Speech
Low Inflation
[*]
Guy Debelle Deputy Governor
Address at The Economic Society of Australia (QLD) Business Lunch
Brisbane - 22 August 2018
The inflation rate is currently just over 2 per cent (Graph 1). This is consistent with the inflation
target for the Reserve Bank agreed between the Governor and the Treasurer. However, that follows
a period where inflation has been a little below target for a number of quarters. While inflation has
averaged 21⁄2 per cent since the inflation target was introduced, over the past three years it has
averaged 1.8 per cent (Table 1).
Graph 1
How broad based has the recent decline in inflation been? In 2016, only around one-quarter of the
[1]
CPI basket had an inflation rate of above 2.5 per cent. In the June quarter this had risen but only
to 40 per cent. To look at it another way, in recent quarters around 80 per cent of the basket had an
inflation rate below its inflation-targeting average (Graph 2).
Graph 2
There are a number of macroeconomic forces at work that have contributed to these outcomes, but
today I am going to focus on some of the individual price developments that underpin the aggregate
[2]
inflation outcome. I will examine pricing dynamics at a more disaggregated level and how these
dynamics have changed in recent years. An understanding of these changing dynamics and what
might be behind them is useful in assessing the outlook for inflation. Important drivers of recent
lower outcomes include competition in the retail sector, historically low increases in rents, low wages
growth and slower growth in some administered prices.
Table 1: Inflation by Component
Effective weight Average since 1993 Average since 2015
Retail 30 1.2 -0.1
(b)
Consumer durables 15 0.1 -0.8
(c)
Food 7 2.4 -0.1
Fruit and vegetables 2 3.2 1.1
Alcoholic drinks 4 2.7 1.6
Non-alcoholic drinks 1 2.3 -0.5
AVC and telecommunications equipment 4 -2.8 -4.7
(d)
Housing 17 3.0 1.9
New dwelling purchase 8 3.5 2.8
Rents 7 2.9 0.7
Dwelling maintenance and repair 2 2.2 2.2
Administered prices 19 4.4 3.8
Utilities 4 4.5 4.2
Education 4 5.1 3.2
Health 5 4.3 4.0
Other administered 5 4.0 3.6
(e)
Market services 18 2.9 2.0
Tobacco 3 8.4 13.9
Automotive fuel 3 3.3 6.7
Holiday travel and accommodation 6 2.2 0.8
(f)
Headline CPI 100 2.5 1.8
(f)
Trimmed mean 70 2.6 1.8
One of the factors having a significant impact on inflation outcomes in recent years has been
increased competition in the retail sector. Prices of many retail items have been steady or falling over
recent years. Since 2015, retail prices have on average. The price of the typical food basket
declined
has not increased all that much over the past 10 years, while the prices of consumer durable items
such as fridges and furniture (adjusted for improvements in the quality of the goods) have not
changed noticeably over the past 25 years (Graph 3). Most notably, the prices of audiovisual
equipment have declined by 90 per cent over the past 25 years (see below). In the case of consumer
durables and audiovisual equipment, technological improvement has clearly been an important factor,
but competition in the retail sector has also played a significant role.
Graph 3
One way of illustrating the effect of competition on retail prices is by examining the changing
dynamics of exchange rate pass-through. That is, the way that changes in the exchange rate affect
price changes for retail items.
Graph 4 illustrates that changes in the exchange rate typically pass through quickly to import prices
for retail goods. That is, the prices of imported goods at the docks tend to move very much in line
with movements in the exchange rate (first-stage pass-through). When the exchange rate
depreciates, these at-the-dock prices increase. This relationship hasn't changed much over the past
25 years.
In the two decades up to 2010, these changes in import prices at the docks tended to be passed on
to the retail prices faced by consumers. However, over the past decade or so there has been a shift
in these pricing dynamics for retail goods.
Graph 4
While slower growth in consumer spending over this time frame compared with the earlier period has
probably played a role in explaining retailers' reluctance to pass on higher import prices, it is the
structural changes underway in the retail sector that are putting downward pressure on prices.
One aspect of this is that the internet, and technology more generally, have meant that foreign
retailers can now compete with local retailers for online shopping, which is a small but rapidly
growing part of the retail market. In June, online sales made up around 5 per cent of total retail
trade according to the Australian Bureau of Statistics (ABS); however, the value of online sales has
grown by 50 per cent over the past year. This competitive pressure is not confined to online market
share, with a number of large foreign retailers also setting up 'bricks and mortar' retail operations in
Australia. In addition to the direct competition from this source, there is also greater information
about prices, which has allowed households to comparison-shop more easily and negotiate greater
discounts off listed prices.
Competition is not directly observable, but we can look at some proxies for it to assess how it has
changed. Two proxies for competition are mark-ups and margins. Mark-ups measure the ratio of a
firm's sale price to its marginal cost (i.e. the cost of supplying one more unit of the good) (Graph 5).
Net margins capture the ratio of prices to the average cost of production (Graph 6). When
competition increases, this is likely to put downward pressure on mark-ups and margins.
Graph 5
Graph 6
Both of these proxies show some evidence of increased competition. Measures of retail mark-ups
constructed using the firm-level Business Longitudinal Analysis Data Environment (BLADE) database
[3]
peaked in 2011/12, and have generally declined since then. While these data are only available
until 2014/15, more timely data on retail net margins show a similar story, with net margins for food
and other retailers declining over the past few years.
Companies have responded to the increased competition by reducing their costs and improving their
productivity. This has been evident in the retailers themselves as well as their supply chains. This has
put further downward pressure on prices. Labour productivity growth in the retail sector has
averaged 31⁄2 per cent since 2010, quite a lot faster than that in the economy as a whole (although
growth hasn't obviously picked up in recent years as it grew at a similar fast pace in the five years
prior to 2010).
How retail competition plays out over the period ahead is one of the uncertainties for the Bank's
inflation forecast. There have already been foreign entrants into many parts of the retail sector in
recent years, which have driven down margins in the sector. But there are other entrants who are
only just establishing their foothold, which suggests that they, at least, regard the current level of
margins as still quite attractive, notwithstanding the decline over recent years. Our expectation is that
these forces still have some way to run.
In contrast, there is some prospect that the effect of margin compression on the rate of food price
inflation could be near an end. Recent commentary by market analysts suggests that the transition
by some supermarkets to 'every day low price' strategies may have run its course.
Furthermore, in coming quarters food prices are going to be affected by the severe drought in some
parts of the country. Based on what happened in previous droughts, we expect meat prices to decline
initially as slaughter rates increase, but then to rise beyond that. The impact on fruit and vegetables
prices is less clear. It is worth noting that the ABS now uses scanner data and is better able to
capture 'low-level substitution bias' in the CPI than in the past - i.e., if households shift away from
more expensive drought-affected foods to other foods. This would mitigate the impact of the drought
on inflation.
Technology
Beyond the effect of technology in contributing to greater price transparency and facilitating
increased competition in the retail sector, it has obviously had a direct effect on the prices of a
number of retail goods, most obviously audiovisual and communication goods such as TVs,
computers and phones.
One thing that may not be apparent is that statistical measures of inflation are adjusted for changes
in quality where possible. Advances in technology often improve the quality of products across a
number of different dimensions and the ABS aim to capture this in their measure of inflation.
Smartphones and tablets are a good example: changes to processing speed, data storage, camera
quality, etc. have all contributed to measured declines in the prices of computers and phones
(Graph 7). However, households may not necessarily see that prices of these goods have declined
over time when purchasing these products, particularly if they do not value or use all the services
[4]
that are bundled into their computer or phone. The retail price may remain relatively constant,
but the product you are getting for that price is much better quality. This shows up as a decline in
the price in the CPI.
Graph 7
As I mentioned earlier, the prices of audio, visual and computing equipment (adjusted for quality
change) have been falling steadily over the past 25 years. More recently, the prices of mobile phone
handsets and plans have also fallen after the ABS updated its methodology for measuring the prices
of these items. As a result, the rate of decline in this group of items has picked up to be closer to
5 per cent per annum, which by itself has taken around 0.2 percentage points off CPI inflation each
year.
Price measurement when there is technological change is a long-standing challenge for statisticians.
There is the challenge of appropriately capturing changes in quality and there is also the challenge of
ensuring that the weights used to aggregate the prices of the various goods and services
appropriately reflect households' expenditure patterns. For example, it may take some time for new
goods and services to be included in the CPI basket. More generally, there is the issue of ensuring
that the CPI appropriately takes account of changing expenditure patterns in response to movements
in relative prices. The ABS has recently begun updating its CPI weights to reflect changing household
expenditure patterns on a more frequent basis, which should reduce the size of this 'substitution bias'
[5]
in the future.
Housing
The cost of housing services has a large weight in the CPI, with the weight about equally split
between the cost of building a new home and the cost of renting (Graph 8). There have been quite
divergent dynamics in each of these two components in recent years.
Graph 8
New dwelling costs
New dwelling cost inflation, which has an 8 per cent weight in the CPI basket, has tended to move
[6]
closely with the residential building cycle over time (Graph 9). However, despite the historically
high level of activity in housing construction over recent years, new dwelling cost inflation has been
running at a bit below its long-run average. During the late 2000s, new dwelling cost inflation was
higher than it is currently because the residential construction sector was competing for materials
and labour with the resources sector in the midst of its investment boom. This competition for inputs
has clearly abated. Wages growth in housing construction has been generally contained except for
some particular skills such as bricklayers, in part because workers have been moving from the
resources sector as projects there finished and also reflecting the general slow pace of wages growth
in the economy. Reports from liaison suggest that competition for inputs between public
infrastructure projects and high-rise residential developments has put some upward pressure on new
dwelling cost inflation in Sydney and Melbourne. This includes competition for labour such as
engineers and project managers, as well as competition for materials such as concrete. Liaison
contacts suggest that firms have also been able to limit cost inflation by switching to lower-cost
building materials.
Graph 9
Rents
The pace of rent inflation has been falling since 2008, and year-ended rent inflation is around its
lowest level since the mid 1990s. This has been a considerable drag on inflation: rental inflation was
nearly 3 percentage points lower per annum in the past three years than in the previous twenty,
which has reduced aggregate inflation by nearly 0.2 percentage points per annum in recent years.
The decline in rent inflation can be attributed to a mix of supply and demand side developments. As
mentioned, housing construction activity has grown strongly in recent years, which has increased the
supply of rental properties. Growth in the housing stock has outstripped population growth since
[7]
2014, which put downward pressure on rents. Furthermore, rents are changed relatively
infrequently and can be indexed to CPI inflation, so there is a self-reinforcing dynamic to this too.
The national rent inflation series masks considerable variation across capital cities. Rent inflation has
been much lower in Perth than in other capital cities in recent years, indeed rents have been falling in
Perth at quite a rapid rate for a number of years. The vacancy rate in Perth - that is, the share of
properties that are vacant and available to rent - has more than doubled since 2008.
But slower growth in rents is not just a Perth story. Rent inflation in Sydney and Melbourne has
slowed considerably in recent years reflecting the substantial additions to the dwelling stock in these
cities, and notwithstanding the faster population growth, particularly in Melbourne. Rents are flat in
Brisbane and Adelaide. Only in Hobart are rents growing at a high rate.
We expect the pace of rent inflation to increase gradually over the next couple of years. The vacancy
rate has declined over the last year, and newly advertised rent growth has increased. However, it will
take some time for the flow of new rents to materially affect the stock of rents captured in the CPI.
Graph 10
Service Inflation
Services make up over one-third of the CPI basket and can be split into two broad categories. The
first is what can be described as market services. These are services for which pricing tends to be
market-based. This includes household services such as hairdressing, financial services, and meals
out & takeaway. The prices of market services are generally driven by domestic factors such as
wages, commercial rents and utility prices. There is little or no competition from imports and they are
not affected by movements in the exchange rate.
The second category is administered prices. These are the services for which prices are at least partly
regulated, or for which the public sector is a significant provider. This includes services such as
health, education and child care. It also includes utilities, which I will talk about separately.
Market services
Labour costs comprise about 40 per cent of final market services prices, which means that wages
growth is a key determinant of the pace of market services inflation. Market services inflation and
wages growth were both growing strongly in the run-up to the terms of trade peak in 2011
(Graph 12). More recently, wages growth has been subdued, and this has been a significant factor
contributing to the slower pace of market services inflation.
There have also been a number of idiosyncratic developments that have weighed on market services
inflation in recent quarters. This includes the removal of some ATM withdrawal fees in September
2017, the introduction of a CTP green slip refund scheme in New South Wales in December 2017,
and the introduction of the Active Kids sports participation program in New South Wales in January
2018.
Notwithstanding these one-off developments, the outlook for market services inflation is intrinsically
related to the outlook for wages. The Bank's forecast is that, as the labour market continues to
tighten, wages growth should gradually pick up, and along with that we would expect market
services inflation to also increase. However, as we have noted on a number of occasions, there is
considerable uncertainty about the extent of unutilised capacity in the labour market and how quickly
a reduction in spare capacity would translate into higher wage and price inflation. It is possible that
the unemployment rate could fall faster than expected and wages growth could pick up more
strongly as a result. Alternatively, it is possible that the flow of new workers into the labour force
could continue to be stronger than usual, so that unemployment declines more slowly than we expect
and wage pressures could take longer to emerge.
Administered prices
Administered prices have generally risen at a faster rate than other prices for the past couple of
decades. One reason is that demand for administered items has grown particularly strongly over
time, and is relatively insensitive to the business cycle (Graph 13; Graph 14). For example, demand
for health services has increased as the population has aged and as we have become wealthier. The
share of children in formal child care has also increased markedly. Another reason is that growth in
unit labour costs has been a little higher in administered services than in other industries.
Graph 13
While administered services inflation continues to exceed the rate of inflation in other items, it has
slowed since 2012. This has been broad based across the various administered components.
Education inflation is noticeably below its inflation-targeting average. In recent years, several state
government initiatives have been introduced that have weighed on education inflation. These include
initiatives to freeze TAFE fees and lower the cost of preschool education. Annual increases in school
and tertiary education fees have been lower than usual, since some fees are indexed to wages
growth and CPI inflation, both of which are subdued.
Health inflation has also been lower in recent years, although it is still one of the categories with the
highest rates of inflation (Graph 15). At around 4 per cent, the most recent increase in health
insurance premiums was the lowest average increase in more than 15 years.
The pace of child care inflation has also declined in recent years. On a quarter-to-quarter basis, child
care inflation tends to be affected by changes in the fees that are charged by child care centres.
However, many families also receive child care benefits from the government, and changes in the
level of these payments are factored into the measurement of child care inflation. The last time that
the child care payment system changed noticeably was in the September quarter 2008, when the
child care rebate was increased to cover 50 per cent of out-of-pocket costs. It had previously only
covered 30 per cent of costs. The net effect of this change was measured deflation in child care
prices of over 20 per cent in that quarter.
Looking ahead, as we discussed in the recent Statement on Monetary Policy, there are a number of
developments in some of these prices, which have resulted in the Bank lowering its forecast for
inflation in the current (September) quarter. The education component is expected to be lower over
the next few quarters because of initiatives in a couple of states to make vocational education more
affordable. The recent changes to the child care benefits system that came into force on 1 July lead
us to expect that the cost of child care will fall in the September quarter. However, there is
considerable uncertainty around what the magnitude of this decline will be. There is also uncertainty
around whether the changes will affect measured inflation in subsequent quarters. For example, child
care inflation has historically increased in the March quarter since this is when families have typically
reached the caps on their benefit payments. Under the new system, many families will no longer be
limited by these caps, which means that child care prices could also fall in the March quarter next
year.
These identifiable prices changes are likely to result in a lower inflation outcome in the September
quarter, although it is possible that there are other offsetting movements in other prices that are not
as apparent at this stage. We expect these price changes to be mostly confined to the September
quarter but there might be further declines in administered prices in subsequent quarters because of
other government initiatives to reduce cost-of-living pressures. At the same time, it is worth bearing
in mind that such price changes do also boost household purchasing power. This will boost spending
on other goods and services potentially leading to higher prices elsewhere.
Utilities
Utility prices have risen at a faster rate than other prices for the past couple of decades, including
large rises in electricity and gas prices in 2017 (Graph 16).
Graph 16
outlined the factors contributing to this outcome. The ACCC highlighted significant over
investment in state-owned networks in some states and that networks have recouped the cost of this
over-investment from customers. Meanwhile, the supply and demand balance within the wholesale
market has tightened following the retirement of some coal-fired generation capacity. High prices
have also led households to increasingly make use of solar panels and energy efficient appliances,
which has reduced demand for energy from the National Electricity Market. Gas generation has
become an increasingly important source of energy, but the cost of this gas has increased
dramatically alongside an increase in exports and domestic restrictions on further exploration. The
ACCC also identified some elements of the energy market's structure that have contributed to higher
bills for customers. High and rising prices are usually a signal to market participants to invest in
additional supply. However, the payoff period for new energy generation assets is long, and
uncertainty around energy policy has contributed to significant underinvestment in new supply.
As a result of these factors, wholesale energy prices increased markedly over the course of 2016 and
2017. Higher wholesale prices led to an increase in electricity and gas inflation, since wholesale
market costs account for around 30 to 40 per cent of consumers' electricity bills.
However, these dynamics have changed quite markedly. Wholesale electricity prices have declined
from their recent peak and the large volume of new renewable energy generation expected to come
on line may put further downward pressure on wholesale prices (Graph 17). The recent decline in
wholesale prices and an increase in competition amongst energy retailers has seen a decline in
market offer prices in many states. Furthermore, many energy retailers have indicated that they will
not be changing their standing offer prices in the September quarter, while others have indicated that
they will be lowering their prices. As a result, we expect utility prices to decline in the coming
quarters. How this plays out over the period ahead is another significant uncertainty for the Bank's
inflation forecast.
Tobacco
Finally, I will briefly touch on the contribution of tobacco prices to inflation. Unlike most of the other
components of the CPI I have talked about, tobacco prices have been rising at an historically fast
pace.
Rising tobacco prices have been the single largest contributor to headline inflation for some time now
(Graph 18). In fact, higher tobacco prices contributed 0.6 percentage points to headline inflation over
the year to June 2018. The high rate of tobacco inflation reflects the introduction of a new indexation
regime in December 2013, which was to see the tobacco excise increase by 12.5 per cent per year
above average earnings. This regime, which was originally legislated for four years, was subsequently
extended out to 2020.
Conclusion
In conclusion, I have discussed some of the dynamics that have contributed to the lower inflation
outcomes in recent years. These include increased competition in the retail sector, historically low
rental growth, the slow pace of wages growth and developments in some administered prices.
Utilities prices have been boosting inflation for a number of years but are now expected to reduce it
in the period ahead.
Our current forecast for inflation is broadly unchanged from earlier forecasts. We did revise down our
expectation for inflation in the current quarter for reasons I have just discussed. Beyond the
September quarter, we continue to expect inflation to be around 21⁄4 per cent over the next couple of
years as above-trend GDP growth reduces spare capacity in the labour market and there is an
associated pick-up in wages growth. We expect most of these other forces that have contributed to
the recent low rate of inflation to abate but there is uncertainty about how much longer they will
persist. We would like to be more confident that inflation will be sustained at a rate consistent with
the target.
That said, the Australian economy remains on the path it has been for at least the past year and a
half. Although inflation is likely to be a bit lower in the near term, this is expected to be temporary.
Further gradual progress on both lowering unemployment and bringing inflation closer to the
midpoint of the target is expected over coming years. The current accommodative stance of
monetary policy will assist this outcome.
Endnotes
[*] Thanks to Natasha Cassidy, Jonathan Hambur and Mike Read for their assistance.
[1] The Consumer Price Index (CPI) captures changes in the prices of the basket of goods and services that are
consumed by households. Each individual item is categorised into one of around 90 expenditure classes. In deciding
what goods and services to include in the CPI basket and what their weights should be, the ABS uses information
about how much - and on what - households in Australia spend their income. These expenditure weights will now
be updated on an annual basis. For more information, see RBA (Reserve Bank of Australia) (2017), 'Box D: Updated
Weights for the Consumer Price Index', Statement on Monetary Policy, November, pp 60-63.
[2] Over the longer term, in principle, the inflation rate should be determined by macroeconomic forces and shouldn't be
affected by relative price movements. But over shorter horizons, individual price movements can have a large
impact. A fall in the price of one good should boost household spending power and demand for other goods and
services boosting their price, but this can take some time to play out.
[3] The results of these studies are based, in part, on ABR data supplied by the Registrar to the ABS under A New Tax
System (Australian Business Number) Act 1999 and tax data supplied by the ATO to the ABS under the Taxation
Administration Act 1953. https://www.rba.gov.au/disclaimer/blade-disclaimer.html
[4] See Jacobs D, D Perera and T Williams (2014), 'Inflation and the Cost of Living', RBA Bulletin, pp 33-46 for a
discussion of these issues.
[5]
RBA (2017), 'Box D: Updated Weights for the Consumer Price Index', Statement on Monetary Policy, November,
pp 60-63.
[6] New dwelling cost inflation is measured as the cost of newly built owner-occupied housing, excluding the value of
the land. The price of established dwellings has no direct influence on CPI inflation.
[7] Though this came after a period of time where the growth in the housing stock lagged that of the population, which
likely boosted rents.
[8] ACCC (2018), 'Restoring electricity affordability and Australia's competitive advantage', Retail Electricity Pricing
Inquiry - Final Report, June.