The RBA’s interest rates dilemma just got more complicated

Anyone who’s been on a domestic holiday this summer can probably attest to the jump in prices – whether that’s for accommodation, airfares, or the cost of takeaway fish and chips.

What’s less obvious, however, is that this surge in holiday costs is also a neat illustration of how Australia’s inflation problem is evolving.

A queue at Sydney Airport’s T2 terminal on Thursday morning.Credit:Renee Nowytarger

The first wave of inflation last year was mainly about goods: soaring petrol prices and building materials. Now, increasingly, the price rises getting more attention are those in the services sector – holidays being a prime example.

This may sound like some esoteric issue that would only interest economists, but bear with me. Rising consumer prices in the services sector are actually important because they illustrate how inflation can arrive quite suddenly, but be slow to fall, or “sticky.” Expect that to be a major issue for the economy – and interest rates – in 2023.

The Bureau of Statistics on Wednesday said the consumer price index (CPI) jumped 7.8 per cent in the year to December, the sharpest annual rise since 1990. During the quarter, the CPI rose 1.9 per cent. The good news is this is probably the peak. But however you cut it, it’s a long way above the Reserve Bank’s 2 to 3 per cent target band.

The biggest contributor to the quarterly increase was domestic holiday travel and accommodation, with price rises of 13.3 per cent in three months which Bureau put down to strong demand in the December school holidays for flights and accommodation.

This was much more than the usual summer blip. After two summers of being restricted by lockdowns, state border closures, or fear of disease, many Australians took the chance to travel domestically this summer, while spending on hospitality has also been strong. It makes sense that the prices of these activities have jumped in response.

There are of course endless ways of dissecting the CPI to remove “noise” that can be caused by one-off events, such as swings in the price of vegetables, or petrol prices. The RBA’s preferred measure of “underlying” inflation, for example, rose by 6.9 per cent in the year to December.

But the great surge in holiday costs is still relevant, because it’s a clear example of services inflation, which is a growing focus for many market economists.

Both here and overseas, the initial price rises last year were concentrated in goods: petrol, building materials, fresh food, and the like. Lately, services inflation has caught up. Deloitte Access Economics partner David Rumbens points out services inflation was higher than goods in the December quarter, for the first time since late 2020.

Why does this matter?

The cost of domestic holidays was a key driver of inflation in the December quarter.Credit:Matt Davidson

Because it suggests inflation is becoming more of a feature in the domestic economy, rather than just being something we imported from overseas.

The prices of goods are often volatile – they can jump around in response to swings in commodity prices, factory closures, or soaring shipping costs, as occurred during the pandemic. With supply chain pressures easing, hopefully the worst of this goods inflation is over.

But the cost services tend to move more slowly because they are more affected by wages, which tend to be less volatile than prices of goods. As a result, economists worry that services inflation is “stickier” – it will take longer to decline than goods inflation. That’s one reason so many economists are banging on about how inflation has become more “broad-based” in the economy.

Before getting ourselves in too much of a panic, however, the recent rise in services inflation should be seen in context.

There’s every chance the surge in summer spending on holidays – which helped fuel the price rises – was another form of “catch-up” after many missed out on summer holiday travel for the two previous years.

Services businesses such as pubs, hotels, restaurants, and theatres were among the most affected by COVID-19 lockdowns – with many of them put on life support.

Commonwealth Bank economist Gareth Aird says many of these service operators probably struggled to lift their prices in 2020 and 2021. It’s a brave hotel operator who jacks up rates when much of the population is locked down, or restricted from travelling.

Aird points out that services inflation has still only risen by 8.9 per cent in the last three years – an average of about 3 per cent a year. That’s hardly runaway price growth. Indeed, it suggests a fair bit of the increase in prices for services might be “catch-up.”

Spiralling inflation is not the only issue RBA chief Phil Lowe is dealing with.Credit:Alex Ellinghausen

What happens next to the price of these labour-intensive services will be crucial for inflation more broadly. The big concern of economists, and RBA governor Philip Lowe, is the dreaded “wage-price spiral”, in which higher wages drive higher prices, in turn driving higher wage demands.

But there’s no sign that is happening today. Latest official figures showed wage growth of 3.1 per cent a year, which the RBA expects will rise to 4 per cent by mid next year.

Moreover, inflation is only part of the picture for Lowe, who will also be well aware of the huge hit rising interest rates have already inflicted on household budgets.

This week’s high CPI reading did not reflect the impact of these rate rises because it takes months for banks to raise repayments, and households to change their spending patterns, and businesses to adjust prices accordingly.

But consumer spending will surely slow sharply this year. There’s every chance the surge in summer spending on holidays – which helped fuel the price rises – was another form of “catch-up” after many missed out on summer holiday travel for the two previous years.

When households inevitably tighten their belts, one of the first things they’ll probably cut will be discretionary spending on pricey holidays and eating out at nice restaurants. That should remove some inflationary heat from these sectors.

All of which just illustrates the dilemma facing Lowe. With typical understatement, he’s said the economy faces a “narrow” path in bringing inflation under control while keeping the economy on an “even keel.” This is central banker speak for saying that putting the brakes on spending without also derailing the economy is a very delicate balancing act indeed.

Ross Gittins is on leave

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