15 October 2023

Why inflation’s enemy No.1 and hard to tame

Still can’t get a booking at your favourite restaurant in Sydney or Melbourne at short notice? Surprised that tickets to Taylor Swift and Coldplay are sold out despite news about falling household incomes, rising interest rates and mortgage stress? It’s complicated.

Part of the story seems to be substitution, with consumers still spending more than normal on local entertainment and doing less international travel than before COVID. Another part of the story is that households accumulated substantial savings during the pandemic, which are still being deployed – the so called ‘revenge spend’.

A further element is that sharply higher interest rates and high inflation are having an uneven impact on the community, with more of the burden falling on lower income households. Not everyone is dining out and going to rock concerts. Providing some offset, a still fairly tight employment market means that there are lots of jobs available.

As is well understood, the pandemic heavily disrupted consumer spending patterns and saving behaviour. In the early stages, consumers could not go to rock concerts, the theatre, or to restaurants, and with a closed border international travel was off the agenda too. But thanks to significant government spending programmes and historically low interest rates, household disposable incomes grew strongly.

Households spent some of this on goods, like decking out a home office and buying a home gym, but much more of the household income was saved than usual. Then the economy re-opened, and spending bounced back strongly, particularly on services. So strongly that it added a hefty amount to inflation, given that demand for goods and services was much stronger than the economy could supply. At that time, supply was still being heavily disrupted by the effects of the pandemic.

To slow inflation, the RBA lifted interest rates rapidly and this has suppressed growth in overall consumer spending.

At the same time, patterns of consumer spending have headed back towards pre-COVID levels, although they are not fully back to normal. The same applies to international travel. In the second quarter of 2023, consumers spent $A11.5bn on international travel, down from $A14.5bn in Q2 2019.

Instead of travelling internationally, consumers are still spending much more on cafes, restaurants and takeaway food than they were in the pre-pandemic period. They are also willing to spend more on clothing and footwear. It seems that if you haven’t been out for a while, a new outfit is needed.

Even though incomes have been falling as inflation has outpaced wages, households have been supporting this spending by saving less and, in some cases, drawing down on previously accumulated savings. Some households are likely to have mentally set aside money that they saved during the lockdowns to spend on rock concerts and other entertainment when the restrictions were lifted.

The sum of excess savings through the pandemic was substantial. Our estimates suggest that at the peak of this effect, households had saved $A275bn, or 23% of annual household consumption, more than normal. Some of this has been drawn down recently, supporting spending, but a lot remains – perhaps as much as $A255bn.

However, it is difficult to know how willing households will be to deploy more of this excess savings, given falling real wages and rising interest rates. Many households are also likely to have invested these funds, some in housing and other illiquid assets, making it less likely that these savings will be spent.

Of course, this aggregate picture of the economy hides significant divergence across different households. Although aggregate household consumption growth has slowed, rather than fallen outright, some households have had to cut back on spending recently. On the RBA’s estimates, 5% of households with variable rate owner-occupier mortgages are unable to pay for essentials without running down savings as a result of higher interest payments. Of these households, the RBA estimates that 70% have sufficient mortgage buffers, perhaps in mortgage offset accounts, to support essential spending for more than six months, while 30% have less than six months of buffer available. After that, there is a higher risk of mortgage default for this group of borrowers.

The strong jobs market has so far helped households meet expenses, with evidence of more people getting multiple jobs and boosting the number of hours they work. Rising housing prices also mean that, although it is a tough choice, it is easier for households to choose to sell their home and down size to deal with excessive debt levels. High and rising rents are also weighing heavily on the disposable incomes of low income households as well as their spending.

With inflation still too high, we expect a sustained period of suppressed overall consumer spending will be needed. The burden of much of this is likely to continue fall most heavily on lower income households.

Given this challenging situation, getting the right balance of policy measures, both monetary and fiscal, is essential and there are difficult trade-offs. The RBA needs to focus on lowering inflation, in part because high inflation is one of the key factors weighing on household incomes. But interest rates are a blunt policy instrument and the impact is likely to be highly uneven across households. Fiscal policy tools can be more targeted, so they can and should play a bigger role in managing the economic cycle.

This article first appeard in The Australian, on 15 October 2023.