‘Left of field’ shocks to global supply chains such as the tensions playing out in the Red Sea are the biggest risk to inflation and interest rates, the Reserve Bank governor has warned.
Cooling inflation has given homebuyers more confidence to jump into the property market amid forecasts of several interest rate cuts later this year, while those with a mortgage hold out for some repayment relief.
But RBA governor Michele Bullock has warned it’s too soon to rule out future rate hikes just yet.
Addressing her first parliamentary hearing since taking over the top job, Ms Bullock said the main risks to inflation reaccelerating were likely to be unforeseen.
“What we’ve observed over the last few years is that supply shocks can come from left field,” Ms Bullock said.
“We had the pandemic, we had Russia-Ukraine, now we’ve got the Middle East, we’ve got concerns about supply chains there.
“We are seeing an impact on shipping costs and so there’s a potential that there’s some supply issues out there. So that’s a risk.”
Recent attacks on shipping vessels in the Red Sea – through which about 12% of global trade and 30% of all global container shipments pass – have driven up freight costs as ships use longer, more costly shipping routes.
Red Sea shipping disruptions put pressure on freights and supply chains:
NAB chief economist Alan Oster said while the impact remains minimal compared to the supply chain disruptions of the pandemic, it poses a risk to inflation.
“Geopolitical factors remain a risk,” Mr Oster said in the NAB Forward Review report.
“Recent disruptions to shipping through the Red Sea and Suez Canal have seen a spike in freight rates which, if sustained, will add to global inflation and is already causing some factory disruptions.”
Ms Bullock said that while the increases to date have been small relative to those seen during the pandemic, the way households respond is a concern.
“Typically, we would try to look through those sorts of things, but I also highlight that inflation expectations being anchored is important.
“If you keep getting supply shocks, which keep pushing inflation up, at what point do people seem to think well, actually, this is just the new world? So I think we’ve got to be alert.”
A flow on effect
The RBA’s newly updated economic forecasts see Australia’s inflation rate easing to 3.1% by June 2025, although it’s not expected to reach the middle of the 2-3% target range for more than two years.
If realised, inflation will have remained above the target range for four years.
“That’s quite a long time, and we think that if it stays outside of that much longer then it just increases the risks that inflation expectations [rise],” Ms Bullock said.
“When people see things that are in their face all the time, like grocery prices and fuel and those sorts of things, when they see those prices going up quite quickly, they get this in their mind that [inflation will continue to rise].”
The RBA held interest rates at 4.35% in February, but said returning inflation to target within a reasonable timeframe remains the highest priority.
“At this stage, the board hasn’t ruled out a further increase in interest rates but neither has it ruled it in,” Ms Bullock said.
AMP deputy chief economist Diana Mousina said the theory is that inflation expectations influence future actual realised inflation, although questioned how reliable the correlation actually is.
“Central banks pay close attention to inflation expectations, especially in the recent period of high inflation, out of concern that inflation expectations will become unanchored and lead to prolonged high inflation,” she said.
Housing costs and essential items keeping prices elevated
A sharp slowdown in the Consumer Price Index (CPI) over the past year has seen markets price in several interest rate cuts later this year.
Annual inflation cooled to 4.1% in the December quarter, down from a peak of 7.8% a year earlier.
However, while the cost of discretionary items – such as clothing, footwear and furnishings – has eased, the price of essential goods and services have been much slower to respond, which Ms Bullock said poses a risk to inflation reversing.
“Some of the ‘goods’ side has been very kind to us but if some of that reverses and services inflation doesn’t come down enough then we’re not going to be reaching our band,” Ms Bullock said.
CBA head of Australian economics Gareth Aird said the RBA’s 13 interest rate hikes to date have been successful in pulling down the rate of inflation for discretionary goods.
Instead, he said the risks lie within four essential items.
“It has primarily been a tale of four expenditure items; the cost of building a home (good), rent (service), electricity (good) and insurance (service). These are all housing related,” Mr Aird said.
“There will be pockets of both goods and services inflation that prove a little sticky because monetary policy is unable to directly influence price changes for some non-discretionary components of the basket – particularly those influenced by strong population growth.
“But overall we expect ongoing disinflation to be the key theme in 2024.”
CBA expects three rate cuts this year, beginning in September, and a further three cuts in the first half of 2025 to take the cash rate to 2.85%
PropTrack data shows national rent prices have surged by a third in the past two years, with the share of all rental properties sitting vacant more than halving since the pandemic.
While supply chain disruptions pushed up building costs in recent years, the latest inflation data shows these price pressures have cooled dramatically, with labour costs largely responsible for continued price rises.
PropTrack senior economist Paul Ryan said financial pressures look to be easing in housing, with slowing price growth, expectations of lower interest rates, and a slower pace of rental increases.
“This will be welcome news for households feeling cost-of-living pressure,” Mr Ryan said.
Ms Bullock said that while much of the persistent inflation sits within essential items, consumers still have the ability to cut back in other ways.
“What a lot of people do is they downgrade, they move from a [branded item] to a home brand perhaps, or they shop at Aldi, or they look for ways to reduce the costs while still consuming their essentials.
“People make decisions about ‘what do I really need?’ and ‘what can I put off consuming at this point in time?’”