PE Economics Oct 2023

Published by Plain English Economics Pty Ltd. PO Box 522 Jannali NSW 2226 Email: info@plain-english.com.au plain-english.com.au Inflation continues to moderate Australia’s inflation rate has continued to pull back from earlier peaks, which is consistent with the general trend being experienced globally. The Consumer Price Index (CPI) rose by 1.2% in the 3 months to September. Whilst this quarterly increase was higher than the 0.8% recorded in the 3 months to June, it allowed the annual rate to decline from 6.0% to 5.4%. Following the surge in price pressure following the COVID crisis, Australia’s annual inflation rate peaked at 7.8% in December 2022. In the lead up to this peak, a combination of high fiscal and monetary policy stimulus, as well as significant supply disruption, had caused a sharp increase in inflation across the globe. Although inflation has subsequently declined steadily over 2023, the fall has not been as fast as many expected. A key contributor to higher prices in the September quarter was the transport category, with fuel prices rising by 7.2%. This reflected higher global crude oil prices, which occurred prior to the tragic Middle Eastern conflict in October. Also making a significant contribution to inflation was the housing category (up 2.2%). Included in this category were electricity costs, which rose 4.2%. Electricity costs rose due to higher wholesale prices being passed through to households from July annual price reviews. These increases were partially offset by the introduction of the “Energy Bill Relief Fund” rebates. Without these rebates, electricity prices would have been 18.6% higher. Additionally, council property rates rose by 4.4% over the quarter, largely reflecting annual rate reviews, which were the highest since 2015. Also included in the housing category are rental costs, which jumped 2.2% in the quarter. The annual increase in rents of 7.6% is the highest recorded since 2009 and reflects exceptionally low vacancy rates across residential property in most cities and regions. Partially offsetting the above price increases was a decline in household services costs, primarily due to Childcare costs dropping 13.2% following changes to the Childcare Subsidy arrangements. These Subsidy arrangements also impacted on the Education category, where prices fell by 0.2%, as families with children in long day care as part of a preschool program also benefiting from the Subsidy. Also having a moderating impact on the inflation rate was the food category, where price rises of 0.6% were below the overall CPI average. A fall of 3.7% in fruit & vegetable prices contributed to this lower result, with climate conditions generally favourable in many agricultural regions. The decline in Australia’s inflation rate may have been faster over the past year if it were not for movements in the Australian dollar. On the Trade Weighted Index (which measures the value of the Australian dollar against a basket of currencies, weighted according to their share of trade with Australia), the $A dropped 2.0% over the year to the end of October. A lower exchange rate will increase the $A price paid for imports and can therefore inflate the price of those categories in the CPI measure that are imported. Source: Australian Bureau of Statistics 6401 The above chart traces both the “headline” and the “underlying” rate of inflation. The “underlying” measure of inflation removes seasonal factors, outliers and more volatile components of the CPI, in an attempt to measure October 2023 Volume 30 Issue 10 (ISSN Digital 2208-0325)

2 the “core” rate of price increase. As the chart demonstrates, underlying inflation is less volatile than the “headline” unadjusted CPI measure. Currently, the underlying rate is measured at 5.2%, which is marginally below the 5.4% headline rate. The sharp increase in fuel prices may be one factor contributing to the headline rate being above the underlying rate. Notably, underlying inflation is well above the Reserve Bank’s longer-term average target range of 2% to 3%; after being consistently below this range in the pre COVID period. Q1: Identify 2 factors that contributed to a lower rate of inflation over the September quarter. Q2: Define the term “underlying rate of inflation”. Monetary policy tightened again Despite the fall in the inflation rate, the pace of decline has not been significant enough to avoid another tightening of monetary policy. To reduce inflationary pressures in the Australian economy, the Reserve Bank (RBA) has progressively tightened monetary policy, lifting interest rates steadily since May last year, when the cash interest rate was at an “emergency” low setting of 0.1%. However, there was recently a pause in rate rises, with no change in policy between July and October of this year. However, following its Board Meeting in early November, the RBA announced a further 0.25% increase in the cash interest rate, which is now targeted at 4.35%. Source: RBA By raising interest rates, the Reserve Bank is attempting to dampen spending growth. Higher interest rates make it more expensive for individuals and firms to borrow, thereby providing reduced incentive for loan funded expenditure and diverting income to loan repayments rather than spending. In addition, higher interest rates also provide more incentive for saving, making consumption expenditure less attractive on a relative basis. In this way, a tightening of monetary policy can lead to reduced spending, potentially slowing economic growth and taking upward pressure off prices. In announcing the change in policy, the Governor of the Reserve Bank, Michelle Bullock, highlighted that inflation had not fallen as quickly as expected, as per the statement below: “Inflation in Australia has passed its peak but is still too high and is proving more persistent than expected a few months ago. The latest reading on CPI inflation indicates that while goods price inflation has eased further, the prices of many services are continuing to rise briskly. While the central forecast is for CPI inflation to continue to decline, progress looks to be slower than earlier expected.” The Governor also made refence to the fact that housing prices continued to increase and that unemployment was forecast to rise more slowly than previously expected. Both these factors may have added to the rationale to increase interest rates. However, the Governor also acknowledged that household consumption growth was weak and that there were uncertainties stemming from the Chinese economy and overseas conflicts. Q3: Explain how higher interest rates can lead to less upward pressure on inflation. Q4: Evaluate the rationale for the tightening of monetary policy by the RBA in November. Consumer spending has started to ease As mentioned by the RBA Governor in the November Monetary Policy Announcement, there has been some slowing in consumer spending across the Australian economy over recent quarters. After initially showing some resiliency in the early periods of interest rate increases, the volume of retail trade has been in decline. Over the year to the end of September, retail spending (adjusted for price change) has declined by 1.7%, with 3 of the past 4 quarters showing volume decline. The contraction in retail spending is even more significant, when considered on a per person basis, as the rate of population growth has been very strong. The latest estimate of the Australian population annual growth rate (for the period ending March 2023) is 2.2%. Assuming this rate of population growth has continued through to

4 (referred to as Quantitative Easing) and the fiscal stimulus unwound, money supply growth has been reduced significantly. Source Reserve Bank of Australia Money supply growth may be deemed high or excessive when it is well above the nominal rate of economic growth (i.e., real output growth plus inflation). When the money supply is growing faster than nominal output, additional money can create demand pressure and lead to a bidding up of prices i.e., inflation. The relationship between money supply and inflation is described by the “Quantity Theory of Money”, an economic theory revived by Milton Friedman in the late 1940s. Although money supply has at times been a key focus area of central banks, it has become a less prominent indicator since the 1980s. None-the-less, the recent experience of escalation in money supply growth coinciding with higher inflation across the globe in the COVID period is consistent with this theory – as is the subsequent slowing in money supply, inflation and economic growth in the more recent period. Q7: Describe the potential implications of the decreasing rate of growth in the money supply on inflation. Trade surplus narrows Following a period in which the export sector has made a significant contribution to demand in the Australian economy, there are signs that net exports are slowing. Monthly data comparing receipts from the export of goods to the payments for imports in September (the “ Balance on Goods ”) showed the smallest net export surplus since March 2021. The trend for export receipts has been negative over the past year, with declining commodity prices being a key factor reducing receipts. Source: Australian Bureau of Statistics As shown on the chart above, whereas export receipts have been declining, payments for imports are close to a historical high and have risen over recent months. Although moderate consumer expenditure has resulted in consumption imports remaining relatively stable, there has been an ongoing increase in capital or investment goods (particularly industrial transport). Higher imports of capital goods are consistent with the relatively strong growth in business investment recorded over recent quarters, which has defied the impact of higher interest rates so far. With exports receipts in decline, there is less income flowing into the economy from the trade in goods. This impacts the profitability of export businesses, which in turn reduces the profit base from which the Government can collect company tax. Higher commodity prices and export receipts over 2021 and 2022 were key factors in shifting the Commonwealth Government Budget position to a surplus of $22.1 billion in the 2022/23 financial year. This was the first surplus recorded for 15 years. Q8: Explain why Australia’s exports receipts have been in decline over the past year. Stats on Australia Latest Previous Year Economic Growth 2.1% (Year to Jun) 3.1% Inflation 5.4% (Year to Sep) 7.3% Unemployment 3.6% (Sep) 3.6% Employment Growth 2.9% (Year to Sep) 6.5% Wage Price Index 3.6% (Year to Jun) 2.6% Exchange Rate (TWI) 60.2 (31st Oct) 61.3 Cash Interest Rate 4.35% (Nov) 2.85% Current Account Surplus $30.4 bn (Yr to Jun) $43.4 bn Current Acct (% GDP) 1.2% (Year to Jun) 1.9% Foreign Debt (% GDP) 46.3% (End Jun) 50.5% Source: Australian Bureau of Statistics & Reserve Bank This is the final issue of Plain English Economics for 2023. Best wishes to all readers.