What inflation means for your business

By Ivan Colhoun

The recent Q2 CPI result has suggested interest rates will not have to rise further, with markets quickly switching their attention to when Australian interest rates might first fall. This will depend on how much inflation continues to moderate, and the extent to which the unemployment rate rises in the coming months.

What is the RBA trying to achieve? The RBA is seeking to reduce the rate of inflation to around 3% by the middle of 2025 and to 2.5% in mid-2026. Importantly, this is not saying that prices will return (fall) to previous levels, but that the rate of increase in prices will be a more moderate 2-3% going forward. Indeed, if the RBA achieves its forecasts, the trimmed mean CPI price level that the RBA targets will be around 27% higher in mid-2026 than in Q4 2019, the quarter before COVID hit. That’s roughly the same increase in prices over the six-year period as over the eleven-and-a-half-year period from Q2 2008 to Q4 2019.

Why is low inflation important? Central banks target low inflation as this best contributes to sustainable economic growth and full employment. It does so by encouraging long-term, productive investment ahead of more speculative activities. Firms focus on controlling costs. In so doing, the central bank hopes to avoid short, stop-start economic cycles and recessions. In practical terms, if very high inflation persists, central banks historically have implemented high interest rates that have often led to recession. Recessions are extremely damaging with widespread business failures and job losses, though they also provide the opportunity for those with strong balance sheets to purchase assets cheaply. High inflation also tends to impact most on those on lower incomes.

How will the RBA achieve this? The RBA only has one tool to achieve this outcome, interest rates. If it is not confident that inflation is on track to moderate to these forecast lower rates of increase, it will raise interest rates again. The Q2 CPI published in late July was a key release for markets. Very pleasingly, a lower-than-expected 0.8% q/q outcome for the trimmed mean resulted, which is consistent with the RBA’s May forecasts for inflation to return to 2.5% in the next 18-24 months. A higher result would have meant a stronger likelihood the Reserve Bank Board would have implemented another insurance rate increase of 25bps at its August Board meeting. This now looks extremely unlikely even though Australian inflation is only slowly declining.

Where has the current bout of inflation come from? Economists theoretically argue that inflation reflects an excess of demand over supply. You may have read the RBA refer in some of its statements to current interest rate settings bringing about a better balance between supply and demand. Practically, the current bout of inflation reflects large impacts on both demand and the capacity to supply across many parts of the economy. COVID was the genesis of many of these shocks and economic imbalances.

The most important were the supply shocks as goods demand surged in the early part of COVID; the labour market shock as closed borders reduced foreign worker supply; the housing shock as extra space was demanded during COVID and ultra-low interest rates boosted demand – and more recently as foreign workers and students returned to our shores; and pent-up demand or COVID flow-on effects for a number of services, most notably overseas travel and accommodation after borders reopened but also insurance costs reflecting previous goods price rises. The overlapping surge in energy prices that occurred provided another important inflationary pulse to add to the host of COVID influences.

Thankfully, much of the goods market supply distortions have been resolved and labour markets are beginning to ease, though it’s clear that housing markets and energy prices remain an important source of price pressure in Australia. Inflation is easing more clearly in other countries, a trend that is likely also to be clearer in Australia next year. This slowing rate of inflation offshore is allowing central banks to begin to moderately reduce interest rates, with the US Federal Reserve expected to reduce rates in September. What happens in the US is very important as US interest rate trends are already producing downward pressure on longer-dated Australian interest rates.

What should I consider as a business, given the high rate of inflation?

A few ideas worth considering:

1. monitor the volumes of activity in your business (the number of units sold, or services produced) as well as the value of sales. When inflation is low, this distinction is mostly negligible, however, that’s not the case when inflation is high. It’s the volume of sales that drives important costs such as staffing and inventory levels, while the value of sales may be disguising an important downturn in demand;
2. examine opportunities for productivity improvements – this could be either by investment in a new machine or technology or by reviewing your business processes. Productivity improvements begin at the business level;
3. begin to push back on price rises and/or check the prices available from other suppliers, while also constraining your price rises where possible. This helps contribute to a lesser chance of a high interest rate led recession; and
4. for those with strong balance sheets, look for the opportunities that inevitably present during less favourable economic times and when interest rates are high.

What else should I expect?

1. The RBA won’t be reducing interest rates until it is more confident that inflation is tracking towards its 2.5% midpoint target over the next two years, or the unemployment rate is more clearly rising. Thankfully it now doesn’t look like it will need to raise rates further in August, while the first interest rate reductions may occur in the first half of 2025. High interest rates have predictable effects on discretionary spending and construction activity and for those with large debts. Growth will likely remain relatively slow and unemployment continue to drift higher over the next twelve months, though the 1 July income tax cuts will provide useful support to the economy in the near term;
2. Wages have not risen as much as inflation over the past few years, so the Fair Work Commission is likely to continue to increase minimum and award wages by a little more than the inflation rate in the next few years;
3. Be wary of economists making very confident predictions. Given the number of very large and diverse shocks hitting economies simultaneously, expect quite varied performance across different sectors of the economy. Some sectors will be experiencing weak business conditions due to high interest rates but also because of the pull forward in demand experienced during COVID. Others will likely benefit from the tailwinds of technology investment, the trend to renewable energy, defence spending and the ageing population. As always, it’s important to understand the fundamental factors driving demand in your business and not simply extrapolate current trends.

If you would like further detail, you may like to refer to the RBA’s Quarterly Statement on Monetary Policy (available at www.rba.gov.au).

 

Author: Ivan Colhoun  Consulting Economist for Bank of Sydney Bachelor of Economics (Hons) Ivan is a highly experienced chief economist and keynote speaker on the Australian economy and financial markets. His career has included leadership roles within financial and professional service organisations, as well as the Reserve Bank of Australia.