The Reserve Bank of Australia (RBA) is bracing for a potentially “bumpy” road ahead as progress towards bringing down inflation becomes more drawn out.
Speaking at the UBS Australasia Conference on Monday, RBA acting assistant governor (economic) Marion Kohler noted that the decline in inflation seen to date has been driven by lower goods price inflation since issues in global supply chains have improved.
“However, inflation is still too high and underlying inflation is higher than expected a year ago. This reflects strong domestic cost pressures and a still-robust level of aggregate demand,” she said.
“Prices of many services have been rising briskly in Australia. I also want to note that services price inflation has been slow to decline in many other economies.”
In annual terms, headline inflation declined to 5.4 per cent in the September quarter, down from a peak of 7.8 per cent in the December quarter of 2022.
The RBA raised the cash rate to 4.35 per cent last week, with governor Michele Bullock conceding that inflation is “proving more persistent than expected a few months ago”.
“Inflation has been declining over the past year as the direct impacts of earlier supply shocks have faded. That decline is expected to continue as below-trend growth helps to bring demand and supply more into balance,” Dr Kohler explained.
“However, we now expect this to be a more gradual process than we previously thought, due to the still-high level of domestic demand and strong labour and other cost pressures.”
As noted by the RBA in its latest statement on monetary policy, inflation is expected to be at the top end of the central bank’s target range of 2 to 3 per cent by the end of 2025.
Dr Kohler said that domestically sourced inflation, and particularly services price inflation, have been “widespread and slow to decline”.
“More broadly, still-strong levels of demand have allowed businesses to pass on cost increases to customers. Business costs such as energy, rent, and insurance have risen strongly, and labour costs have been pushed up by poor productivity outcomes,” she said.
As a result of these ongoing issues, the RBA said that the next stage in bringing inflation back down to target will likely be more drawn out than before.
According to Dr Kohler, this has also been the experience of some other advanced economies who are further progressed in the current inflation cycle.
“The recent increase in fuel prices is also a timely reminder that upside surprises from supply shocks could affect headline inflation. All to say, the road ahead could be bumpy,” she added.
As part of her speech, Dr Kohler also highlighted the risk that high inflation today could lead households and businesses to expect high inflation in the future, which would put upwards pressure on actual prices and wages.
“Encouragingly, measures of medium-term inflation expectations have generally remained consistent with the bank’s inflation target,” she continued.
“But, if high inflation did become entrenched in people’s expectations, it would be very costly to unwind, involving even higher interest rates and a larger rise in unemployment.”
Dr Kohler also noted that the “very tight” labour market conditions of the past year have now begun to ease. The unemployment rate is forecast by the RBA to reach 3.75 per cent by the end of 2023 and 4.25 per cent by the end of 2024.
“That is a smaller increase than in our August forecast due to the stronger-than-expected outlook for economic activity. Broader labour under-utilisation rates are also expected to rise gradually as the labour market moves into balance,” she said.
GDP growth is expected to be below trend, which Dr Kohler said is mainly due to “subdued growth in household consumption as cost-of-living pressures, higher interest rates, and higher tax payable all continue to weigh on disposable incomes for a time”.
Australia’s GDP is expected to grow 1.5 per cent in 2023, up from its previous forecast of 1 per cent in August and to 2 per cent in 2024 (up from 1.75 per cent).
