Beyond housing, regional underlying inflation is remarkably similar
Once housing is excluded, state inflation outcomes look strikingly alike, despite large differences in economic growth, labour market conditions and income growth.
- Underlying inflation is remarkably similar across the states despite, at times, very different economic conditions. Indeed, once housing is excluded, state measures of underlying inflation are strikingly close even in periods when there are large differences in growth, labour market conditions, household incomes and unit labour costs. This suggests that outside the housing sector, supply is generally able to respond relatively quickly to regional demand pressures as traded goods, and much domestic production, relies on national supply chains.
- Where there are divergences, housing costs have accounted for around half of the gap in underlying inflation since 2000 and more than 60% of the divergence during the mining boom. Housing supply responds slowly to demand shocks, making inflation outcomes more dependent on local demand conditions.
- The mining boom showed that labour inflows helped contain broader inflation pressures but also intensified housing demand and related inflation. Today's data centre and renewables investment boom (see here) is less likely to drive large population shifts, but competition for construction labour, materials and housing supply could generate an inflationary impulse.
As our Coast to Coast report has highlighted over the years, economic conditions can vary significantly across states. However, many of these differences narrow over time, partly as associated price and wage differences encourage individuals and businesses to adjust. That process can differ depending on the exact nature of imbalances across states. Here we take a closer look at how inflation has behaved across states, where gaps have emerged in the past and where they have tended to be more material and persistent. This, in turn, may provide some clues about the drivers of cycles in underlying inflation nationally.
A difficulty with this comparison is that headline inflation measures are heavily distorted by state specific government policy. Cost-of-living measures, including energy rebates and housing-related interventions, have had a significant influence on CPI outcomes in recent years. To look through these effects, we construct state-level measures of underlying inflation, including a housing-adjusted trimmed mean that excludes new dwelling purchase costs, rents and property rates.
The chart below shows our estimates of trimmed mean inflation across the capital cities (which we use as proxies for states). They reveal significant differences in underlying inflation over time. The clearest sustained differences are around the surge in inflation in WA and Qld in the initial stages of the mining boom of the mid-2000s, and the subsequent period of markedly lower inflation (including a brief period of deflation) in WA during the mid-2010s. However, divergences have generally been short-lived, with state inflation outcomes eventually converging towards the national pulse.
For the most recent periods, the trimmed mean measures effectively strip out the noise coming from cost-of-living measures (as per the national measure). The state TMs show underlying inflation has accelerated across all jurisdictions. But there are some significant variations with Vic recording the lowest rate of underlying inflation (3.6%yr) in Q2 and Tas the highest (4.3%yr).
Much of this remaining variation comes from housing-related components (new dwellings, rents and property rates). Indeed, we estimate that these components account for around 50% of the underlying inflation gap between states since 2000, and over 60% of the gap during the mining boom.
We can see this visually by stripping out housing components from our TM measures. As the chart below shows, the difference across states largely disappears when we look at underlying inflation (ex-housing).
Importantly, these results provide valuable clues about the drivers of inflation, both today and into the future. Despite substantial variation in economic conditions, income growth and labour market outcomes across states, underlying inflation excluding housing has remained remarkably similar across state. This suggests that, outside the housing sector, supply is generally able to adjust to variations in demand across states relatively quickly, ‘equalising’ the impact on price inflation.
Clues from the mining investment cycle?
Why would state variations in housing costs be more persistent? The mining investment cycle may offer some insights here.
The boom phase of the mining investment cycle saw dramatic rises in commodity prices in its early stages with windfall gains for miners, some of which passed on to household and government incomes (including via share holdings). As the surge in investment mobilised, supply constraints started to emerge, particularly in the construction sector. Notably, differences in wage inflation (and unit labour costs) between the mining and non-mining states are somewhat starker and more sustained than for broader inflation. The stronger employment and wage gains added to the state wedge in household income growth. However, it also drew a supply response. Surging international and inter-state migration flows saw population growth hit 3.5%yr in WA with labour supply also significantly augmented by the use of ‘fly-in-fly-out’ workers travelling inter-state.
For housing, the situation is more difficult. Supply responses are slow at the best of times but faced intense competition for inputs from mining-related activity, particularly labour but also some locally-sourced material inputs. Meanwhile the population shift was pumping up housing demand. Perth’s rental vacancy rate, which was around 4% coming into the boom, dropped to just 1.4% by 2007. With incomes also rising, the combination saw both the city’s rents and established dwelling prices surge at a strong double-digit growth rate that lasted the best part of five years.
These dynamics reverse during the downturn phase of the cycle. And again, the effects can be more lasting for housing related costs, as the turnaround in migration flows and a lagged rise in housing supply amplifies the income effects from the investment wind down.
Fast forward to today
As data centre and renewable energy investment accelerates, the key inflation risk may not be stronger demand itself but the extent to which it spills over to the construction side of the housing sector. The data centre and renewables boom has a very different geographic pattern that suggests population shifts are unlikely to present the same challenges they did during the mining boom. It is also unlikely to draw in international migrants in the way the mining boom did either.
However, the competition for labour and locally-sourced construction materials will be the key factor. And construction capacity, labour and housing supply are all coming into this cycle from a tighter starting point than in the early 2000s, suggesting even modest increases in demand for construction services could generate a significant inflationary impulse.
While that leaves some open questions, the general takeaway from this analysis of state inflation trends is that housing related components of the CPI are the ones to keep an eye on when assessing how these developments may be influencing underlying inflation trends.
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