Coronavirus: Deflation will make recovery a slow burn

Falling inflation will make economic recovery from the COVID-19 pandemic a slow-burn process, economists warn.

UBS Australia chief economist George Tharenou. Picture: Hollie Adams/The Australian

The COVID-19 pandemic will drive a “deflationary shock” not seen since the Great Depression, and economists have warned falling consumer prices could complicate efforts to reboot the economy once the health crisis has passed.

Desperate discounting by struggling retailers, falling rents amid a ban on evictions, a near 20 per cent fall in fuel prices and government interventions to make childcare essentially free will contribute to the consumer price index falling by “at least” 1.5 per cent over the three months to June, UBS chief economist ­George Tharenou said.

That would be the largest drop in the CPI since the 1930s, when a three-year collapse in economic activity drove much steeper falls in consumer prices.

Prices plunged by nearly 12 per cent over the year to September 1931, with peak quarterly deflation at 4.1 per cent in the final months of 1930, Reserve Bank data shows.

Nonetheless, deflation in coming months will be “unprecedented in the current context”, Mr Tharenou said.

With most people observing ­social-distancing rules, which has driven a collapse in consumer confidence and spending, retailers are being forced to offer large discounts to lure potential buyers.

A collapse in oil prices will drive an 18 per cent fall in fuel costs over the June quarter, UBS forecasts. Housing costs, which make up about 15 per cent of the CPI basket, are also likely to fall as a moratorium on evictions helps drive a wave of rental relief, and as developers offer deals to entice reluctant would-be homeowners and investors.

Government intervention will also contribute to the deflationary pulse. Childcare is now essentially free, as is TAFE. Utilities providers and councils are deferring bills.

Economists expect the ­deflationary pulse to be temporary, with the anticipated rebound in the economy helping quarterly CPI to lift again by the end of the year. Meanwhile, falling costs for goods and services mean Australians’ wages can buy more.

But Mr Tharenou said a self-­reinforcing feedback loop between low wages growth and deflation risked changing Australians’ inflation expectations permanently, creating a deflationary trap that can be difficult to escape, particularly in the absence of traditional monetary tools.

“The key issue will be the persistence of high unemployment and spare capacity in the labour market, and the downward pressure this puts on wages — that’s what will drive a deflationary outcome over the medium term,” he said. “If households view this as temporary, then you can have a normalisation in a year or two. If unemployment stays double-digit, then the risk of deflation increases significantly.”

Mr Tharenou said there was a presumption of “near zero” wage growth in the near term, as it was “quite likely at this point that many companies are freezing wages because of uncertainty over revenue”.

The main driver of inflation over the medium term is wages growth and, after expanding at a rate of about 2 per cent for the past couple of years, pay packets are more likely to grow at 1.25 per cent in 2021, he said.

Monetary policy has been the chosen tool to manage inflation over the past 30 years, but the ­deflationary threat arrives at a ­moment when the RBA has ­already pushed rates as low as it considers prudent, and is now ­intent on preserving stability and liquidity in financial markets.

In that context, Westpac senior economist Justin Smirk said “monetary policy is tapped out”.

“The RBA doesn't have an antidote to this — it’s up to fiscal policy now,” he said.

Scott Morrison has promised to enact “pro-growth” policies to help revitalise the business sector once the health crisis has passed.

Business lobby groups have emphasised the need for reforms to industrial relations laws.