Central Banks eye inflation risks as supply disruptions snowball

In light of the developments over the past two years, many businesses have reassessed the resilience of their supply chains, pushing some businesses to diversify their supply network to avoid dependency on a particular country.

Importantly for Australian manufacturers, there is a push to scale up domestic production capabilities for critical products. The government has noted medicine, personal protective equipment and fertilisers as points of focus.

Another consequence of supply disruptions is that energy-related commodity prices have increased significantly since the middle of the year. Energy prices have been boosted by strong demand for goods alongside the global economic recovery.

Relief is coming… eventually

The immediate question is, how much longer will these disruptions persist?

Unfortunately, it will take some time for these bottlenecks to be worked out. Our customer liaison suggests that disruptions will persist in some form over 2022.

On the upside, the move to relax COVID-19 restrictions around the world (notwithstanding recent setbacks in some countries) will see a rebalancing in consumption back towards services and away from goods. The Reserve Bank (RBA) Governor Lowe has stated he expects this shift may help disruptions begin to ease. However, Lowe made these remarks before the emergence of Omicron. Omicron could prolong the supply-chain disruptions for longer.

Inflationary pressures are swelling

The disruptions to supply chains, alongside strong goods demand and rising energy prices, have pushed producer price inflation to its highest level in many years in a number of economies. However, the extent to which this has been passed onto consumers varies.

In the US annual producer price inflation surged to 12.2% in the year to December 2021. Personal consumption expenditure (the Federal Reserve’s target measure of consumer prices) hit 5.8% in December, the fastest rate since the early 1980s.

In Australia, the disruptions have contributed to large price increases for some consumer durable items, including cars and some household goods. These developments, alongside the lift in energy prices, and pushed up annual headline consumer price inflation (CPI) to 3.5% in the December quarter. But overall, producer price inflation remains much lower than some other parts of the world, touching 3.7% in the December quarter. If producer prices lift more than consumer prices, this may squeeze the profit margins of some businesses, as it suggests rising costs have not been entirely passed onto consumers.

Trimmed mean CPI, a measure of underlying price pressures and the Reserve Bank’s preferred measure of inflation, has also picked up. In fact, it hit 2.6% in the December quarter – the highest rate in more than seven years, and notably above the mid-point of the central bank’s 2–3 per cent target band.

Pandemic curveballs

The emergence of the Omicron variant poses a fresh hurdle for the economy although we expect it will only temporarily pause the recovery. Surging case numbers have underpinned a ‘shadow lockdown’. Millions of Australians have been forced to isolate after contracting the virus or being identified as close contacts. Many others have been more cautious about leaving home. Subsequently, absenteeism has strained many businesses.

The fresh disruptions also may delay when supply bottlenecks are resolved.

We expect activity will pick up as case numbers decline, and as such the recovery is likely to resume through February or March. In fact, we still expect 5.5% GDP growth in 2022 – that represents strong growth at more than twice the long-run average. However, the pandemic remains a key downside risk, with the possibility of another wave of infections, particularly as we head into the winter months.

Central banks are watching closely

Central banks, up until relatively recently, were at pains to frame inflationary pressures as transitory. The longer supply disruptions persist, the bigger the likelihood that these ‘temporary’ price increases will become entrenched. The risk for central banks is the increase in inflation is faster and more persistent than they have forecast.

Indeed, inflation and employment have picked up considerably faster than the RBA expected. Accordingly, it dropped its bond-buying program in February, and sharply revised up its inflation forecast and moved its unemployment forecasts lower to sub 4 per cent. These shifts lay the groundwork for rate hikes later this year.

Governor Lowe has conceded it is ‘plausible’ that the cash rate could lift ‘later this year’, marking a significant shift in guidance. Not long ago, the RBA was maintaining that its ‘central scenario’ was that the cash rate would not increase before 2024. However, the RBA has continued to emphasise it is prepared to be “patient”, highlighting the need to observe more wage and inflation prints before determining that inflation is “sustainably” in the target band.

We expect the RBA will kick off the hiking cycle by lifting the cash rate by 15 basis points in August. At that point, there will have been two more wage prints and two more inflation prints, which we expect will be enough evidence to satisfy the RBA. Although, we wouldn’t rule out the possibility of lift-off as early as June.

And what does this all mean for the Australian equity market? On one hand, higher interest rates are typically perceived as a headwind for equity markets, as it becomes more expensive to borrow, and companies and consumers curb their spending. But on the other, we are at the start of an upswing in global economic growth as restrictions lift, notwithstanding any setbacks from new variants such as Omicron, which will support equity prices. Given these competing forces, and the enduring uncertainties over the pandemic, volatility in equity markets seems likely.

BT Economics

BTeconomics@btfinancialgroup.com