News Analysis: Australia needs demand-side reform to arrest falling inflation expectations

Australia needs demand-side reform to arrest falling inflation expectations or risks entering the dangerous negative feedback loop hindering other markets, analysts here have said.

Australia recorded its slowest headline inflation since 1999 on Wednesday while core inflation remained well outside the target 2 to 3 percent band.

"The longer it stays below target, the greater the risk inflationary expectations will fall and feed through to lower wages growth, which will feed back to even lower inflation," AMP Capital's Shane Oliver told Xinhua.

Australia hasn't escaped the wave of deflation impacting global markets due to excess capacity in increased competition, with large signs of weakness within household consumables, and falls in rental prices from a large uptick in investor housing.

"Something like two-thirds of (inflation) is now growing at less than 2 percent per annum," Commonwealth Bank of Australia chief economist Michael Blythe said.

"This risk is that it does feed into expectations over time as we've seen in other countries."

RBA MUST MANAGE INFLATION EXPECATIONS

Australia's central bank has a mandate to keep inflation within its target range, thus the Reserve Bank of Australia (RBA) will likely ease policy at its Aug. 2 meeting, albeit through gritted teeth.

The falls in the Australian dollar in the current easing cycle haven't flown into inflation as expected, noted by the tradable inflation printing a 0 percent annualized rate, suggesting the rise in import prices have been absorbed in key supplier markets due to their own deflationary pressures.

Australia's consumer market is also highly competitive as foreign entities flock to an economy that has outperformed post-GFC thanks to a once in a generation mining boom, thus increased costs have also been locally absorbed.

But the competition is seeing retail giants bring forward seasonal sales by months in the fight for the retail dollar, perpetuating the negative feedback loop in the consumer mindset.

"At the same time, companies faced with a more competitive environment, their ability to pay (wage increases) is lower than it used to be ... reinforcing the weakness we're seeing in inflation," Oliver said, adding Australia's labor market too has slack, weighing on wage growth.

Following 10 quarters of below target inflation, economists sense the RBA may revise its inflation outlook over the medium term, though that might undermine the credibility of the bank's policy framework.

"It may also lead to lower inflation expectations which could push inflation down even further," Blythe said.

"While a low but stable rate of inflation is considered optimal for delivering sustainable economic growth, a very low rate comes with increased risks."

DEMAND-SIDE REFORM NEEDED

It's arguable however that Australia's domestic economy is actually in need of any additional monetary stimulus as growth is still tracking just above 3 percent, and fears any further cuts will just add fuel to an already hot housing market.

Demand-side reform and stronger growth is what's needed, Oliver said, though that has been a challenge both in Australia and globally.

Reforms of the 1980s saw supply side reform that boost productivity as a way to bring excessive inflation under control, and ultimately down, but now there is excess capacity and not enough demand, Oliver said.

"An environment of stronger demand growth is key," Oliver said, adding it's up to the Australia's policy makers, and to a point, the central bank to encourage demand.

However the scope for demand-side reform from Australia's policy makers is limited as the central government attempts urgent budget repair in a hostile political environment, while Wednesday's inflation print, while soft, may not be enough to cause further RBA easing.

There has been debate regarding whether cuts to the cash rate, already at a record low 1.75 percent would have much of an effect, or whether it would work too well and cause another expansion in the housing market.

"Central banks everywhere would like extra stimulus to come from lower currencies and more infrastructure spending," Blythe said.

"Both are beyond the ability of the RBA to deliver -- they remain the policy maker of last resort."

Hence all market participants will be closely watching the Aug. 2 policy meeting.

The RBA could hold off on cutting rates as economic activity remains strong, but risks deflationary expectations becoming entrenched.

"It's not an easy decision for the RBA ... trying to balance up these competing forces," Oliver said. Endit