base-effects-propel-inflation-to-a-13-year-high

But most of the jump in the CPI reflects a combination of base effects (remember, the June quarter last year marked the largest quarterly fall in the CPI on record and the first bout of annual disinflation Australia has seen this century), pandemic-related disruptions and the distortionary impact of government policy measures such as free childcare.  All of which means that a better indication of underlying inflationary pressures is given by core measures such as the trimmed mean which rose by a rather more subdued 1.6 per cent over the year.  Moreover, any near-term prospects for a sharp pickup in inflationary pressures are now receding in the face of the expanding lockdown in Greater Sydney.  More evidence of the latter’s growing drag on activity came in the form of last Friday’s ‘Flash’ Composite PMI survey for July which showed private sector activity contracting for the first time since August last year.  Similarly, consumer confidence suffered a second substantial consecutive weekly fall last week, although it still remains well-above last year’s lows.   Meanwhile, although the IMF’s latest forecast update left its projection for global growth this year unchanged at a relatively robust-looking six per cent, a dive into the detail shows the Fund is worried about differential access to vaccines leading to a divided world economy and the consequent downside risks.

This week’s readings include a summary of the latest government financial support in the face of the NSW lockdowns, what’s in the CPI, an update on the state of the states, Australia’s governance failures, the unpleasant implications of three degrees of global warming, the rise and fall of WeWork, a deep dive on the US economy, understanding demographics, debt and declining interest rates, how the wealthy invest differently, Tooze on China’s rise and growing indispensability, Roach on Beijing’s tech crackdown, and the economics of US antitrust reform.

Finally, stay up to date on the economic front with our AICD Dismal Science podcast .
Listen and subscribe: Apple Podcasts | Google Podcasts | Spotify

What I’ve been following in Australia . . .

What happened:

The ABS said that Australia’s consumer price index (CPI) rose 0.8 per cent over the June quarter to be up 3.8 per cent over the year.

australia-consumer-price-index-cpi

According to the Bureau, price rises over the quarter were driven by increases in transport (up 2.8 per cent), health (up 1.5 per cent) and furnishings, household equipment and services (up 1.1 per cent) while in annual terms, the biggest increases were for the furnishings, household equipment and services group (which jumped by 16.9 per cent) and the transport group (up 10.7 per cent).

australia-cpi-by-main-groups-june-quarter-2021

Base effects and COVID-related developments were behind much of the overall increase in the CPI this quarter.  In the case of the transport group, for example, fuel prices rose 6.5 per cent in quarterly terms while soaring 27.3 per cent relative to their Q2:2020 level, reflecting developments in global oil markets over the course of the pandemic.  Likewise, in the same group, the price of motor vehicles rose 2.2 per cent over the quarter and 7.4 per cent over the year due to the impact of strong consumer demand meeting supply constraints arising from the global semiconductor shortage.  In the case of the furnishings, household equipment and services group, the main contributor to the overall increase was childcare, which rose 1.7 per cent over the quarter and jumped 16.9 per cent over the year.  Here the key explanatory factor was the unwinding of the free childcare policy that had been introduced in the same quarter last year, with the Bureau noting that if this was excluded, instead of hitting almost 17 per cent annual growth in the group would have been just one per cent. 

Other temporary factors worked to push prices down, rather than up. For example, consider the impact of the HomeBuilder grant along with several state-based housing construction grants.  The ABS reported that while prices for new dwellings fell 0.1 per cent over the June 2021 quarter, without the offset from housing grants, the outcome would instead have been a 1.9 per cent increase. Similarly, the Federal government’s half price airfares package contributed to fall in domestic airfares over the quarter (although it may also have contributed indirectly to a 5.4 per cent rise in accommodation prices).

Measures of core inflation, including the RBA’s preferred measure of the trimmed mean, were relatively more subdued.  The trimmed mean rose 0.5 per cent over the quarter and 1.6 per cent over the year while the weighted median was up 0.5 per cent quarter-on-quarter and 1.7 per cent year-on-year.

australia-measures-of-underlying-inflation

Why it matters:

The last time Australia’s headline rate of CPI inflation hit three per cent was in the June quarter of 2014, the last time it exceeded that figure and pushed through the top of the RBA’s target band was in Q3:2011 and the last time it was higher than 3.8 per cent was all the way back in Q3:2008.  All of which suggests that this was a pretty dramatic result.  But it was also a widely anticipated one.  The market consensus had been for a 0.7 per cent quarterly rise and a 3.7 per cent annual rate for the headline CPI, so the actual June quarter results were only a little stronger than expected.  The RBA has also been flagging the likelihood of a Q2:2021 surge in headline inflation for some time, including in the May 2021 Statement on Monetary Policy when the central bank had noted that ‘Headline inflation is expected to spike to above three per cent over the year to the June quarter 2021, largely because the initial declines in prices from pandemic-related policies (such as free child care and preschool) drop out of the year-ended calculation’ and gone on to predict an annual rate of 3.25 per cent for the quarter.

To provide some additional context for the result, it’s also important to recall that in the same quarter last year Australia saw the CPI fall by a record-breaking 1.9 per cent over the quarter and drop 0.3 per cent over the year. That was the largest quarterly fall in the 72-year history of the CPI, and until then there had only been four previous quarters since 1949 in which the annual inflation rate had been negative, none of which were in this century. 

With the headline CPI result being buffeted by a range of base effects, pandemic-related disruptions and government policy measures, a better guide to underlying inflationary pressures in the economy is given by core measures such as the trimmed mean and weighted median which are deliberately constructed to exclude large, one-off price changes.  And while it’s true that both of these series also rose over the quarter, it’s also the case that both were comfortably in line with market expectations and that in each case the rate of annual increase remained below two per cent.  Indeed, the trimmed mean – the RBA’s preferred measure of underlying inflation – has now been below two per cent and the bottom of the RBA’s target band for 21 consecutive quarters.

The ABS also suggested comparing the current CPI to pre-pandemic levels in the March 2020 quarter, which again shows headline inflation up a more muted 1.9 per cent, delivering a similar message to the core readings.

So despite that attention grabbing headline rate, the underlying story here is broadly consistent with the narrative that the RBA has been pushing about the Australian economy: we should expect a temporary (or transitory to use the preferred terminology) surge in inflation in the short-run, but then also expect inflation to fall back again. 

As we’ve discussed previously, one important risk to this sanguine official view is that high current rates of inflation could end up destabilising inflation expectations.  There are some signs that inflation expectations have risen, with business surveys in particular reporting rising cost pressures and higher final product prices.

australia-measures-of-inflation-expectations

But the overall scale of increases remains modest while for their part financial markets are still far from predicting any substantial inflation overshoot.

australia-inflation-expectations-break-even-rates

Moreover, near-term inflation risk has now retreated given the likely impact of the extending lockdown in Greater Sydney.  Granted, in theory lockdowns can have offsetting impacts on price pressures: as we’ve seen, disruptions to the supply side of the economy can serve to push costs up even as the demand side of the economy is squeezed.  In practice, however, the balance of the evidence to date suggests that the disinflationary impact of weaker demand and a softer labour market tends to dominate, at least in the short term.

What happened:

Last Friday, the Flash IHS Markit PMI (pdf) slumped to 45.2 this month, down from a final reading of 56.7 in June, where a reading below 50 signals that private sector activity is contracting

australia-composite-purchasing-managers-index-pmi

The IHS Markit Flash Services Business Activity Index fell to 44.2 in July, from a final reading of 56.8 in June while the IHS Markit Flash Manufacturing PMI eased to 56.8 this month from 58.6 last month.

australia-manufacturing-and-services-purchasing-managers-index-pmi

IHS Markit reported that demand and output conditions overall softened significantly in July, particularly for services where order book volumes slipped into contraction. And while new orders for manufacturing remained in positive territory in July, the PMI survey reported that ‘anecdotal evidence suggested that the COVID-19 movement restrictions contributed to the rate of expansion easing to the slowest since last November.’

The Composite PMI survey also reported a sharp slowdown in the pace of job creation, although the overall indicator for employment conditions remained in positive territory.  Likewise, while optimism about output levels over the next 12 months dropped to its lowest level in almost a year, it too remained in expansionary territory.

Price pressures eased in July across both input prices and output charges, though both also remained above their respective survey averages. And in an exception to the overall trend, manufacturing input cost inflation accelerated this month with firms reporting higher cost pressures that were being intensified by COVID-19 disruptions.

Why it matters:

This month’s falls in the Composite PMI and the Services Activity Index marks an end to ten consecutive months of positive readings for both indices.  It also takes them both down to their lowest level since May 2020.  Manufacturing activity, however, remains relatively resilient, with the Manufacturing PMI now having been in expansionary territory for an uninterrupted run of 14 months. The pandemic also continues to disrupt firms’ supply chains. 

At the same time, and despite some steep falls in both confidence and employment indicators, businesses in aggregate are still able to look beyond current lockdowns enough to keep both of those indicators in positive territory.  That degree of resilience will be tested by the longevity of current public health restrictions in New South Wales.

What happened:

The ANZ-Roy Morgan Index of Consumer Confidence slumped 3.5 per cent last week to an index level of 100.7.

australia-anz-roy-morgan-weekly-consumer-confidence

All five subindices fell over the week, with the largest drops coming in those that report on current conditions: ‘current economic conditions’ tumbled six per cent while ‘current financial conditions’ declined 3.4 per cent.

The index of ‘Weekly inflation expectations’ rose 0.1 percentage point to 4.3 per cent, its highest level since March last year.

australia-anz-roy-morgan-inflation-expectations-two-year-ahead

Why it matters:

After dropping by more than five per cent in the previous week, last week saw the confidence index drop a further 3.5 per cent, leaving the index at its lowest level since November last year.  Ongoing public health restrictions and continued increases in case numbers saw the national index dragged down by a 2.2 per cent drop in Sydney and a 6.4 per cent fall in Melbourne. Confidence also fell in Brisbane (down 6.1 per cent) and Perth (down 4.6 per cent) but edged up slightly in Adelaide (a rise of 0.5 per cent). 

Despite those two large, consecutive weekly declines, however, the index is still up around 13 per cent in year-on-year terms  and is also about 54 per cent higher than the low reached in the week ending 28-29 March 2020 early in the pandemic.

. . . and what I’ve been following in the global economy

What happened:

The IMF released its July 2021 World Economic Outlook (WEO) Update.  In the April 2021 WEO, the Fund thought that the world economy (with output measured at purchasing power parity exchange rates) would grow by six per cent this year and 4.4 per cent in 2022.  The new forecasts still see output growing at six per cent this year but have revised up growth expectations for next year by half a percentage point to 4.9 per cent, with that upgrade largely underpinned by further US fiscal support and the associated spillovers to growth in the rest of the world economy.

global-real-gdp-growth-2000-2022

From the IMF’s sample of countries, India is still projected to be the fastest growing in 2021 (albeit in this case on a financial year basis), despite a substantial downgrade relative to April’s forecasts, with that country followed in the growth rankings by China, the United States, the United Kingdom and Argentina.  The IMF sees Australia growing at 5.3 per cent this year before slowing to three per cent in 2022, but these figures do not include the impact of the current lockdowns, which will see a significantly softer growth performance for 2021.

global-imf-forecasts-for-real-gdp-growth-in-2021

That unchanged headline number for global growth in 2021 also hides a significant shift in the IMF’s views on the global outlook.  In particular, while the forecast growth rate for advanced economies this year has been revised up by half a percentage point to 5.6 per cent the Fund has also downgraded the growth outlook for emerging and developing economies by 0.4 percentage points to 6.3 per cent.  There are also forecast revisions for both blocs in 2020, with the growth outlook for advanced economies upgraded by 0.8 percentage points and the outlook for emerging and developing economies lifted by a more modest 0.2 percentage points. 

That shift in the composition of growth is also apparent when global growth is calculated at market exchange rates (which give a relatively higher weight to advanced economies than emerging economies) instead of purchasing power parity exchange rates: on this basis, global GDP growth is expected to grow at six per cent this year, up 0.2 percentage points from the April 2021 WEO, and at 4.6 per cent in 2022, up 0.5 percentage points relative to the April WEO. 

As a result of these forecast revisions, the convergence gap (the difference between emerging economy growth and advanced economy growth) is projected to fall to just 0.7 percentage points this year, its lowest level since 1999.

world-the-growth-gap-and-convergence-1980-2022

Why it matters:

The most important story in the WEO update is the increasing divergence in growth prospects between advanced economies and much of the rest of the world economy, a performance gap that the Fund puts down to differential levels of vaccine access and of policy support. 

In the case of vaccine access, the IMF notes that while close to 40 per cent of the population in advanced economies had been fully vaccinated by early July, less than half that number had been vaccinated in emerging market economies and only a tiny fraction in low-income countries.  According to the Fund, that difference is splitting the global economy into two blocs. One bloc comprises most advanced economies and here the good news is that the Fund judges that the vaccination rollout is contributing to prospects for a normalisation in economic activity by the end of this year.  In the second bloc, however, the IMF worries that inadequate access to vaccines leaves countries vulnerable to resurgent infections and rising numbers of deaths.

global-distribution-of-vaccines-as-of-july-2021

The IMF’s targeted rate of vaccination to end the pandemic would see at least 40 per cent of the population of every country vaccinated by the end of this year and at least 60 per cent by mid-2022. But hitting that 40 per cent target will require a sharp increase in the supply of vaccines to low-income countries. By the end of June this year, the Fund estimates that about three billion doses of COVID-19 vaccinations had been administered worldwide, but nearly 75 per cent of those were in advanced economies and China.  That leaves close to half the world’s countries with daily vaccination rates below the rate needed to meet the 40 per cent target (given by the 45-degree line in the chart below).

global-vaccination-gaps-across-economies

The IMF also reckons that the economic fallout from the gap in public health outcomes is likely to be further exacerbated by differences in the scale of policy support available.  Advanced economies will continue to deploy active policy measures, led by aggressive fiscal actions in the United States plus new fiscal initiatives in countries including France, Germany, Italy, Korea and the United Kingdom.  Further, the Fund expects that the world’s major central banks will leave their policy rates untouched until at least the end of 2022.  In contrast, it points out that many emerging and developing economies have already started the process of trying to rebuild fiscal buffers while some of their central banks have also started a process of normalising monetary policy in response to rising price pressures and weaker exchange rates.

Finally, the July WEO Update also sets out some key risks to the IMF’s baseline projections, with the Fund noting that short-term risks are skewed to the downside.  Unsurprisingly, top of the Fund’s worry list is the global vaccine rollout, with a slower rollout than the one in the baseline, which assumes that most countries will have broad access to vaccines by the end of next year.  Failure to meet that target would risk the spread of new variants including higher chances of breakthrough infections among vaccinated populations.  The WEO includes two scenarios that consider the impact first of a new infection wave in emerging market and developing economies in the second half of this year, and second, the risk that new variants also trigger problems for those advanced economies where vaccine hesitancy has slowed the rollout of vaccinations.  Both scenarios indicate substantial cumulative losses to global output approaching US$4.5 trillion by 2025, albeit with different distributions between developing and advanced economies.

Another threat to the outlook highlighted by the July WEO is that the US fiscal impulse could turn out to be smaller than is currently expected while a third flagged risk is tighter global financial conditions that would drag down growth, worsen debt dynamics and intensify fiscal pressures, particularly in emerging and developing economies.  The WEO identifies three possible sources for such a development: a rise in corporate bankruptcies; price corrections in market segments such as crypto assets that could then trigger broader market sell offs; and a resurgence in inflation.  With regard to the last of the three, the Fund’s baseline forecast assumes that current inflationary pressures will largely be transitory, a judgement that rests on three pillars: the presence of significant labour market slack; well-anchored inflation expectations; and the persistence of structural factors that have previously contained price and wage pressures such as automation (which may even intensify going forwards).  But if current inflationary pressures instead turn out to be persistent, driving up inflationary expectations, the consequence could be a significant reassessment of the outlook for monetary policy, particularly in the United States.

Rounding out the IMF’s list of downside risks are social unrest, geopolitical tensions, cyberattacks on critical infrastructure and weather-related natural disasters.  The lone upside risk to the forecast is better global cooperation on the vaccine rollout, leading in turn to a sooner-than-expected resolution to the health crisis, a resurgence in household and business confidence, and faster economic growth.

Despite the unchanged global growth forecast for this year and the upgrade to next year’s outlook, the imbalance between the long list of downside risks versus the single upside risk tells us something uncomfortable about where we are in the global economy right now: while the overall outlook for growth remains relatively positive, there is no doubt that the impact of the Delta variant and the rise in case numbers has dented some of the earlier optimism around the economic outlook and reintroduced a significant note of caution.  Businesses, households and economists have all been reminded that – despite the positive news around vaccines in many advanced economies – the world economy overall has yet to escape the grip of the pandemic.

What I’ve been reading . . .

  • ABC Business provides an overview of the latest COVID-19 financial support and highlights some big forecast downgrades for Q3 GDP.
  • Peter Martin explains what’s in the CPI in some useful background for this week’s inflation release, discussed above.
  • Commsec’s July 2021 State of the States once again awards Tasmania the title of best performing state economy.
  • From the AFR, Delta and the Dangers of Whiplash Economics.  (FT version here).
  • The July 2021 edition of the Department of Industry’s Australian Innovation System Monitor is now available. 
  • Noted but not yet read: the Tax Institute has set out the case for change for Australia’s tax system in the form of an extensive (more than 280 pages) report that covers the case for reform, business taxes, personal taxes, indirect taxes and superannuation. 
  • Gridlock: removing the barriers to policy reform, a new report from Grattan, argues that without an improvement in Australia’s governance, there is little prospect of the country getting the sort of substantial policy reforms that the Tax Institute and others are advocating.  A podcast with report author John Daley is also available.
  • A new RBA discussion paper looks at the Australian experience with macroprudential limits on mortgage products.  The paper reviews APRA’s 2014 policy requiring banks to limit their annual growth in investor mortgages to no more than 10 per cent and its 2017 policy that required banks to limit interest-only mortgages to no more than 30 per cent of their total new lending.  It finds that both policies were successful in that they led to a relatively quick reduction in growth in new lending of the type directly targeted by the policies. There was a difference across banks: large banks substituted across different types of housing credit to sustain their overall average rate of mortgage growth while mid-sized banks did not substitute and saw a decline in average growth.  An early sign that ‘macropru’ will once again be deployed in response to a runaway housing market?
  • The Parliamentary Budget Office (PBO) on JobSeeker.
  • An Economist magazine briefing on the potentially grim implications of three degrees of global warming: ‘a pretty likely outcome if nothing more gets done and the worst that might still happen even if things go very well indeed.’
  • Bloomberg profiles the Saudi Prince of Oil Prices.
  • The WSJ on the Rise and Fall of WeWork.
  • Also from the WSJ, Greg Ip on how inflation threatens the US recovery. Rather than ‘good’ demand-driven overheating, the danger is ‘bad’ supply-side cost push factors.
  • The latest IMF Article IV report on the US economy reckons that the combined impact of Washington’s Rescue, Jobs and Families Plans plus the Fed’s new Flexible Average Inflation Targeting Framework will add a accumulative 10.25 per cent to the level of GDP during 2021-23.  That in turn will bring the unemployment rate down to close to three per cent and return labour force participation rates to pre-pandemic levels by end-2022.  Supply-side changes are also expected to boost potential growth to around two per cent.  The IMF thinks that core PCE inflation (the Fed’s preferred measure, rather than CPI) will peak later this year but then fall back, with the report arguing that ‘significant remaining labour market slack…should serve as a safety valve to dampen underlying wage and price pressures.’  Inflation expectations are also assumed to remain ‘well-anchored.’  But the Article IV does note that an ‘overheating of the US economy that causes a surge in underlying inflation is not a likely outcome but does represent an important risk to both the US recovery and to global prospects’ going on to explain that a faster-than-expected rise in inflation would see markets start to reprice the path for policy rates and the inflation risk premium in dollar funding costs, leading to a steepening of the yield curve that could offset the positive demand effects for the rest of the world from a strong US recovery. There could also be an increase in risk premia leading to tighter financial conditions that could either slow the US recovery itself or even trigger a new downturn. 
  • The World Bank introduces a global database on inflation.
  • Gertjan Vlieghe’s final speech as a member of the Bank of England’s Monetary Policy Committee returns to the theme of why the world has ended up in a low interest rate environment and what the implications might be.  Vlieghe argues that demographics, debt and income inequality have all been important factors in lowering the neutral rate of interest.  In particular, he reckons we’re currently ‘about two thirds of the way through a multi-decade demographic transition that is affecting interest rates’ marked by increased saving on the part of the ageing.  This demographic downward pressure on rates is then exacerbated by income inequality that boosts private debt while also acting as a credit supply shock that drives down rates.  The policy implication is that not only is the current headroom for easing monetary policy strictly limited but that this is set to remain the case.  For more context I’d also recommend his Bank of England working paper Eight centuries of global real interest rates, R-G, and the ‘suprasecular’ decline, 1311–2018.
  • The FT Big Read asks can a new commodities boom revive Brazil?
  • Some Israeli evidence on the impact of the rise in telemedicine. The authors argue that their evidence suggests that the increased convenience of telemedicine does not compromise care quality or raise costs.
  • Barrero, Bloom and Davis use survey evidence to suggest that, along with some of the usual suspects  (labour market tightness, spatial mismatch and skills mismatch), another factor that might help explain the historically high level of quits and job openings seen in the US economy in recent months is that many workers and employers have discovered that working from home works better than anticipated, leading to the desire to continue working remotely after the pandemic ends. With only some employers willing and able to accommodate those desires, many workers are re-sorting across employers and into jobs that better suit their preferences over working arrangements. As that process plays out, they posit that it will push up quit rates while also driving high job opening rates, as employers contend with the need for a higher-than-normal pace of replacement hires.
  • Related, a new WEF survey on how attitudes to WFH vary by country.
  • The very wealthy invest differently: higher returns, more risk and a greater exposure to alternative assets (private equity, hedge funds).
  • Adam Tooze with a long essay on the significance of the rise of China.
  • Stephen Roach worries that Beijing’s crackdown on China’s technology firms could strangle the country’s most dynamic sector and undermine private sector development more generally.
  • Two podcasts to close.  First, Tyler Cowen in conversation with historian Niall Ferguson (I linked to another podcast on Ferguson a while back, but that one was more concerned with his recent book while the conversation here is more wide-ranging with a focus on ‘doing history’). Second, the Hexapodia podcast tackles US antitrust.