02 May 2016
by Greg Jericho

Inflation is scarily low – but it's Morrison who needs to act, not the RBA

Falling fruit prices helped drive lower inflation in the March quarter. The Coalition’s policy of letting the private sector boost demand hasn’t worked

Falling prices are a sign of lack of demand but that is a problem for government to fix in the budget rather than the central bank.

Last week’s inflation figures showed that prices actually fell on average in the first three months of this year. The figures set off strong speculation that Tuesday will see an interest rate cut from the Reserve Bank. But while low inflation is a sign of a lack of demand in the economy, the latest figures suggest that the treasurer, Scott Morrison, is the one who needs to act, rather than the RBA governor, Glenn Stevens.

We currently live in a world of very low inflation – historically so. We have become so used to low inflation that three months ago annual inflation growth of 1.7% was seen as too high to allow an interest rate cut. In previous years such a level would have been seen as scarily low.

Prepare to get scared.

The Australian Bureau of Statistics found that in the first three months of this year prices fell by 0.2% (the first such fall since December 2008) and annual inflation came in at a carpet-burning low of 1.3%:

Underlying inflation, which is generally seen as the guide for interest rate decisions, also recorded very weak results.

In the March quarter the two measures of underlying inflation – the trimmed mean and the weighted median rose – by just 0.2% and 0.1% respectively:

This saw the weighted median recording a record low annual growth of 1.4% and the trimmed mean tying its record low of 1.7%:

However you want to cut it, inflation growth is near enough to “bugger all” to call it thus without risking serious error.

The market reacted swiftly. On Monday the futures market was pricing in a 16% chance of a rate cut tomorrow; by the end of trading on Tuesday it was rated a 53% chance, by Friday it was 58%:

The market now fully expects a rate cut by August and a 50% chance of another cut to 1.5% by February next year.

A big reason for the deflation in the March quarter was petrol. Falling oil prices in January and February saw automotive fuel prices drop 10% in the March quarter – the sixth-largest fall in a quarter since the ABS started recording fuel prices in 1972:

Since February, however, oil prices have been rising slowly, so it is likely that the June quarter will see fuel prices rising on average.

But fuel wasn’t the biggest fall in the quarter – that title went to fruit, which fell 11.1%. Although the fall was less when seasonally adjusted, even on that measure it was the second biggest fall. Fruit, like automotive fuel, is classed as a “tradeable” item – one that has its price determined significantly outside our borders – and it was such items that really drove the fall in inflation.

Tradable items fell 1.4% in the March quarter – the biggest fall since December 2008:

But over the past year it is non-tradable items that are showing record weak growth. In the past 12 months the price of non-tradables items (such as takeway food, rents, utilities charges, house prices, health and education expenses) increased by just 1.7% - the lowest this century:

This low price growth of such goods and services really reflects the lack of demand in the economy and why many expect the RBA to cut rates.

But should the RBA do it? Over the past few years one key aspect of the government’s budget strategy is the decided lack of interest in stimulating demand in the economy. Essentially Joe Hockey hoped the private sector with the assistance of low interest rates would do the job.

But thus far there is little sign of that strategy working. The latest producer price figures released on Friday showed domestic final demand (excluding exports) fell by 0.2% in the March quarter and the annual growth of just 0.8% is a level usually associated with recessions.

The December mid-year fiscal and economic outlook revised up the level of growth of public demand for this year to 2.0% from the 1.5% expected in last year’s budget. But it made no change for 2016-17:

A key measure to look for in Tuesday’s budget is whether or not the government is to increase public demand – in effect trying to stimulate the economy through fiscal spending.

Clearly the signs are there won’t be any major spending of a traditional sort but there is strong talk that the government will use “off-budget” measures to pay for infrastructure. Such spending may not increase the deficit but it should increase public demand growth.

The RBA would be glad to see it. Stevens has for a long time been warning that lowering rates doesn’t have the power to boost the economy that it once did.

Just two weeks ago he told an audience in New York that “while people find global growth outcomes still a bit disappointing, we are reaching the limits of monetary policy in boosting it”. He argued that “central banks must of course do what they can” but “surely diminishing returns are setting in” and he suspected “that more and more people realise this”.

But the question is whether or not the treasury realises this or whether he still wants to leave it up to lower interest rates to do the heavy lifting.