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Inflation is falling: Here's why and how much further it needs to go

Interest rate hikes have inflation heading lower but it's still a long way above the RBA's target zone.

Woman shopping for fresh produce as inflation falls, with an inset of a hand holding a wallet and money
Prices of essential items are starting to drop but inflation still has some distance to fall. (Source: Getty)

The inflation stick may not have been snapped but it has an extreme bend in it as the effect of weaker growth and cumulative policy tightenings work their way through the economy.

The good news from the February Consumer Price Index: prices rose just 0.2 per cent in the month, after falling 0.4 per cent in January; the annual monthly inflation rate eased to 6.8 per cent from the 8.4 per cent peak in December 2022.

Also by the Kouk:

Everything on the inflation front is pointing in the right direction – the issue now is the trajectory of the inflation deceleration, or in other words how long will it take for inflation to fall to the RBA’s 2-3 per cent target band.

Now that we have the facts out of the way, what does it all mean?

At a very superficial level, the 6.8 per cent annual inflation rate is well above the target band.

Superficial, because as everyone who looks at annual data knows, the result includes the surge in prices in March, April, May, etc, 2022. Annual data double-counts - or, actually, 11-fold counts - the high - or low - results until they drop out of the annual run rate.

This is why the sharp falls in the recent monthly data are so encouraging. Even with monthly inflation tracking an average 0.2-0.3 per cent, it won't be long before the annual inflation rate drops to 6 per cent, 5 per cent, 4 per cent and so on.

And the way commodity prices are trending, and the slowdown in the global and Australian economies are unfolding, this is the sort of inflation trajectory that is likely to be seen through the course of 2023 and, almost certainly, into 2024.

The good news on inflation follows the weak retail sales data for February, which is locking in what might be termed a ‘consumer recession’ - that is two, three or even four quarters where spending in real terms is declining in absolute terms, but falling even more in the highly relevant per-capita measure of spending.

The economy is slowing, as it was designed to do with the interest rate hikes and tight budget position, and this is well before the full effect of these measures kicks in.

With policy being too tight for too long, the risk is a hard landing or recession, which of course no one wants.

For the RBA, it means it can comfortably sit tight next week and, indeed, the next few months, with official interest rates at a very restrictive 3.60 per cent - and wait for the 10 straight rate hikes delivered since May 2022 to fully impact the economy.

In addition to that, and arguably more important for the Australian economy, is the effect of the global slowdown, which is still unfolding in erratic steps.

As noted last week, the slowdown is seeing commodity prices steadily fall, which will directly and indirectly feed into a low inflation climate.

There will also be the impact of weaker growth on Australia’s international trade position which, for the moment, is holding up well in the wake of China’s economic rebounding from the COVID lockdowns.

All up, the pressures on inflation are squarely to the downside, which was confirmed by the February inflation data.

Every forecaster, including the RBA, is expecting inflation to fall over the next year or so. The only uncertainty is how long it will take to get back to the target and what damage to the economy and employment will be engineered to get there.

A quickish return towards target, and protracted economic weakness, would see the RBA not only keep rates on hold but move to an interest-rate-cutting cycle.

The futures market is looking for rate cuts in about six months’ time – this looks about right with the risk of an earlier and more aggressive easing cycle than the market is pricing in.

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