There's a 'great divide' in Australia's economy, and it's complicating the inflation challenge (2024)

Are you struggling to understand what's happening with inflation?

We know the economy has been slowing down for a year and inflation has been declining.

In fact, inflation has dropped from an annual rate of 7.8 per cent to 3.6 per cent, which has encouraged talk of interest rate cuts.

But the prices of essentials are still rising faster than other goods, which is keeping many household budgets under extreme pressure.

Why is that happening?

The 'growing divide' in the economy

Last week, Westpac economist Jameson Coombs explained what's going on.

He said there's a growing divide between different components of Australia's economy, and it's making the Reserve Bank's job harder.

"But it also helps explain why the spending announced in the federal budget may not add much to inflationary pressures," he said in a note.

Here's what he meant.

Mr Coombs says inflation can be dissected and rearranged in many ways.

But one of the most telling ways to do it, at the moment, is between essential and discretionary items.

Essential items refer to vital goods and services such as groceries, housing, energy, education and healthcare.

Discretionary or 'non-essential' items refer to things we can delay purchasing if we want, such as holidays, recreation, hospitality, and clothing and footwear.

Mr Coombs says it's our purchases of essential items in the inflation basket that are keeping overall inflation above the Reserve Bank's target.

What does that mean?

Have a look at the graph below.

In the March quarter, the annual rate of growth in discretionary inflation (the purple line) actually fell back into the Reserve Bank's target range of 2-3 per cent, but essential inflation (the red line) is still sitting at 4.2 per cent, well above the range.

That's a problem for the RBA because monetary policy (the controlled manipulation of interest rates) has a harder time reducing our demand for essentials.

There's a 'great divide' in Australia's economy, and it's complicating the inflation challenge (1)

You can see that reflected in our household consumption data.

In the year to the March quarter, household spending on discretionary items rose by a piddling 0.1 per cent, but spending on essential items rose by 2.1 per cent.

"This must also be considered in the context of rapid population growth, which is adding to demand for goods and services," Mr Coombs says.

There's a 'great divide' in Australia's economy, and it's complicating the inflation challenge (2)

He says that weaker demand in the discretionary side of the economy is translating into softer demand for labour in discretionary industries.

"Retail and accommodation and food services industries are among the only industries to have recorded a fall in employment over the last 12 months," he says.

"In contrast, employment growth has been strongest in the essential industries of healthcare and education – these sectors also feature large public components, another source of resilience in demand."

Mr Coombs says that point is important.

He says the RBA has limited ability to influence short-run demand for essential goods and services and it's complicating its decision-making about interest rates.

"Monetary policy has the biggest impact on demand for discretionary goods and services and, therefore, discretionary inflation," he says.

"It doesn't mean that the RBA can do nothing about inflation, but it does mean that if essential inflation remains too high, discretionary inflation will need to be even lower to offset it."

Why the big boost in labour supply has been uneven

But that's not the end of it.

Mr Coombs says an even bigger challenge for the RBA is coming from the supply side of the economy itself, where monetary policy has even less of a direct impact than it does on the demand side.

He says as supply chains recovered from the effects of the lockdowns, many temporary disruptions on the supply side of the economy have unwound.

It's seen the availability of intermediate and capital goods improve significantly, and the source of capacity constraints shift from finding inputs to finding enough labour.

He says the big surge in labour supply that occurred after international borders were reopened has alleviated some labour shortages, but the boost in labour supply hasn't been distributed evenly.

A disproportionate share of the migration intake has belonged to low-skill visa holders, predominantly students, and the influx of low-skilled workers has funnelled towards low skilled roles in industries such retail, hospitality, and administration.

He says the rapid increase in migration hasn't had the same labour supply boost in high-skilled areas needed in healthcare, education and construction.

See the graph below.

"Broadly speaking, discretionary segments of the economy rely more on low-skilled labour and imported manufactured goods where there has been a more meaningful improvement in supply," he says.

There's a 'great divide' in Australia's economy, and it's complicating the inflation challenge (3)

"Combined with weaker demand, market fundamentals have moved into better balance in the discretionary areas of the economy, and this better balance is reflected in the discretionary inflation measure."

The link with our housing (and insurance) problems

And there's another layer to the problem.

Mr Coombs says the lingering effects of the pandemic have been more persistent in some essential sectors of the economy such as housing and insurance.

He says housing inflation, even though it's grounded in supply and demand mismatches, is being exacerbated by the elevated level of construction costs, elongated and uncertain build times, and a spike in corporate insolvencies.

Similarly, he says, the sharp rise in the price of vehicles, healthcare, and dwelling construction after the pandemic has been feeding back into insurance prices with a lag.

"The dollar value of [insurance] cover needs to go up to match the higher cost of goods and services, meaning a larger nominal exposure for insurers," he says.

"Combined with more frequent natural disasters, this is putting significant upward pressure on insurance premiums."

Mr Coombs says as the supply-side of the economy continues to recover over time, these essential sectors should become better balanced and help the RBA to achieve its inflation target.

But time isn't on the RBA's side, because the RBA really wants to get inflation back down before people start to lose faith in its ability to do so.

"This is a quandary facing the RBA," he says.

"A slower expansion of supply in these essential segments of the economy risks inflation staying too high for too long.

"But hiking interest rates further to bring inflation down only serves to hit the discretionary side of the economy harder, potentially risking a bigger economic slowdown and a larger deterioration in the labour market."

Criticisms ignore the 'fundamental structure' of the inflation challenge

Which brings us to the final section.

Mr Coombs says this is where the cost-of-living package in the Albanese government's latest budget comes in.

The package included the revised Stage 3 tax cuts, a $300 energy rebate for every household, a boost to rent assistance, and a freeze on indexation for some items on the pharmaceuticals benefits scheme.

He says fiscal policy (government spending and taxing decisions) should ideally run in the same direction as monetary policy, especially when inflation is too high, and some economists have argued elements of the government's cost-of-living package will be inflationary.

But he thinks the package will buy the RBA more time.

"An important feature of these last three measures is that they directly reduce the out-of-pocket expenses of households on electricity, rent and pharmaceuticals," he argues.

"This mechanically reduces inflation as measured by the consumer price index (CPI). Treasury estimates this will reduce the headline CPI by around 0.5 percentage points over the year to June 2025.

"Many economists have been quick to point out that the subsidies also free up income which would have otherwise been spent on these items, which can now be deployed elsewhere, adding to demand.

"Additionally, it has been argued that the net effect of the mechanical drag on inflation and the boost to demand from the subsidies will add to inflation.

"However, these arguments ignore the fundamental structure of the inflation challenge outlined above."

Mr Coombs says if you look closer, you'd notice that the cost-of-living subsidies directly reduce measured inflation in essential categories (housing, energy, healthcare), and that will buy the RBA more time for the underlying supply-demand dynamics to keep improving.

"Additionally, the boost to demand from the resulting 'savings' is most likely to be concentrated on discretionary rather than essential goods and services, as many households are already outlaying what's needed for essentials," he argues.

"This will dilute the impact on inflation as it adds to demand in sectors where there are not currently capacity constraints but rather, emerging slack."

Does that help to make sense of things?

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There's a 'great divide' in Australia's economy, and it's complicating the inflation challenge (2024)
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