
in October 2020.
“Dumping” refers to the situation where a
company exports its products at a price below
what it would normally charge in its home
markets. It can be used as an anti-competitive
action as it may force other companies out of
production. Under World Trade Organisation
guidelines, Governments can take action against
dumping practices.
Restrictions were also reportedly put in place by
China on imports from Australia of cotton, beef,
coal and lobsters; but importantly, not iron ore.
Australia has filed complaints to the World Trade
Organisation over China’s introduction of tariffs
on wine and barley exports. However, in
response to the recent indication that the barley
tariffs were being removed, Australia’s Minister
for Foreign Affairs, Ms Wong, confirmed that the
WTO legal proceedings in relation to the barley
tariffs would be discontinued. Ms Wong also
stated that Australia expects a “similar process to
be followed to remove the duties on Australian
wine.”
The chart below illustrates the effect the
imposition of a tariff on a good has on both the
market price and volume sold of that good.
Impact of tariff on supply and demand for imports
Free trade and initiatives to remove trade
protection are supported by economic theory
that suggests countries will gain from trade if
they focus their production on those items in
which they have a comparative advantage (i.e.
can produce at a lower relative cost). Surpluses in
production can then be traded for items in which
another country has a comparative advantage.
Despite the theoretical case for free trade, there
has been little progress in the removal of trade
barriers over the past few years. This contrasts
with the general trend of recent decades when
there was a considerable long-term reduction in
trade barriers around the globe. There is a risk
that any introduction of new protectionist
measures creates momentum towards more
trade protection, as affected governments
retaliate to neutralise the effect of protection by
another country on their own industries. As such,
the imposition of tariffs by China on Australian
exports, together with the trade dispute between
the US and China over recent years, were seen as
a threat to both broader free trade principles, as
well as longer term global economic growth.
Q8: Explain how rising trade tariffs can lower living
standards.
Stats on Australia Latest Previous Year
Economic Growth 2.3% (Year to Mar) 3.1%
Inflation 6.0% (Year to Jun) 6.1%
Unemployment 3.5% (Jun) 3.6%
Employment Growth 3.0% (Year to Jun) 3.9%
Wage Price Index 3.7% (Year to Mar) 2.4%
Exchange Rate (TWI) 61.3 (31st Jul) 63.1
Cash Interest Rate 4.10% (Jul) 1.35%
Current Account Surplus $34.8 bn (Yr to Mar) $49.9 bn
Current Acct (% GDP) 1.4% (Year to Mar) 2.2%
Foreign Debt (% GDP) 47.7% (End Mar) 50.6%
Source: Australian Bureau of Statistics & Reserve Bank
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Q1 Q2 Quantity
P1
P2
Price
Supply 1
Supply 2
Demand
Tariff Revenue