‘Stagflationary impulse’: inflation risks rise as economic growth cools

Australia is entering a period where the economy is expected to lose momentum, but inflation remains stubbornly high, says CBA Head of Australian Economics Belinda Allen.

Speaking on the latest episode of the CommBank View: Economics & Markets podcast, Allen said the economy is heading into what could be described as a “stagflationary impulse”, a situation where growth slows but prices continue to rise.

She stressed, though, that this is not a situation she expects to last.

“We don’t think we’re going into a stagflation episode. We’ll call it a ‘stagflationary impulse’, but we think this is more of a temporary situation,” she said.

Stagflation is usually linked to “persistently high inflation and persistently low growth, as well as a lift in inflation expectations”, Allen said.

Why inflation remains the big concern

Earlier this week the Reserve Bank of Australia lifted interest rates for the third time this year, taking the cash rate to 4.35 per cent, underscoring its focus on bringing inflation back under control.

Allen said rising global energy costs are playing a key role, flowing through to Australian households and businesses and helping keep inflation elevated.

“There is a very large supply shock because of the lifting oil price and lower oil supply into global markets at the moment, that is going to lead to an income shock here in Australia,” she said.

When incomes are squeezed by higher costs, spending typically slows. But despite the uncertainty, Allen said, inflation pressures were strong enough for the RBA to raise rates again in May.

“Ultimately, it was the inflation story that really saw them rally around the rate hike again in May,” she said.

Slower growth, but consumers still spending

Most forecasts, including those from CBA and the RBA, now point to slower economic growth ahead, Allen said.

“When we look at both ours and the Reserve Bank’s growth forecasts, we expect to see a slowdown in economic activity,” she said.

However, she noted the effects of interest rate rises take time to show up, adding that households are still holding up better than expected.

“We are only three months since that first rate hike in Australia,” Allen said. “We should see a slowdown particularly by the consumer, but we know at the moment consumers are remaining resilient.”

CommBank’s spending data does show some early signs of people becoming more cautious.

“We certainly have seen some tentative signs of slowdown ,” she said, with weakness in areas such as travel, and “maybe some early indicators in things like hospitality and retail as well”.

Why the outlook remains uncertain

Allen said the big risk is that spending does not slow enough to take pressure off prices. This would make the RBA’s task tougher and could lead to more interest rate rises.

“There’s still a risk that rates will have to move higher because of inflation,” she said.

Global events, particularly the Middle East conflict, could help slow the economy, but Allen warned this is not guaranteed.

“We generally think the conflict offshore will do some of the Reserve Bank’s dirty work for them,” she said. “But the risk is it does not.”

Inflation expectations under the spotlight

One of the biggest challenges facing central banks is preventing people and businesses from coming to expect that high inflation will continue.

“We’re moving into a period of rolling shocks,” Allen said. “Central banks are certainly facing a period of higher inflation and they’ll really have to show what they’re made of and really control inflation expectations as well.”

She said behaviour appears to be changing across the economy.

“We’re certainly seeing signs that firms are willing to pass on costs more quickly and to a higher degree than what we’ve seen in the last decade,” Allen said.

“Wage setting behaviours also seem to have changed,” she added.

What it means for households

The months ahead will be critical in determining whether inflation cools naturally as growth slows, or whether the RBA is forced to tighten interest rates even more.

“The question is, from here, what happens to inflation?” she said. If it doesn’t cool off, “then the RBA will really have to show their credibility by further lifting interest rates”.