WARNING:  QUEENSLAND TREASURY CORPORATION RETAIL BOND SCAM ALERT

Hear from Trent Saunders, QTC Principal Economist

Published: 28 September 2022
The views expressed in this post are entirely the author’s and may not reflect QTC’s position. The article has been posted for general information purposes and does not constitute financial or other advice.

Inflation has increased sharply in Australia over the past year, with prices growing at their fastest rate since 1991. This surge in inflation has been underpinned by several factors, including disruptions to global supply chains and a historically tight domestic labour market. However, the relative importance of these different drivers is not immediately clear. This is important, as the persistence of higher inflation, and the Reserve Bank of Australia’s (RBA’s) response to it, will vary depending on what is driving these increases.

In this note, I take a closer look at what has driven recent inflation outcomes in Australia using a range of different approaches. This includes estimating the contribution of changes in supply and demand to inflation outcomes, as well as assessing that from labour market-sensitive inflation. I find that inflation has increasingly been driven by strong domestic demand and tight labour market conditions in recent quarters, though there are still large contributions from supply disruptions.

Join our email list

Subscribe to economic research updates

Is inflation being driven by supply disruptions or stronger demand?

Whether inflation is driven by supply disruptions or stronger demand has important implications for monetary policy. Supply-driven inflation is typically both shorter-lived and less responsive to increases in interest rates. Because of this, the RBA is more likely to ‘look through’ the effect of supply disruptions. In contrast, monetary policy is well suited for reigning in strong demand, so the RBA tends to be more responsive to bouts of demand-driven inflation.

Zac Gross at Monash University outlines a simple approach to decompose Australian inflation into supply and demand drivers. My replication of this suggests that recent inflation outcomes have increasingly been driven by strong demand.[1]

Demand accounted for two-thirds of household consumption price inflation in the June quarter and around half of the increase over the past year, marking its largest contribution since 2007. The remaining price growth is estimated to largely reflect supply constraints, particularly for fuel, food and ‘furnishings and household equipment’. The results are similar if I update Zac Gross’s results for headline CPI inflation (which is shown in the technical appendix).

Graph 1: Contribution to household consumption price inflation

Have stronger labour market conditions started to flow through to inflation?

The increased contribution of demand to inflation may partly be explained by a tightening of labour market conditions. One way to assess this is to directly estimate the contribution of ‘labour market-sensitive’ CPI components to inflation outcomes, using an approach that I outlined in the previous QTC research article ‘What’s down with Australian inflation?’. [2]

Labour market-sensitive inflation has a similar trend to other indicators of underlying price growth in Australia, though with slightly more pronounced cycles (Graph 2). This measure of inflation increased to 4.5 per cent in the June quarter, which is its fastest pace of growth since 2009.

Graph 2: Underlying inflation measures

This increase in labour market-sensitive inflation partly explains the recent rise in headline inflation (Graph 3). It is estimated to have contributed 0.4 percentage points to quarterly inflation, which is around four times larger than its average contribution in the years prior to the pandemic. Nonetheless, this pick-up in labour market-sensitive inflation still only accounts for around a quarter of the increase in the CPI over the past year.

Just under half of the increase in prices over the past year is explained by new housing costs and fuel prices, neither of which have a significant relationship with domestic labour market conditions.[3]  Higher fuel prices have predominately been driven by global supply disruptions as a result of the Russia-Ukraine war. The higher cost of new housing reflects a combination of supply disruptions and stronger demand, though the majority of the price increases have been driven by material rather than labour costs.

Graph 3: Contribution to headline CPI inflation

How consistent are these estimates?

The results of these decompositions are broadly consistent. The contributions of labour market-sensitive CPI components and demand-driven inflation have increased noticeably over the past year, with both measures at their highest level since the mining boom (Graph 4). Moreover, both estimates suggest that a combination of demand and supply drivers are important for explaining recent inflation outcomes, with the initial decomposition suggesting that demand and supply are of roughly equal importance.

Graph 4: Estimated contributions to year-ended inflation

The estimates are also consistent with measures based on completely different methods. One such approach is principal components analysis, which allows us to summarise the common trends across all of the CPI components in just a few series.

The first two principal components are highly correlated with our estimates of labour market-sensitive and exchange rate-sensitive inflation (Graph 5). The correlations are surprisingly strong, given these series were estimated using completely different techniques and assumptions. Taken at face value, this suggests that my estimate of labour market-sensitive inflation is picking up on the largest source of variation in the CPI data. It is also potentially a strong validation of using the Phillips curve to model inflation in Australia.

Graph 5: Principal components measures of inflation

Conclusion

The increase in inflation over the past year has been underpinned by disruptions to global supply-chains, strong demand and a historically tight labour market. In terms of magnitudes, I find that stronger demand may account for around half of the increase in prices in Australia over the past year. While there is some uncertainty around the size of these estimates, there is less doubt on the direction, with strong demand and tighter labour markets becoming increasingly important drivers of inflation in Australia. This suggests that inflationary pressures may be more persistent but should ultimately be responsive to interest rate increases from the RBA.

Footnotes

[1] I would like to thank Zac for kindly providing the MATLAB code for his estimates. I have replicated his estimates in EViews and made a couple of minor tweaks to the specification. The main difference is that I used the household consumption implicit price deflator for my estimates (rather than the CPI), as these prices are more consistent with the quantities data that are used in the exercise. See the technical appendix for more details.
[2] I would like to thank Gayathri Illungkoo for her significant contribution to this analysis during her internship at QTC. Further information on how this series is put together is provided in the appendix for the previous article. The main change that I have made since the release of this article was to manually reallocate telecommunications prices from being ‘labour market-sensitive’ to ‘acyclical’. While statistical analysis suggests these prices are sensitive to labour market conditions, the movements in this category are more likely to represent a number of structural factors. This change was based on discussions with RBC Macro Strategist Rob Thompson.
[3]  It is somewhat surprising that new housing costs do not have a significant relationship with labour market conditions. One possible explanation for this is if changes in these prices are predominately driven by non-labour input costs (for example, timber, steel, etc). Given the sensitivity of the housing market to changes in interest rates, it is also possible that the effect of labour market conditions on new housing costs is offset by changes in monetary policy.

Disclaimer

The information within this article is intended for general information purposes only and does not constitute financial or other advice. Specific professional advice should be obtained before acting on the basis of any matter covered in this article. This information has been prepared in part by data sourced from third parties which has not been independently verified. Queensland Treasury Corporation (QTC) issues no invitation to anyone to rely on the information and expressly excludes any warranties or representations as to its currency, accuracy, completeness, availability or suitability. All opinions expressed are the views of the author and may differ from the views of QTC or other QTC servants or agents. Forecasts are not a guarantee or reliable indicator of future performance. To the extent permitted by law, neither QTC nor any of its servants or agents accept any liability whatsoever in connection with the use of, or reliance on, the information contained in this article regardless of cause. Copyright in this document is reserved by QTC. No part of it may be reproduced, copied or published in any form or by any means without QTC’s prior written consent.