Analysis: How high could inflation go? Quantifying goods upside risks for Q4 and Q1
The RBA in its November Minutes noted that “while a range of outcomes for global inflation in 2022 were possible, risks to inflation forecasts were tilted to the upside”. Notably though they stopped short of fully encompassing that balance of risks into the Australian forecasts, instead stating that “the distribution of possible outcomes for inflation had widened”. The key question is thus how high are those upside risks?
In this Weekly we assess the upside risks to inflation that is driven by the goods side of the CPI basket. The NAB Business Survey has been showing elevated pricing pressure coming from the retailers and wholesalers for several quarters, though those upside risks were not realised until Q3 when core inflation surprised to the upside. Upside risks to goods prices are important given goods prices prior to the pandemic were subdued with goods prices barely changed over a decade.
We calculate that meaningful goods pass-through could contribute around 1ppt to y/y inflation, and a high scenario allowing elevated surveyed retail price pressure from the NAB survey to sustain and fully be reflected in consumer prices would add something closer to 1½ppts. If other price changes within the basket broadly returned to pre-pandemic patterns, that alone could take quarterly underlying CPI readings from around 0.4% q/q to 0.6-0.9% q/q. In an annual sense then the upside risks are trimmed mean inflation prints at 2.4-3.0% y/y by Q1 2022.
Of course goods prices are only part of the cocktail of shocks buffeting the usually slow-moving inflation process at the moment, with other factors also possibly skewing the risks to the upside in the next couple of quarters. Construction prices continue to lift with NSW and VIC construction prices in Q3 (when in lockdown) not fully reflecting the price increases seen in QLD. The HomeBuilder subsidy unwind is also another factor that could add, along with potential re-opening frictions.
Overall, we think the RBA is vulnerable to upside surprises on inflation coming from both goods and new dwelling costs. The RBA noted some near-term risks to inflation in its latest SoMP, but did not quantify these in their forecast scenarios which instead reflected uncertainty around the timing and extent of a more sustained lift in inflation on the back of wage and price pressures as the labour market tightens further.
How would the RBA react to the realisation of upside inflation risks driven by goods prices? Governor Lowe in a recent speech largely dismissed the risk that inflation picks up more quickly in the near term ahead of a significant further acceleration wages as a ‘hypothetical’ that was quite unlikely. But a realisation of higher inflation in the near term is not in itself enough to make the RBA blink on rates, with the Governor saying when prompted that if underlying inflation picked up to 3% y/y on temporary factors and wages growth had picked up by less, he would be prepared to “look through it.”
NAB expects that the RBA will raise rates from mid-2023 with a relatively aggressive series of hikes thereafter to bring the cash rate to 1.75-2.0% by the end of 2024. The risks around that view are tied to the RBA sticking to its stated reaction function.