Understanding inflation

Earlier this week the Australian Bureau of Statistics released the latest set of quarterly Wage Price Index (WPI) data. This data, simply put, measures how quickly wages are increasing and is used by the RBA when assessing monetary policy conditions. Much like the Consumer Price Index (CPI) tracks a basket of goods and services, the WPI tracks changes in price (i.e. the wages) of a fixed basket of jobs.

Seasonally adjusted WPI rose 0.8% in the March 2023 quarter, comprising a 3.7% annualised growth rate. The private sector was the main driver with the most significant contributors being Education and Training (1.5%) and Professional, Scientific and Technical Services (0.9%).

The WPI is the primary measure of inflationary pressure on wages and salaries, and is one of the key sources for the RBA when reviewing monetary policy. On the one hand, wages need to move in alignment with inflation to ensure standard of living is not negatively impacted. On the other hand, wages and salaries are a major input cost across both goods and services and this can very easily filter through to headline inflation numbers if left unchecked.

A wage-price spiral occurs when increasing wages trigger inflation. In this scenario, higher wages feed through to higher disposable incomes, creating increased demand for goods and services, causing prices to rise. The cost of higher wages are met by businesses through increased prices of their goods and services, in turn fuelling the inflationary engine.

We are not, however, in a wage-price spiral. Inflation and Wage Price data shows that inflation is still running well ahead of wage prices. While the gap is starting to narrow – given inflation is coming off peak – the divergence between the two is still well beyond longer run observations.

In this cycle, wages are playing catch-up and have not been the catalyst of inflation. Consider the following analysis of real household disposable incomes, that is, the position of incomes once you factor in the increased costs of living and elevated interest rates. With real disposable incomes in negative territory, it is difficult to mount the challenge that wages are the catalyst of inflation:

While the inflationary peak may have passed, it remains uncomfortably high. The RBA is acutely aware of this and continues to stress its desire to see inflation return to target range sooner rather than later. In its May meeting minutes, the RBA noted that input cost pressures, both labour and non-labour, were continuing to contribute to price increases across a number of services.

Consistent with their messaging three months earlier, the RBA reiterated that it forecasts inflation will return to target by mid-2025. This is good news. Importantly, the RBA also noted that while wages growth had increased, it was still consistent with the inflation target being achieved.

So where to from here? The RBA has certainly not called ‘peak rates’, and acknowledges that it will do what is necessary to return inflation to target. While inflation has peaked, the pace of the return to target will be a central concern. Although wage growth is a direct contributor to inflation and plays a significant role in monetary policy, it is not the net-inflationary smoking-gun which would alone warrant further upwards movement in the Official Cash Rate.