A genuine cyclical upswing in private sector spending is underway. This is needed, not necessarily a reason to worry about inflation. There is too much pessimism about supply capacity.
- The September quarter national accounts confirmed what we had already flagged in our forecasts and ‘Westpac-Now’ nowcast of activity: that growth in private sector demand is picking up, finally. Rising household incomes have eased cost-of-living pressures somewhat and supported spending. Business investment also picked up in the latest quarter, which is a positive for future capacity.
- Contrary to some views, we do not regard activity growth at this rate as being necessarily inflationary. Estimates of growth in the capacity of Australia’s economy around 2% look too low. Such assumptions are vulnerable to small surprises in population, participation or productivity. The risks on these are all on the upside.
- There are, however, reasons to be cautious about the current inflation environment. As with all inflation releases, there are some categories running well above the overall inflation rate, and some well below. However, the high outcomes recently are dominated by categories where policies of government at various levels determine prices. For many of these categories, high inflation rates are locked in for the next few years. The RBA’s mandate to hit its 2½% inflation target would mean keeping the rest of the economy weak and market-sector inflation low, to offset this policy-driven inflation. Surely there is a better way.
The September quarter national accounts confirmed that an upswing in private sector demand is underway. This was previously flagged by our ‘Westpac-Now’ nowcast estimate, in turn driven by the upswing in our Westpac–DataX Card Tracker and, for business investment, the ABS Capex survey.
For some observers, though, what is good is bad. Stronger growth in activity is seen in these quarters as outstripping the growth rate of Australia’s supply capacity – so-called ‘potential output’. With the economy also seen as having little to no spare capacity in absolute terms, the conclusion is then that demand pressures imply faster inflation. According to this view, the upswing will soon hit a wall of higher inflation and interest rates.
We simply have a different view about supply capacity. As highlighted in the lead-up to the national accounts, we think trend growth is more like 2¼%yr than the RBA’s assumption of 2%. Even higher numbers are achievable if the productivity benefits of AI become evident in coming years.
There are a number of ways to estimate trend growth in supply capacity but most of them boil down to adding trend growth in labour productivity to trend growth in labour supply. We have discussed the RBA’s 0.7%yr near-term estimate of trend productivity growth elsewhere, but for the sake of argument, let’s take that as a base-case minimum. To get 2% for potential output growth, that means trend labour supply growth of 1.3%. Is this realistic? Consider that even if the RBA’s assumption about overall population growth of 1.2%yr over 2027 is correct, working-age population will grow faster; new migrants to Australia are disproportionately young adults without children. The gap between working-age and total population varies over time and on current data is unusually high. Over recent decades it has averaged at least 0.1–0.2 percentage points. So, suppose trend working-age population growth is 1.3–1.4%yr.
How this translates into trend growth in labour supply depends on trends in labour force participation and average hours. Back in September, Westpac Economics colleague Ryan Wells and I highlighted that there is an upward trend in labour force participation in Australia and many other advanced economies. The RBA has since acknowledged this in its November Statement on Monetary Policy. Average hours per working person are trending downwards as part-time work becomes more common. The net of the two trends looks to be a wash, or at worst a gentle downtrend around 0.1%pt per year.
You can then see how the RBA gets its 2%yr estimate of potential output growth. Assume 0.7%yr productivity plus 1.3–1.4%yr growth in working-age population, minus up to 0.1%pt for the net of participation and average hours, implying 1.3%yr trend growth in labour supply.
You can also see how vulnerable the RBA’s conclusion is to small misses, and that all these risks are in the one direction. Population growth of 1.2%yr is 0.4%pt lower than the latest official data and would be lower than at any time in the past two decades. Our own forecast for 2027 is 1.35%. Working-age population is currently estimated to be growing at a 2% pace, though we expect the ABS will revise this down as the estimated resident population figures come in. Even allowing for some narrowing in the current gap between the growth rates of total and working-age population, labour supply growth in the 1.5–1.6%yr range is entirely plausible. Add in the more positive view of productivity growth implied by this week’s national accounts, and it is easy to get a trend growth estimate more in the 2¼–2½%yr range than the 2% advocated by the productivity pessimists.
The September quarter and new October monthly inflation data did nothing to counteract the more pessimistic view of supply capacity, to be fair. While the October headline result, at 3.8%, was not a surprise to Westpac Economics (
we had nowcast 3.9% (PDF 842KB)), it was a surprise to market consensus.
One should avoid the temptation of dismissing an uncomfortable result with words to the effect of “if you exclude all the things that are increasing a lot, inflation is actually ok”. That said, there are reasons to believe that recent inflation outcomes are not suggesting that strong demand is pushing up inflation at present. Rather, much of the strength has been driven by government policy.
One way to look at this question is to consider the categories of the CPI that recorded the highest inflation – say, 5%yr or more. Some of these – beef & veal (10.4%yr), lamb & goat (14.3%yr) and coffee, tea & cocoa (16.5%yr) – are obviously supply shocks that will not continue at that pace forever. They could even fall, as the price of eggs has been for the past six months now that the flock numbers have recovered after a wave of bird flu over 2023–24. Other categories are known volatiles that tell us little about underlying trends (domestic travel, clothing & footwear).
More worrisome, though, is the preponderance of policy-driven categories. From the well-known unwind of electricity rebates (electricity up 37.4%yr) to the NSW pricing decision for Sydney Water discussed last week, to local government property rates & charges (6.2%yr), policy-controlled prices dominated the top of the distribution. Tobacco, child care, school education, postal and medical & hospital charges all exceeded 5%yr as well. About the only non-policy ongoing inflation at these rates was Audio, Visual & Computing Media & Services (9.8%yr). And I just don’t think Foxtel and Xbox (the only announced price increases we could find where the timing matches the 5.4% spike in the month of August) are going to increase their charges every year on that scale.
So we have a bit of an issue in that most of the high inflation is in sectors that are insulated from monetary policy. The RBA can still achieve its inflation target in this environment, but only by squeezing the market sector of the economy with tight policy to offset high administered price inflation with sub-target inflation elsewhere. Given that Australian households’ real incomes per person have been static for half a decade, this is an unsatisfactory way to run an economy. There must be a better way to keep inflation under control than to keep the boot continuously on the neck of the Australian consumer. And there is, but it requires governments at all levels to take charge of their own contribution to inflation.
Nothing about this situation will change this month, of course. The RBA is aware that some of the recent pick-up in inflation is temporary but will be cautious given their view of potential output growth. It will therefore remain emphatically on hold this month and for much of next year.
If we are right about supply capacity, inflation will moderate – at least in the market sector – over the course of 2026, leaving room for the two cuts we still have pencilled in (May and August as the base case). Given the RBA’s beliefs about potential output, this will not be its expectation. It might therefore seek to further dampen expectations of future cuts. The risk to our base case is quite obviously that the RBA stays on hold for longer. If we are right about supply capacity, though, the Australian economy will not hit the wall of capacity constraints. And that means the RBA risks keeping interest rates too high for too long.
