The current bull market for global stocks that began in 2009 is now the longest in history.

And if there’s one theme that has often stumped economists and investors during that time, it’s the stubborn refusal of inflation growth to rise above its historical trend.

Inflation is important because it’s the primary influence on the outlook for global interest rates. For example, the US Fed has a sole mandate for its monetary policy settings based on achieving annual inflation growth of 2-3 per cent.

In turn, rates are a crucial input in calculating the value of asset prices across stocks and real estate.

While its not the RBA’s only mandate, Australia’s central bank has the same 2-3 per cent target. And despite its best efforts, it has consistently fallen short in recent years.

After three rate cuts in 2019, Australia’s cash rate is at an all-time low of 0.75 per cent, yet trimmed inflation (adjusted for volatile items) has fallen short of the 2 per cent mark for 16 straight quarters.

And that low inflation rate is one of the main reasons why markets are currently priced for the RBA to cut rates even further in the months ahead.

Given its importance to the economy, for this week’s edition of Think Big we decided to ask the question — what is inflation actually comprised of?

It’s a complex question but for an Australian perspective, we looked at a 2018 speech on inflation by RBA deputy governor Guy Debelle, which offered a breakdown analysis of each component in the domestic inflation (CPI) basket.

Two sectors that stood out were retail and telecommunications, where prices weren’t climbing; in fact, both components were stuck in a deflationary trend since 2015.

In addition, they have a combined effective weighting of 34 per cent; the largest portion in the CPI basket.

With headwinds like that, one may wonder how inflation in Australia can meet its target growth band when the largest component is not only flat, but going backwards.

But to learn more, Stockhead spoke to Alex Joiner, the chief economist at global investment fund IFM Investors.

Joiner highlighted that while the frontline numbers were broadly accurate, they needed to be considered with some added layers of context.

“There’s no doubt those retail and telecommunication components of the basket are dragging on CPI. But there’s a difference in how CPI prices are measured in the first instance and how they’re measured in the economy,” he said.

To be sure, structural forces giving rise to the weak retail environment make it difficult to pass on price increases. But to understand CPI we also need to consider how the data is quality-adjusted.

Joiner explains:

“Take the example of a 50-inch plasma TV screen, which 10 years ago cost around, say, $5,000. You can now buy an even bigger QLED screen for the same price.”

“In the CPI basket, that quality adjustment turns up as deflation. Whereas in effect the consumer still pays the same amount.”

The trend has also been particularly evident in telecommunications, where phone prices stay the same while data packets get bigger.

“It’s an interesting situation because it’s not really reflective of what it costs the consumer, but in CPI it shows up as deflation,” Joiner noted.


Retail apocalypse

While context is important, Joiner also added some good insights into some of the structural forces driving deflation in the retail sector.

Amid a raft of local retail brands falling into administration, Joiner pointed to the challenge of increased competition from the rise of online sales and big offshore players.

“Go back 20 or 30 years when the retail precincts were led by Myer and David Jones. Now we’ve seen the introduction of brands such as Uniqlo and H&M — high-volume, low-margin companies that are outcompeting traditional brick and mortar retailers,” he said.

“You can see it in retail data, where you get deflation from the department store component. They haven’t been able to pass on any inflation for six or seven years.”

That in turn creates a negative feedback loop for wage growth, which remains consistently low in Australia and is another important input to inflation growth.

“It’s a circular thing because retail is also one of the biggest employers in the country. And when margins are getting squeezed they can’t pass on any wage increases,” Joiner says.

Ageing demographics are another important factor, because elderly consumers typically spend less on retail while ramping up spending for other components such as travel and healthcare.

But while retail drags on CPI growth, not all components are falling below the target brand. The numbers in Debelle’s speech showed “administered prices” such as utilities, education and health costs climbed by an average of 3.8 per cent.

If the whole basket was rising at that level, the RBA would be committed to a steady rate hike cycle to control inflation, and the economy would look very different.

Joiner said prices of those components were driven in large part by inelastic demand. If utility prices go up, people still need to pay their bills — a concept which rings even truer for healthcare.

In addition, he noted that the CPI basket doesn’t take into account the frequency of purchases.

“You’re paying utilities prices once a quarter, but you don’t buy a new TV every three months,” he says.

“And that’s why people feel the cost of living is getting away from them because they see prices for frequent purchases increasing. It’s not a cost of living index, it’s a consumer price basket.”

Ultimately, in taking a closer look at what inflation actually is, one thing became clear: the CPI basket is a relatively complex beast.

And the net effect of all those competing forces is that inflation expectations still remained anchored below the 2-3 per cent target.

While rates stay low, stocks and real estate prices have continued climbing to new highs.

The latter asset class is a particularly acute challenge for policymakers in Australia, which has some of the highest levels of household debt in the world. As Joiner neatly concluded:

“We’re seeing the traditional relationship between asset prices and interest rates work probably as well as it ever has,” he said.

“But the traditional relationship between interest rates and the economy is significantly different in the post-GFC period.”