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Inflation? Nothing (much) to see here

You may have heard that inflation is surging around the globe. Some commentators point to lax policymakers who are still ‘printing money’ and engaging in fiscal largesse even as demand strengthens, labour markets tighten and global supply bottlenecks linger. They warn of a return to the price spirals of the 1970s, a dismal time for most asset classes and especially fixed income.

Despite warnings, inflation signs are weak

The truth is that we cannot be sure whether these tail risks will emerge. Economists have a lousy record of forecasting inflationary regime shifts and there seems just as many (if not more) vocalising the opposite argument – that the ultimate economic impact of COVID will be deflationary.

Yet, some things can be said with greater confidence.

Top of the list is that Australia should be one of the last places where we'd expect to see worrying inflation rates. This much is evident in the latest consumer price index (CPI) data. Whilst the raw headline measure jumped to 3.8% year-on-year in Q2, this is easily explained by the reversal of factors that had caused it to drop negative last year, such as childcare subsidies and the slump in fuel prices.

Looking at the RBA's preferred trimmed mean shows just how tepid underlying inflation is, with the index running at just 1.6%.

Chart 1: Core inflation still below RBA’s target, where it has been for more than 5 years

Source: Bloomberg

The labour market also does not ring any alarm bells. Australia’s unemployment rate has already pushed below the 5% level that had proved sticky prior to COVID and, with the tap of inward migration turned off, some have argued that this might finally result in a strong pick-up in wages. But this is not borne out in the aggregate data.

Wages grew at a disappointing annual rate of 1.7% in Q2, a period largely free of lockdown distortions, which remains far from the 3%-plus that the RBA aspires to. Our explanation is simple. The uncertain demand backdrop means employers are reluctant to lock-in higher wage costs. It is hard to see this changing any time soon.

Still below the RBA target

In fact, it could still reasonably be argued that Australia's problem is a shortfall of inflation, at least when it comes to meeting the central bank's 2-3% target. It is this which sets Australia apart from the likes of New Zealand, US and Canada, which are all currently experiencing above-target core inflation. Longer-term market measures of inflation expectations such as the breakeven rates implied by 10-year linkers paint a similar picture, anchoring close to 2%.

Chart 2: Inflation trend appears lower than peers such as US, Canada, UK and NZ

Source: UBS Asset Management, Bloomberg
Note: Core inflation is central bank preferred measure

What are the implications for investors?

This has two implications for Australian Commonwealth Government Bonds (ACGBs), both positive.

First, inflation trends still point to market expectations of low-for-longer interest rates persisting. RBA Governor Lowe has increasingly acknowledged the inflation undershoot and, with his term approaching expiry, has vowed not to raise interest rates until inflation is sustainably within the 2-3% target band, a condition the bank does not expect to be met until 2024, at the earliest. A shallow expected path of the cash rate should exert a gravitational pull on bond yields.

Second is how this relates to the other component of bond yields, the term premium that compensates bondholders for the risk of holding the security to maturity. Greater uncertainty over the inflation outlook argues for larger absolute levels of term premium and wilder swings in bond yields. The table above however shows that Australia is not just experiencing lower inflation than most of its peers but also that volatility is lower.

This need not mean local bond markets will be dull - witness the high sensitivity of ACGBs to the rout in global bonds in February. What it does say is that investors can take advantage of these episodes of volatility, adding duration in the knowledge that higher yields are unlikely to be warranted by fundamentals. As it has turned out, investors taking that view in March would’ve been rewarded handsomely with ACGBs staging a world-beating rally since.

Chart 3: ACGB yields have fallen the furthest since March

Source: Bloomberg


Tom Nash is Portfolio Manager, Australian Fixed Income Investment Team at UBS Asset Management Australia. UBS is a sponsor of Firstlinks. This article is intended to provide general information only and should not be construed as an offer or invitation to the public, direct or indirect, to buy or sell securities as it does not take into consideration your investment objectives, legal, financial or tax situation or particular needs.

For more articles and papers from UBS, click here.


September 13, 2021

Here is a good article from AFR “Central banks battle the wrong inflationary enemy”, short, no pretentious jargon, to the point.

I quote “But that doesn’t mean that the cheap money printing won’t continue to spill over into higher prices for assets such as housing, equities and commodities.
Asset price inflation can be just as economically damaging as consumer price inflation, by distorting the allocation of resources into speculative investment, injecting more risk into the financial system and causing political angst by widening wealth inequality.“

I don’t think we need to be reminded of economics 101 back at the uni days. I would hope the economists actually exist to solve problems rather than regurgitate what we learned in the classes.


September 13, 2021

Nearly everything is more expensive now compared to before Covid hit and a lot more than the inflation rate indicates. Housing, rent, petrol, car prices, fresh food, timber, alcohol etc. While a lot of this is blamed on supply chain problems the consumer still has to pay the higher price.
The RBA simply deny the problem exists because they know if they raise interest rates the stock and housing market will collapse. Lowe wouldn't cut interest rates before the last election as this would have confirmed the economy was weak rather than "jobs and growth- strong economy" mantra. There is no way he will move to control inflation before the next election as when people "feel wealthier" they are more likely to vote for the government.
If you own your home you have a roof over your head. Prices go up and you still have a roof over your head. Sell it, get a higher price and then pay a higher price getting a roof over your head.

Warren Bird
September 13, 2021

Martin, every item on that list is included in the CPI with price data sourced by the ABS from real prices in real shops. So if they have increased as you believe then they are in the inflation rate. The measured inflation rate IS on the rise with the most recent CPI figure up nearly 4% over the year.
Personally I think there is more "to see" than the article and many other other analysts believe, but it's not rampant and at least some of it is temporary due to COVID restrictions. Too early to cry foul on the RBA for not putting rates up while demand is still under duress also from COVID.

Peter Symonds
April 03, 2022

Totally agree Martin good work. The CPI is innaccurate they should have a second index with everything in it that will reflect
real inflation. Sadly Phillip Lowe and RBA are in bubble removed from reality.

Trevor G
September 10, 2021

I remember what it was like back in the day when there were lots of strikes and wage increases and higher inflation. I like it better now. Low inflation is good.

One benefit from covid is the reduction in immigration. Australia should be able to create wealth by being smarter rather than by endlessly pumping up the population. Increasing GDP via population growth seems like lazy policy to me. Unfortunately the way politics is no government is prepared ( or able?) to take the hard decisions that would flow from adopting a zero population growth policy.

The asset price inflation that we have now, in my opinion, could alternatively be viewed as a diminution of the value of cash.

Just got my latest electricity bill. It's becoming very expensive.

September 09, 2021

If house prices were included in the inflation calculation, it would be a completely different story.

Warren Bird
September 09, 2021

Got news for you, Chris - house prices are included in the CPI, as a percentage of the total that lines up with the actual amount of our spending that is taken up with building a house rather than the amount of news headlines space they take up.

House price inflation is an important issue, but it is not the same thing as what we mean by inflation - a general rise in the price of goods and services that we consume. When the prices of all the things we buy, from groceries to haircuts to petrol, etc goes up, the value of our assets is diminished in terms of its purchasing power. That's why it's always been a big deal.

But when house prices go up, then our wealth increases, rather then diminishes. Creates social issues for those not yet in housing, but that is a very different policy challenge than inflation in goods and services prices.

So we need to keep them separate and I believe the ABS captures new dwelling prices appropriately in the CPI.

September 11, 2021

Hi Warren, I would think having a roof over one’s head is just as important as being fed and clothed. These are basic human needs. House price inflation should be taking into account when the overall inflation is considered. We need central bankers and economists with COMMEN SENSE.

We fully own our home and investment properties. I want the house price to crash so that the next generation can afford to buy. Not everyone can or want to get that highly paid job as Joe Hockey has suggested.

September 12, 2021

Define "house price"? It is rare to pay cash for a house like your groceries. You take out a very long term loan to buy a house and the actual cost of the house is the sum of your initial deposit and all the loan repayments which comprise interest as well as the principal. Much of what we see today is the result of ultra low interest rates allowing people to borrow more for the same repayment, and using this additional money to push up house prices. You cannot have a sensible discussion on house prices if you leave one of the main actual costs (interest payments) out of the conversation. Much of the angst about "boomers" taking advantage of high property prices ignores in most cases they are just recouping some of their high cost mortgages which again people have ignored when looking at what a house "cost" 20 years ago.


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