From inflation to deflation…and back again?

Australia’s Consumer Price Index rose by 2.2 per cent over the year in the March quarter, marking the first time that headline inflation made it inside the RBA’s target band since 2018. Next quarter will unwind that achievement however, as disinflation looms. Meanwhile, economists remain divided over the longer-term implications of the Coronavirus Crisis (CVC) for prices.

The Treasury secretary delivered an update on the economy this week. Credit growth to business jumped in March as firms sought to bolster liquidity. US GDP slumped in the first quarter of this year as spending on services plummeted by the most since the data series began. Worse is ahead. This week’s readings look at a bunch of new data from the ABS, the relative performance of advanced economy labour markets during the initial phases of the CVC, a demographic theory of lockdowns, the threat of a ‘Greater Depression’ and the impact of COVID-19 on retail and the urban landscape.

If you’d like some additional economics this week, I gave a webinar to AICD members on the economics of the CVC. You should be able to access the recording here.

And if you’d like even more economics (OK, maybe I’m pushing my luck a bit now, but lockdowns do strange things to people, so it’s worth a shot!), can I direct you to our weekly podcast, The Dismal Science. You can find it via your podcast provider, and back issues also appear on our AICD website. Also, and to do a better marketing job, I should say that Apple iTunes recently pulled together a collection of COVID-19 Essential Listening and The Dismal Science warranted an entry in ‘the Economic Impact’ section, so it gets their seal of approval.

What I’ve been following in Australia . . .

What happened:

Australia’s headline consumer price index (CPI) rose by 0.3 per cent over the March quarter to be up 2.2 per cent in annual terms, according to the ABS.

Measures of underlying inflation were relatively more subdued: the trimmed mean – typically seen as the RBA’s preferred measure of inflation – rose 0.5 per cent over the quarter and was up 1.8 per cent over the year while the weighted median index was up 1.7 per cent over the year. The CPI excluding volatiles rose 2.1 per cent in annual terms.

The most significant price rises in the March quarter were for food and non-alcoholic beverages (up 1.9 per cent, including vegetables which were up 9.1 per cent), tobacco (up two per cent), secondary education (up 3.4 per cent), and pharmaceutical products (up 5.1 per cent). The ABS said that drought conditions were the main driver of price rises for vegetables, along with price rises for fruit, dairy, grain and cereal products, while the bushfires also increased transport costs for some fresh produce.

The ABS also reported that increased spending in response to COVID-19 showed up the data in the form of price pressures for a range of food products due to high demand and less discounting towards the end of the March quarter. That included price rises for other non-durable household products, the category which includes toilet paper (up 3.4 per cent); personal care products, which includes soap and hand sanitiser (up 2.2 per cent); and other cereal products, which includes rice and pasta (up 4.4 per cent).

The most significant price falls in the March quarter were automotive fuel (down six per cent due to slumping world oil prices), domestic holiday travel and accommodation (down 3.1 per cent) and international holiday travel and accommodation (down three per cent).

Why it matters:

The headline CPI in March was stronger than expected – consensus had expected a quarterly print of 0.2 per cent and an annual rate of 1.9 per cent. Instead, we saw the first annual increase with a ‘2’ in front of it since Q2:2018 and the fastest pace of increase since Q3:2014. So, headline inflation is now back inside the RBA’s target range – although it won’t stay there for long.

Underlying inflation as measured by the trimmed mean also surprised on the upside: the consensus forecast had expected 0.3 per cent over the quarter and 1.6 per cent over the year. In this case, however, the rate stayed stuck below two per cent. It has now been there for 17 consecutive quarters.

There was also an interesting mix of inflationary and deflationary forces at work in the details. On the inflation side of the ledger, supply disruptions due to the drought and bushfires pushed up some prices, while a COVID-19 demand shock pushed up others and told a similar story about precautionary buying to the preliminary retail sales data we saw last week. At the same time, falling global oil prices and disruption to domestic and international tourism were sources of disinflation. Next quarter’s result is widely expected to see the disinflationary forces overwhelm the inflationary ones, with the RBA predicting that Q2 annual inflation could well be negative, as low global oil prices, falling rents and weaker demand all depress prices. Moreover, the government’s initiative to provide free childcare will be recorded as a significant price fall.

Interpreting the June quarter data will be further complicated by some specific impacts of COVID-19. The ABS included a special section in this quarter’s release explaining some of the factors to consider (and see also the discussion in this week’s readings, below):

• The ABS suspended in-store data collection of prices from late March, although this only affects less than two per cent of the weight of the CPI and in most cases the data can still be collected online or by telephone.
• ‘Missing prices’ occur when stock is unavailable or when a surveyed business shuts down. The ABS expects to see more missing prices next quarter but has an established process in place to deal with this, imputing price changes based on changes in similar but available items.
• A more complex challenge arises when consumer spending on goods or services falls to zero or very small amounts. The ABS thinks this will apply to some of the CPI’s 87 expenditure classes next quarter, including international and domestic travel and accommodation, attending sporting and cultural events, and the consumption of alcohol on premises. It identifies two options for dealing with the problem: (1) it can Impute a quarterly movement based on the headline CPI which has the effect of the series in question not contributing to the CPI quarterly movement; or (2) It can impute a quarterly movement based on the average of the same quarter in recent years, thereby assuming that the seasonal nature of price change for the impacted series would have been maintained if lockdowns weren't in place. The ABS has yet to decide which of these two options it will take.

What about the longer-term implications for inflation beyond the June quarter?

To date (and here the CVC is providing something of a re-run of a GFC debate), economists are divided on whether they see the CVC as an inflationary or a deflationary shock. One way to think about this is in terms of different weights being applied to the relative severity of the unfolding supply and demand shocks now hitting the economy. Simplifying things a bit, those more worried about an inflationary outcome see the disruption to the economy’s supply capacity as being larger than the disruption to demand. The aggressive fiscal and monetary policy response applied to date means, they conjecture, that as lockdowns are lifted, demand will return, but the scarring to productive capacity that has meanwhile taken place means that this resurgence in demand will meet an inadequate supply response, and prices will be driven up. On the other side of this debate, the view is that the demand destruction generated by the CVC will be so large – due to an unholy combination of higher unemployment and underemployment, lower wage growth, increased risk aversion and stressed household balance sheets – that it will more than offset any shortfall in supply, putting downward pressure on prices.

As with many arguments about what comes next with COVID-19, it’s probably too soon to tell. For what it’s worth, though, market signals clearly show that the initial impact of the CVC has been to drive inflationary expectations down, not up.

Likewise, the balance of evidence to date (particularly in the form of the huge slump in global oil prices and the stresses on labour markets across the world) suggests that the disinflationary story is more likely to dominate the near future.

My own instinct here is that demand weakness will indeed be the more important factor in determining the trajectory of prices for at least the next year or two, and possibly well beyond if the world ends up bungling the recovery phase. But as the time horizon pushes out and new structural factors come into play (much higher public debt stocks, possibly less globalisation, potentially lower productivity growth) the risk of inflationary outcomes would seem likely to grow, including for political economy reasons. Perhaps the most complex outcome – and the hardest to navigate for central banks – however, would be a volatile period of shifting inflationary and deflationary pressures as both competing forces have temporary periods of dominance.

What happened:

Treasury Secretary Steven Kennedy appeared before the April 2020 Senate Select Committee on COVID-19. In his opening statement to the Committee, Kennedy stressed that we ‘have never seen an economic shock of this speed, magnitude and shape’ and explained that this had prompted an unprecedented government fiscal response, including direct fiscal measures equivalent to about 10 per cent of GDP and which were ‘larger than any support package provided by Government in the past 50 years.’

He reported that around $10 billion of this support had been rolled out over the past three weeks with ‘around three times that amount expected over the next month.’ Of that $10 billion, a Treasury colleague later suggested that it included around $4.3 billion of payments to households and $4.5 billion of ‘boosting cash flow’ payments.

In the subsequent discussion (pdf), the Treasury Secretary also noted that Australia’s relative economic performance has benefitted from our ability to leave more economic activity running than in many other advanced economies, and that as a result, Australia will have been able to avoid seeing the kind of 20 – 25 per cent of GDP fall in output that the OECD estimated would be the consequence of a full lockdown (see the discussion here).

Other interesting comments included:

• There may be some opportunity for Australian businesses, including in the manufacturing sector, to benefit from the CVC by substituting for disrupted global supply chains.
• There will also be some natural diversification in supply chains as a result of the current crisis (Kennedy pointed to the diversification of Australian exports to North America as a result of the Asian financial crisis as a possible parallel) but China will continue to offer ‘a great economic return to Australia’.
• So far 540,000 Australian businesses have enrolled in the JobKeeper scheme, which Treasury estimates would imply coverage for around 3.3 million employees.
• Treasury has not been asked to develop a fourth economic package, indicating that the government thinks (hopes) that it has now done enough.

Why it matters:

While we’re waiting for June’s promised Treasury forecasts, this testimony provided some insight into current official thinking on the economy. One point of note is that Treasury clearly sees Australia’s ability to have kept significant sections of our economy running outside of lockdown (mining, manufacturing, construction, agriculture) as a source of relative strength in terms of the recovery phase, and likewise both the scale of our direct fiscal measures relative to those deployed by many of our peers and the relative timeliness with which those measures were rolled out are additional elements in our favour in terms of gauging our performance in the post-CVC world.

What happened:

The RBA released data on financial aggregates for March 2020. The numbers showed private credit growing by 1.1 per cent over the month (seasonally adjusted) and up 3.6 per cent in annual terms.

That monthly increase in the headline number was the largest gain since December 2007 and was driven by a jump in credit to business (up 2.9 per cent over the month in its largest rise in about three decades and rising by 6.3 per cent over the year).

Personal credit fell by 6.5 per cent in March 2020 relative to March 2019. The series has been falling in negative terms since 2016 but this was the largest drop seen since June 2009. Housing credit was up only 0.3 per cent over the month and grew 3.1 per cent in annual terms.

Why it matters:

The March credit numbers provide another insight into the impact of COVID-19 on the Australian economy, this time in terms of Australian businesses seeking to tap credit lines as the crisis intensified and they sought access to liquidity.

. . . and what I’ve been following in the global economy

What happened:

US real GDP shrank at a 4.8 per cent annualised rate in the first quarter of this year, according to an advance estimate from the Bureau of Economic Analysis (BEA). That was the steepest drop seen since the 8.4 per cent decline recorded during the GFC and effectively marks the end of the longest US economic expansion on record (June 2009 – February 2020).

Personal consumption expenditure dropped at an annualised rate of 7.6 per cent, marking the biggest decline in consumer spending since 1980.

Business investment fell by 8.6 per cent. That was the fourth consecutive quarterly decline in nonresidential investment, which has been dragged down by policy uncertainty and the US-China trade wars. It was also the steepest fall in 11 years, albeit well short of the huge drops seen during the GFC.

A quick note on US GDP statistics. The US reports changes in quarterly GDP on an annualised basis. That means that what in Australia we would report for example as a one per cent fall in GDP over the quarter would typically be reported in the United States as roughly a four per cent drop. (For a bit more on this, see the article by Justin Fox in this week’s readings.)

Why it matters:

The Q1 GDP numbers capture the start of the economic hit from the CVC to the US economy. In a now familiar story, since the lockdowns only impacted the last two or three weeks of March, most of the quarter was not actually influenced by COVID-19. Even so, the sizable drops in consumption and investment show that the economic toll was already substantial

The details also tell an interesting story. For example, there are obvious differences with the GFC, reflecting the way that lockdowns have influenced both the economy and consumer behaviour. Back then, a collapse in business investment took the lead. This time, it is the fall in consumption that is the more dramatic change. And a look at the details behind that drop in consumption also show a stark difference between spending on goods and services, with the former down by 1.3 per cent and the latter plummeting by 10.2 per cent – the largest drop for that series since US quarterly data began back in 1947.

The details also shed light on which sectors of the economy have been most vulerable to date, and where there have been pockets of resilience. For example, the big drops in spending on services included falls in expenditure on recreational services (down 32 per cent), food and accomodation services (down 29 per cent) and health services (down 18 per cent, reflecting in part the cancellation of a range of elective surgeries). In the case of spending on goods, there was a marked split between durable and non-durable goods. Spending on the former fell 16 per cent, including a 33 per cent drop in expenditure on motor vehicles and parts. In contrast, spending on non-durable goods was up almost seven per cent, powered by a 25 per cent jump in expenditure on food and beverages to be consumed off premises.

While Q1 was bad, Q2 is likely to be much worse. One early indicator of that is the huge increase in US initial unemployment claims, which have now risen by about 26 million over the past five weeks. One of the main acheivements of the record US expanion that has just come to an end was to create more than 22 million new jobs. That took 11 years. The CVC has now unwound all that job creation, and more, in the space of just a few weeks.

Another indicator signalling a big drop in activity is the NY Fed’s Weekly Economic Index (we first looked at this new indicator a few weeks ago). The WEI is currently at -11.59 per cent for the week ending April 25, indicating that – if the WEI remained at this level for the full quarter – we’d expect Q2 GDP to be down more than 11 per cent over the year.

What I’ve been reading

Three from the ABS this week. First, Migration 2018-19. According to this report, there were around 7,530,000 people living in Australia in 2019 who were born overseas, or 29.7 per cent of the population. That figure was up from 7.3 million people born overseas in 2018. Those born in England (986,000 people, of which I’m one) continue to be the largest group of overseas-born residents, accounting for nearly four per cent of Australia's total population.

(Related, Abul Rizvi on the coronavirus and future trends in Australia’s population.)

Second, the ABS also released data on Australia’s general government accounts for 2018-19. The Government Finance Statistics publication is useful because it pulls together data across the various levels of Australian government and for the total public sector. The general government comprises the Commonwealth Government, state governments and local government municipalities. It also includes agencies and government authorities under departmental administration which are engaged in the provision of public administration, defence, law enforcement, welfare, public education and health. Also included are a bunch of non-departmental bodies and public universities. The total public sector then comprises general government, public non-financial corporations and public financial corporations. So, for example, the report tells us that in 2018-19 net government debt as a share of GDP was about 46 per cent for the national government, rose to a bit more than 59 per cent of GDP once states and local governments were included, and reached a little over 69 per cent of GDP for the entire public sector (based on the L5 concept).

And the third ABS publication to note this week: an introduction to new information on microdata from its Business Longitudinal Analysis Data Environment (BLADE). BLADE combines business tax data information from ABS surveys and other administrative data over time to provide researchers with insights into Australian businesses.

NAB Economics’ State handbook provides a useful state by state overview of the impact of the CVC.

Grattan’s Terrill and Crowley cast a sceptical eye over the case for a high speed train between Brisbane and Melbourne. (Confession: I have a soft spot for fast trains and as a result have something of a weakness for these kinds of proposals, so it’s always helpful for me to be reminded of the counterarguments.)

ANZ Bluenotes tells the story of recent developments in Australian retail spending in pictures.

The latest version of the Australian innovation system monitor is now online.

Relevant to the discussion in the main section: FT Alphaville explains why official inflation numbers are ‘about to get fuzzier.’ And here’s The Economist article cited in the Alphaville piece, which looks at the impossibility of measuring inflation in a pandemic.

Also from The Economist: how the CVC is spurring a wave of corporate innovation.

Justin Fox on the peculiarities of the way the US presents its GDP numbers.

Two from the WSJ. This weekend piece refers back to last week’s oil price movements but also takes in the price of power and the price of money and asks what negative prices tell us about the future. And Greg Ip on the future of globalisation in the US after the CVC.

Brookings has published a new report looking at the impact of COVID-19 and government lockdowns on labour markets across 20 advanced economies. The preliminary results show New Zealand, Australia, Denmark, and Germany scoring well in terms of both containing the virus and preserving economic relationships. The authors also find no clear relationship between social distancing and the degree of economic harm (the comparison between Sweden and Denmark is interesting here).

Scott and Old consider the implications of demography for the economics of lockdowns, and argue that ageing societies and longer lives justify longer lockdowns than would have been the case in the past.

Nouriel Roubini contemplates the possibility of a ‘Greater Depression’ that could scar the 2020s. Roubini flags ten ‘ominous and risky’ trends: rising debt; ageing societies; growing deflation risk; currency debasement; digital disruption; deglobalisation; the backlash against democracy; the US-China standoff; a broader new Cold War; and environmental disruption. Ouch. Where’s my comfort blanket, it’s time for a little lie down…

Coutts UK ponders the risks of a CVC-induced break-up-of the EU.

Unherd asks, which epidemiologist do you believe?

Interesting piece in the Atlantic on the future of US retail post-COVID-19 (via Marginal Revolution). The main thesis is that the virus will accelerate pre-existing trends, leading to more big chain stores relative to small retailers (the former have larger cash reserves, better access to capital, and HR departments that can manage staff stand-downs and step-ups which will make them more resilient) along with more e-commerce and fewer physical stores. For cities, the implications are more homogeneity in store fronts and quieter streets. And the transformation of more restaurants into ‘for profit kitchens’ (fancy takeaway?). The result will be cities that are ‘healthier, blander and more boring.’ So, would those changes also make them cheaper to live in, perhaps by making them a bit less desirable?

The theory that ‘bigger is better’ during the CVC is also echoed in this NYT story, which argues that investors are betting on larger companies relative to smaller ones.