US inflation data makes budget a tougher task

Framing the federal budget just got a lot harder as the ‘last mile’ in taming inflation globally is turning into a marathon.

Federal Reserve Bank chair Jerome Powell. US core inflation in the past three months is now running at 4.5 per cent Picture: Getty Images

Framing the federal budget just got a lot harder as the “last mile” in taming inflation globally is turning into a marathon. Australia is not immune to this reality.

The third successive, higher than expected inflation in the US sent financial markets back to the drawing board, scaling back expectations of how quickly the Federal Reserve is likely to begin to ease monetary policy. US core inflation in the past three months is now running at 4.5 per cent, well above the 2 per cent target that the Fed is aiming for. Even on a very generous interpretation of recent developments, the declining trend in inflation has stalled.

This also has implications for Australia as there is a very close relationship between inflation in the US and Australia.

The Reserve Bank of Australia already had noted that “the path of disinflation in other countries had not been smooth, which could hold lessons for Australia”, and unlike some of its peers the RBA board sensibly was not foreshadowing rate cuts later this year. Instead, it said it “was therefore not possible to either rule in or out future changes in the cash rate target”.

Post the US CPI, markets still see the next move by the RBA as being down, but now see only one 25-basis-point rate cut this year by the RBA late this year. And this is by no means a done deal.

To be sure, there are differences between the economic circumstances of the US and Australia. The Australian economy is not growing as strongly as in the US. Last year the US economy grew 3.1 per cent, well above Australia’s 2.1 per cent. On a per capita basis, the comparison is even starker as Australia’s population growth has been much faster than in the US and indeed GDP per capita in Australia fell last year.

And so far this year the economic data has been surprisingly strong in the US, in contrast to in Australia.

It therefore is possible that the US faces a more challenging task than Australia to bring demand in the economy back into balance with supply, and therefore to decisively wind down inflation.

However, it’s worth recognising that the supply side of the US economy may have more scope to stretch than in Australia. Productivity growth in the US has picked up strongly and the US is at the forefront of innovations in technology related to AI.

And demand in Australia is about to get a series of boosts that may make the RBA’s job somewhat harder.

For starters, the federal government is flagging in next month’s budget more cost-of-living relief for the most affected households. On top of this, income tax cuts worth $20bn, or more than 1 per cent of household disposable income, kick in from July. And the Fair Work Commission is likely to announce another large increase in the minimum wage and award wages that will cement further rises in real wages.

Households are sensing this prospective improvement in their finances. While consumer sentiment remains depressed, their perception of future family finances is not far from neutral. Moreover, households’ concerns about unemployment have eased and are now at their lowest level in almost a year.

The big question is how much of this prospective improvement in household finances leads to a large enough rebound in consumer spending that triggers renewed inflation pressures.

The RBA’s forecasts have factored in at least a chunk of this improvement in finances yet still show a gradual easing of inflation this year. But the bank acknowledges that the outlook is highly uncertain.

Like in the US, housing is a source of stubborn inflation pressures. In Australia’s case, housing supply is chronically below underlying demand, with the result that the housing component of the CPI is punching well above weight, contributing about a quarter of annual inflation.

Yet housing is just a subset of the broader consequences of underinvestment by businesses and governments, thereby limiting the speed on the economy’s ability to meet demand.

Similarly, labour supply is not keeping up with population growth, keeping the labour market historically tight and placing sustained upward pressure on labour costs.

All up, this is a more challenging economic backdrop than the federal government would have been hoping for as it frames the annual budget Jim Chalmers will deliver on May 14. The margin of error to avoid tipping over the RBA into further rate rises is now much larger.

Paul Brennan is chief economist at Suncorp.