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Why is Australia's inflation rate so stunningly low?
Australia’s inflation rate is stunningly low. At just 1.0 per cent in annual terms, it is well below the bottom of the RBA target band of 2 to 3 per cent and it is low for reasons that are not all that favourable. In simple terms, the economy is too weak and the unemployment rate is too high.
There is a simple and well established link between the strength of an economy and the rate of inflation. It suggests that when an economy is strong with people spending at a rapid pace, businesses ramping up their investment and the unemployment rate falling, inflation is high or rising.
It is high because in these sorts of strong and optimistic economic times, businesses feel that they can edge up their selling prices without driving away customers. This is, by definition, inflation. The optimistic customers are willing to pay the higher prices because their financial circumstances are favourable.
What usually happens in these circumstances is interest rates go up. In lifting interest rates, the Reserve Bank wants to discourage borrowings and encourage savings and those people with debt will have to allocate more of their otherwise disposable cash to pay interest on that debt. This means they have less spare cash for elsewhere in the economy and as a result, the economy slows and with a lag, inflation falls back.
Get set for a further interest rate cut on 2 August, which is the date of the next meeting of the Board of the Reserve Bank of Australia. With the economy expanding at a moderate pace, at best, with the unemployment rate appearing to edge up and global economic conditions only fair, the case for a 25 basis point rate cut, to a fresh record low of 1.5 per cent, is solid. It will, nonetheless, be the inflation data next Wednesday that will help to lock in the case for lower rates.
Based on available information, inflation is set to rise by 0.8 per cent in the June quarter, which will leave annual inflation at 1.4 per cent. During the June quarter, there was a sharp lift in petrol prices driven by the jump in global oil prices. This alone will account for around 0.25 percentage points of the 0.8 per cent inflation rate.
The high inflation rate for the quarter (0.8 per cent equals annualised inflation around 3.25 per cent) would seem high enough to prevent the RBA from cutting. After all, the RBA acts with its interest rate settings to keep inflation between 2 and 3 per cent and a 0.8 per cent quarterly rise might be considered the start of a worrying uptick in price pressures.