The RBA’s rate predicament became even more complicated

But the big rise in vacation costs is still relevant because it’s a clear example of service inflation, which is increasingly the focus of many market economists.

Both here and overseas the initial price increases last year focused on commodities: gasoline, building materials, fresh food and the like. More recently, services inflation has caught up. David Rumbens, Partner at Deloitte Access Economics, notes that services inflation was higher than goods inflation in the December quarter for the first time since late 2020.

Why is that important?

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

Commodity prices are often volatile – they can skyrocket in response to fluctuations in commodity prices, factory closures, or rising shipping costs, as seen during the pandemic. As pressure on the supply chain eases, hopefully the worst of commodity inflation is over.

But cost services tend to move more slowly because they are more affected by wages, which tend to be less volatile than commodity prices. As a result, economists fear services inflation is “firmer” — it will take longer to come down than goods inflation. That’s one of the reasons why so many economists argue about how inflation has become “broader based” in the economy.

However, before we panic too much, the recent surge in services inflation should be put in context.

There’s a chance that the surge in summer holiday spending – which contributed to price hikes – was another form of ‘catching up’ after many missed summer holiday trips in the previous two years.

Service businesses such as pubs, hotels, restaurants and theaters have been among the hardest hit by COVID-19 lockdowns – many of them on life support.

Commonwealth Bank economist Gareth Aird says many of these service providers likely struggled to raise their prices in 2020 and 2021. It’s a bold hotel operator, raising prices when much of the population is on lockdown or barred from travel.

Aird points out that services inflation has still risen by just 8.9 percent over the past three years — an average of about 3 percent a year. That’s hardly runaway price growth. In fact, it suggests that a sizeable chunk of service price increases could be “catched up.”

What happens besides the price of these labor-intensive services will be crucial to overall inflation. The major concern of economists and RBA Governor Philip Lowe is the dreaded “wage-price spiral”, in which higher wages lead to higher prices and, in turn, higher wage demands.

But there’s no sign of it happening today. The latest official figures showed wage growth of 3.1 percent a year, which the RBA expects to increase to 4 percent by the middle of next year.

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

This week’s high CPI reading did not reflect the impact of these rate hikes as it takes months for banks to increase repayments, for households to change spending patterns and for companies to adjust prices accordingly.

Loading

But consumer spending will certainly slow down sharply this year. There’s a chance that the surge in summer holiday spending – which contributed to price hikes – was another form of ‘catching up’ after many missed summer holiday trips in the previous two years.

As households inevitably tighten their belts, one of the first things they’re likely to cut will be discretionary spending on expensive vacations and dining out at nice restaurants. That should remove some inflationary heat from these sectors.

All of this only illustrates the dilemma Lowe faces. Using typical understatement, he said the economy faces a “narrow” path to bringing inflation under control while keeping the economy on a “steady course”. This is the language of central bankers saying that restraining spending without derailing the economy is indeed a very delicate balancing act.

Ross Gittins is on vacation

The Business Briefing newsletter delivers important stories, exclusive coverage and expert opinions. Sign up to receive it every weekday morning.