A lack of shock and awe
The United States is an outlier among advanced economies, so how much signal should policymakers elsewhere take from recent upside surprises on US inflation? Less than some people seem to think.
Perhaps the issue didn’t strike them as pertinent to a conversation with an Australian. Still, I could not help noticing that none of the offshore customers I have spoken with over the past two weeks were that shocked by the recent upside surprises on US inflation and retail sales. After all, it’s not hard to end up with high inflation when your government is running a deficit of 6% of GDP, growth is above average and the labour market is already tight. So despite the ‘shock and awe’ reaction in financial markets, perhaps people were not that surprised after all.
As discussed last week, the US fiscal and consumer situations stand in contrast to Australia. In many respects, the United States is an outlier among advanced economies.
How much signal, then, should policymakers elsewhere take from recent US inflation surprises? It does highlight that, once inflation becomes domestically focused and driven by a high level of domestic demand, it can be sticky and hard to return to target rates. This is the source of the RBA’s concern about market services inflation. While services inflation has so far declined in line with the RBA’s earlier forecasts, the RBA is mindful that progress could stall, as it seems to have done in the United States. That said, as highlighted this week by Westpac’s Head of International Economics Elliot Clarke, current high rates of services inflation in the United States have less to do with the components related to discretionary spending and more to do with slower-moving components such as insurance and medical services. Discretionary spending is high but lacks further momentum. So there are downside risks here as well as upside risks.
Another point of comparison is the role of housing-related inflation. In the US CPI, this relates only to rents, scaled up and adjusted to include imputed rents for owner-occupiers. In Australia (and Canada and New Zealand) rental inflation’s weight in the total relates only to rents actually paid by renters. The contribution of owner-occupied housing to inflation is captured by the ‘acquisitions method’ – in other words, home-building costs. These, too, have increased significantly and in Australia they continue to escalate at an above-average pace.
The question is how long housing-related inflation will stay high. Across this group of economies, we have seen surges in population growth adding to demand for rental housing. At the same time, housing construction industries remain supply constrained, with domestic supply chains an issue in some cases. There is also a question of how much of the increased demand for housing represents a longer-lasting effect of increased working from home, which has seen some households needing more space than before.
If – as is the case for Australia and Canada – the population surge is largely a catch-up from pandemic-era restrictions, it should normalise over the next year or so. Indeed, this is Westpac Economics’ projection for Australia’s population growth, returning to the pre-pandemic norm of 1½% or a little above that in 2025. The rent component of CPIs relates to the stock of all rented properties, so it is slow-moving compared with most other components of inflation. But if we are right about the population surge in Australia being mostly a post-pandemic catch-up, then the burst of rental inflation should subside over time as well. (It would normalise even faster if the construction industry found a way to recover from current supply constraints.) The drivers of US population growth are somewhat different, and a slowing is not already baked into the dynamics there. This means that a slowing in US rent growth is less assured.
The upside risks to domestic inflation in countries such as Australia and Canada should not be dismissed. Given the nature of the housing-related inflation and the state of the consumer, though, neither should they be overblown. Recall that the Australian household sector has pulled back on consumption per capita in a way not seen elsewhere. Population growth initially masked this pullback from the perspective of the business sector. More recently, surveys are suggesting that businesses are now seeing the softness in demand and reacting to it, including in their pricing strategies.
We therefore cannot rule out – as a risk scenario, not currently our central case – that the conditions for withdrawing some of the restrictive stance of monetary policy will be met in Australia and some other economies before they are met in the United States. As we have explained previously, the RBA and other central banks do not need to wait for the Federal Reserve to move before they can do so. The RBA was cutting rates in the years leading up to the pandemic while the Federal Reserve was raising them. The signal from the US experience is as an example of what could happen elsewhere, not a direct linkage between rates decisions. It is also not the only such example. For this reason, watch the outcomes in Canada and Europe, not just the United States.
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