• 15/08/2022

Three reasons inflation could be lower by next year

Scott Haslem| Australian Financial Review| 1 August 2022

https://www.afr.com/wealth/personal-finance/three-reasons-inflation-could-be-lower-by-next-year-20220728-p5b5bq

Fears of a global recession and a housing market crash have dominated headlines after Australia’s 6.1 per cent inflation figure last week, our fastest pace in over 20 years. Fuelling the car, building a home (or just living in someone else’s) and keeping food on the table were all key drivers of the latest spike.

Of course, we are being outdone by the US, UK and Europe, where the inflation rates of about 9 per cent are their worst in over 40 years.

There is little doubt that central banks’ ultra-loose (money printing) policies were held “too stimulatory for too long” through 2021, underpinning a faster than expected post-pandemic surge in growth, both here and offshore.

That has stressed already tight global supply chains – making the cost of getting goods here expensive – as well as the jobs markets, pushing up the cost of labour and domestic goods and services. Australia has almost half a million job vacancies and the unemployment rate is already near a 50-year low of 3.5 per cent.

Other inflationary forces haven’t helped, including the extended war in Ukraine (which has spiked energy and commodity prices, adding to the cost of construction materials) and China’s on-and-off-again lockdowns (creating supply shortages for post-pandemic consumers flush with cash).

The persistence of high inflation through the second quarter has led to belated but accelerated central bank rate hikes.

In the US, rates have risen from zero to 2.5 per cent in six months, and in Australia, from 0.1 per cent to a likely 1.85 per cent this month. For investors, rapidly rising interest rates have driven one of the most significant dual corrections across both equities and bonds in more than 20 years and in virtually every region of the globe.

With that as a backdrop, markets are starting to fret that taming this inflation beast will require a global recession.

But for those prepared to look forward, there has to be a reasonable chance that we are living amid peak inflation fear. There are three key reasons why inflation will likely be lower over the coming year, first in the US and then by early next year in Australia.

First, there is a broad range of what are called “inflation leading indicators” which, after rising sharply last year and early this year, are correcting lower. These include a range of supply delivery time and backlog indicators across global business surveys, shipping queues and freight rate costs, the last of which have been down 40 per cent since May.

Commodity prices are also correcting, with iron ore halving from mid-last year, global oil down 20 per cent since February, wheat down 40 per cent since May and lumber down 60 per cent since April.

Second, consumer and market indicators of inflation expectations have also started to reverse. Why is our expectation of inflation important? Because that’s what gets fed into wage negotiations and businesses’ pricing behaviours. Having risen to more than 3.5 per cent, these have fallen to about2.5 per cent. This suggests the inflation genie isn’t out of the bottle and getting people to again expect more “normal” 2-3 per cent inflation may not be as challenging as thought several months ago.

Finally, while easing supply chain pressures is important, one of the best ways to reduce inflation is to reduce consumer spending. Weaker demand limits the extent businesses can push through cost increases into prices and leads to the build-up of inventories that businesses then liquidate at lower prices.

The rapid tightening in financial conditions, with many homeowners and investors in Australia facing mortgage repayments double the level they were at the start of the year, is very likely to dampen demand. The correction in asset prices, both markets and property, will also temper the desire to spend as we will all feel that little bit less wealthy.

Of course, there is always the risk that with large saving balances, we just go on spending and push inflation and rates so high that a recession is inevitable. But a more likely scenario is that inflation is peaking, and while policy rates have further to rise, they will most likely top out before year-end.

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