Building up a ‘home-grown’ inflation issue?
Issues in the home-building sector are still boosting goods inflation in Australia.
This week RBA Head of Economic Analysis Marion Kohler gave a speech on the economic outlook. Normally an RBA speech so soon after the release of the Statement on Monetary Policy will be designed to reinforce the messages in that publication, rather than present new ones. Nonetheless, one can often find useful detail or nuance that was not in the SMP.
One graph that caught my eye from Dr Kohler’s speech was Graph 3, decomposing core inflation into goods and services components for a range of countries. (The version in the SMP was six-month annualised, not the smoother year-ended measure, and excluded Australia.)
A few takeaways from this view of the data.
Electricity costs and the goods price rollover
First, core inflation measures have not fallen anywhere near as much as headline measures in most countries. Headline series are being flattered by the unwind of the previous surges in food and energy prices. Once those price falls wash out, headline inflation will converge on core rates. Depending on the pace of decline of core inflation, headline inflation could therefore pick up temporarily in some economies.
Australia is in a different situation. Because of the way our electricity market is regulated and priced, the main effect of Russia’s invasion of Ukraine on Australian retail electricity prices did not occur until the second half of 2023. The rise in businesses’ power costs has also been drawn out as supply contracts roll over. By contrast, in many countries the effect was already unwinding by then and dragging headline inflation down. This more drawn-out inflation dynamic is one of the reasons why headline inflation in Australia is still outpacing its peers.
Second, most of the decline in core inflation in advanced economies has been driven by the unwind in goods prices. During the pandemic, goods prices surged. Part of the reason was because supply chains were disrupted. Another was the shift of demand away from services to goods. People could not consume the same amount of services because many service industries were locked down. So they consumed goods instead; goods were effectively ‘other fruit’ to the disrupted services industry. Another part of the boost to demand for goods was the one-off purchase of electronics and other goods needed to support working from home.
These effects are now unwinding around the world. A general decline in demand was not required to achieve this. It was to be expected because the increase in goods prices was a response to other temporary factors, both on the supply side and on the demand side.
A ‘home-grown’ inflation issue
Third, Australia saw a larger peak contribution from goods inflation – almost 4 percentage points – than the other peer economies. At first glance this might have been interpreted as implying that Australia had a larger imbalance of supply versus demand than its peers. However, a deeper look shows this is not the case in general.
At its peak in mid-2022, nearly 2 percentage points of the contribution of goods inflation to total annual inflation was accounted for by one component – home-building costs. Part of this was because supply chain issues affected building materials as well as other commodities. Prices of many building materials are still rising in Australia, even though comparable data for some other countries are showing declines.
But there is more to it than this. ABS data on output prices for residential construction have been rising a bit faster than building materials costs in recent quarters. The price rises therefore can’t all be the passing on of recent increases in materials costs. Some of the difference might be labour costs, including from weather-related stoppages or more generalised poor productivity. Margins are presumably being rebuilt as well. This is understandable given that many builders were squeezed when rising costs collided with existing fixed-price contracts, with some becoming insolvent or otherwise leaving the industry.
Most countries do not include home-building costs in their CPI measure, but Canada does. It is a useful comparator given it, too, has seen strong population growth and rising housing prices. Population growth has been even stronger there than in Australia, exceeding 3% over 2023. The surge in rent inflation in Canada has been similar to that in Australia, peaking at around 8%.
Like Australia, Canada also saw a surge in building costs, but this peaked around the middle of 2022. Since then, the home-building component of the CPI has been declining slightly; it is now 2% below its peak. In contrast, home-building costs as measured in the Australian CPI have increased by around 7% over the same period. This is a significant gap to open up over a relatively short horizon.
An explanation for these Australia-specific developments cannot be found in price data alone. They do, however, show that the economics of construction are not compatible with meeting Australia’s home-building needs. The lingering backlog of approved but uncompleted homes also supports the view that construction industry capacity is currently the main binding constraint. Zoning reform or other interventions unrelated to the capacity and costs of construction will do nothing to address this specific issue. And while some might point to the high level of non-residential and infrastructure construction work calling on the same resources, it is noteworthy that price deflators for these sectors have increased by less than for housing construction.
Given the RBA’s focus on services price inflation, we do not expect this ‘home-grown’ inflation issue would cause it to misinterpret the underlying dynamics of supply and demand in Australia. It should, however, be front of mind in discussions about measures to expand housing supply.
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