Inflation and the Recession


What Has Happened?

The COVID-induced recession has contributed significantly to the deflationary price effects experienced today, with Australia experiencing inflation of -0.3% in the 2nd quarter of 2020. While the decline in consumer spending (and thus demand-pull inflation) and wage growth (and thus wage-push inflation) have contributed to deflation, it should be noted that Australia’s pre-recession inflation was already below the 2-3% target band, being 1.9% in 2019.

The RBA aims to keep average inflation between 2-3% over the course of the economic cycle. However, the expected sluggish recovery from the recession will mean that inflation will continue to lie below this target band for a prolonged period of time. The RBA predicts that inflation will only return to the target band by early 2023, with some economists pessimistically forecast that inflation will remain below-target for at least half a decade.

This raises the question of whether the 2-3% target band is a critical goal to achieve adequate economic growth. After all, some other countries have achieved economic stability despite having lower inflation targets than Australia – the EU has an inflation target of below, but close to 2% in the medium term. With this in mind, it is reasonable to conclude that temporarily lower inflation target (say 1-2%) is unlikely to be detrimental to Australia, since low inflation is not as damaging as high inflation or deflation. 

Syllabus Links

The low inflation seen in Australia is generally regarded as being the result of two influences. Firstly, the low level of income growth (which in real terms is almost zero, and has occasionally been negative in some recent quarters) puts downward pressure on wage-push inflation. Additionally, low wage growth tends to reduce consumer confidence, encouraging them to save more. The reduction in (or at least slower growth in) consumption puts downward pressure on demand-pull inflation.

The low consumer confidence can also be seen in measures of consumer inflation expectations, which are down 0.7% this year, with consumers forecasting inflation to be 3.2%. Note that this is generally not regarded as being an accurate measure of inflation as it is influenced by (often unrealistic) consumer perspectives. Nonetheless, this statistic demonstrates that consumers by and large expect inflation to fall, signifying poorer consumer confidence and lower expected consumption levels in the short to medium term.

The CPI – a direct measure of headline inflation – has seen some variability in prices. Petrol prices, for example, are at their lowest real prices in 21 years (adjusted for inflation). This has been in part been due to the dumping of oil by major oil producers such as Russia and Saudi Arabia that culminated in negative oil prices earlier this year. However, the appreciation of the AUD relative to other countries (a result of our less severe recession) has reduced the price of imported oil in AUD terms. 

The US Fed has signalled that instead of forcing inflation to remain around 2% in the post-pandemic recovery (through contractionary policy to prevent “over-heating”), the Fed may allow inflation to temporarily rise above the US inflation target. As a result, the Fed has signified that it intends for the US reserve rate to remain close to zero for several years, even when the economy is recovering. 

While the Australian cash rate is expected to remain at 0.25% (or even fall further in possible increments of 10 basis points) for at least 2 years, the announcement that the US reserve rate will remain near-zero for several years means that in the medium-to-long-term, Australian investments will have a higher relative return compared to US investments. This would lead to a higher demand for the AUD, and result in an appreciation of the AUD. 

During the pandemic, the AUD has seen a steady appreciation from a low of 55 US cents in late March to around 72 cents today. This is seen below in Figure 1.

Figure 1: AUD/USD Exchange Rate over Time

If this appreciating trend of the AUD is supported by a higher cash rate (relative to other countries) in the future, Australia’s economic recovery could be hindered.

An appreciation of the Australian dollar reduces the international competitiveness of exports in overseas markets. This is not a profound issue for Australia however, in the sense that Australia’s exports are dominated by largely price-inelastic commodities. Indeed, the trade tensions between China and Australia are expected to have much greater effects on Australia’s commodities exports than any moderate appreciation in the AUD. Other exports that are traditionally sensitive to exchange rate movements (such as tourism and education), have been severely restricted by border closures, and so exchange rate movements are unlikely to have major effects on these sectors. Indeed, Ray Attrill from the NBA states that any volatility in the AUD is “much less significant” in the current economic climate.

Mailing List

Thank you! Your submission has been received!
Oops! Something went wrong while submitting the form.

Reference List