Download Remarkable times: The end of pricing power?

Economic Insights
Economics | May 11 2016
Remarkable times: The end of pricing power?
Economic & financial issues
 Low inflation, low interest rates: The Reserve Bank expects inflation to stay at the bottom of the 2-3 per
cent target band through to 2018.
What does it all mean?

How many people realise just how remarkable are the current economic times? Over the next few years, the
Reserve Bank expects both an above-average economic growth rate and sub-normal inflation rate – inflation is
expected to be locked at the bottom of the 2-3 per cent target band.

Last Friday, the Reserve Bank Statement on Monetary Policy made the following points:
 “Growth is forecast to be 2½–3½ per cent over the year to December 2016, and to increase to 3–4 per cent
over the year to June 2018, which is above estimates of potential growth in the Australian economy.”
 “Underlying inflation is now expected to remain around 1–2 per cent over 2016 and to pick up to 1½–2½ per
cent at the end of the forecast period.”

In simple terms, interest rates are poised to remain low for as far as the eye can see. That doesn’t mean that
rates have to be cut again. In fact the Reserve Bank has again adopted a neutral stance – it is effectively in “wait
and see” mode. But with the mid-point of inflation forecasts at 2 per cent – the bottom of the 2-3 per cent target
band – interest rates are more likely to fall than rise.

Still, in May 2009 the Reserve Bank forecast underlying inflation to fall to 1.5 per cent by 2011. But the RBA left
rates unchanged through to September 2009 before lifting interest rates a quarter of a per cent in October.

The Reserve Bank is certainly running “very accommodative” monetary policy at present while, the Federal
government is also serving to boost economic growth. That it plain for all to see – the Budget catch-cry is “jobs
and growth”.

No one had predicted this turn of events. Some economists had suggested rates could fall from 2 per cent – but
only because they thought the economy would soften. Rather, the economy is poised to strengthen further rather
than weaken. Australian economic growth is a world-leading 3 per cent; unemployment is at 2½-year lows;
dwelling starts are at record highs as are car sales and tourist
arrivals; and business conditions are at 8-year highs in trend
terms.

The ‘so-what?’ question is that these new inflationary times
have implications for investors. Returns on investments will
ratchet lower; borrowing rates will stay near record lows; the
Budget will take longer to get into surplus; and people are more
likely to stay in the workforce for a longer time.
Technology & disruption

It’s important to point out that prices and wages in Australia are
growing relatively slowly not because our economy is weak –
that is far from the case – rather because of broader global
trends. Some would say “secular” trends.
Craig James – Chief Economist (Author)
Twitter: @CommSec
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Economic Insights: Remarkable times: The end of pricing power?

Technology is producing significant efficiency and
productivity gains – gains that aren’t being picked up in
“traditional” productivity measures. And technology is
creating “disruption” in almost all industries. The celebrated
examples are Airbnb and Uber.

Simply, today consumers can buy or consume goods and
services wherever and whenever they want to. For
businesses, your competitors are no longer other local
businesses. That’s because consumers can shop for rival
goods and services across regions, states, nations and
across the globe.

It doesn’t matter whether you are buying running shoes,
booking hotel rooms or wanting to study at university, the
options are global rather than local.

How do you measure the efficiency gain of jumping on-line
and obtaining want you want? There are cost and time savings and the ability to do a number of transactions at
one time – book flights, transfers, car hire and hotels.

Businesses are benefitting with employees able to more efficiently carry out more mundane tasks. But
technological advances, especially on-going computerisation and automation, are reducing costs across
industries. For instance in Australia car affordability is the best it has ever been, especially when you “quality
adjust” – account for the fact that the quality and inclusions of equipment in cars in 2016 is far away from where it
was in 1974. And the affordability of air travel is again the best it has ever been.
Consumer attitudes

The low inflationary environment is also a product of the economic times. The Global Financial Crisis (GFC) – or
as Americans refer to it – the Great Recession – is still influencing consumer attitudes and behaviour. If it hadn’t
been for the GFC, then super-low interest rates may have worked their magic in lifting borrowing, investment,
spending and employment.

It has been around eight years since the GFC reigned but it continues to have a lasting effect on economic
behaviours across the globe. Rates are near zero or even negative in some cases but consumers and businesses
are still reluctant to grow. It is a far cry from the ‘conspicuous consumption’ of the late 1980s and double-digit
interest rates of that time and the early 1990s.

So globalisation and disruption are reinforcing the conservatism of the economic times.

The $64 question is when attitudes will change to something regarded as “more normal”. But perhaps something
similar occurred, but on a far lesser scale, in the 1930s after the depression. It took war then technological
change and the consumerisation in the 1950s to see a change in consumer attitudes.
Global disinflation

Obtaining consistent long-run data on inflation is difficult. Especially estimates of “world” inflation. The latest data
from the International Monetary Fund shows that the annual rate of inflation hit a record low (data to 1980) of
2.894 per cent at the end of 2015 (30-year average 11.3 per cent). Data from the World Bank back to 1968 shows
world inflation at a record low in 2014, and presumably this fell further in 2015.

In Australia inflation figures date back to the 1920s. And while inflation has been low over the last 18 months,
averaging 1.5 per cent, headline inflation was below 2 per cent from September quarter 1997 to December
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Economic Insights: Remarkable times: The end of pricing power?
quarter 1999. And in that 1997-99 period, annual economic
growth averaged 4.5 per cent. Before that inflation was also
super-low from 1962-64 (economic growth averaged 6 per
cent). So periods of below “normal” inflation may be rare
but not unprecedented.
Expansionary monetary & fiscal policy

While the Reserve Bank expects underlying inflation to lift
from 1-2 per cent to 1.5-2.5 per cent, it has left open the
possibility of different outcomes.
 “The outlook for domestic cost pressures is a key
source of uncertainty. Despite above-trend growth in
economic activity and improvements in labour market
conditions over the past year, it is possible that
domestic cost pressures may weaken further, and so inflation may not pick up as expected. However, it may
be that the strengthening in the labour market embodied in the forecasts is associated with growth of labour
costs picking up sooner or by more than is currently forecast.”

So it is possible that interest rates could be cut again. Inflation is already below the target band and there is the
risk is that annual growth may slow even further.

Monetary policy is clearly expansionary. And the weakening of the Aussie dollar over the past week is reinforcing
the stimulatory conditions.

At the same time the Federal government has adopted stimulatory settings in the “Jobs and growth” Budget.
 Youth jobs PaTH scheme
 Tax cut: Small & medium enterprises
 Lift threshold for SME to $10 million
 Write off of assets up to $20,000
 Tax bracket change
 Infrastructure spending
 Superannuation changes

While some may raise eyebrows about the last dot-point, certainly the proposed changes to superannuation have
enhanced the prospect of older people staying in the workforce. Those in their 60’s and 70s can now stay in the
workforce and still contribute to superannuation. And higher income earning workers can contribute funds to
superannuation of their lower earning spouses.

Federal Treasury has been actively following a PPP strategy for some time to address challenges posed by an
ageing workforce. That is, measures have been focussed on boosting Population growth, workforce
Participation and lifting Productivity. A faster growing economy has greater potential to assist governments in
meeting the costs of higher spending on health, aged care and social security.

Clearly with all arms of policy currently focussed on achieving solid economic growth, it is clear that there are few
worries that this could lead to excessive inflation.
An end to pricing power?

For any business, the ability to lift prices if and when required without the fear of losing much, if any, market
share, is regarded as nirvana. But across the globe those businesses that have had some degree of pricing
power have seen that advantage whittled away. Technology,
innovation and globalisation have served to reduce the barriers
to entry into industries or markets. Any business that is
perceived to have a high or ‘above-normal’ profit margin is the
target for new entrants.

Productivity and efficiency gains are allowing high cost
producers to reduce costs quite quickly and thus narrow the
gap with lower cost competitors. The oil industry is a clear case
in point with higher cost North American shale oil and oil sands
producers throwing down the gauntlet to lower cost Middle East
crude oil producers.

Two years ago US shale oil producers had average breakeven
prices near US$70-80 a barrel. Today breakeven prices are
closer to US$40-50 a barrel.

Whether it is banks, retailers, airlines, steel producers or energy
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Economic Insights: Remarkable times: The end of pricing power?
producers, pricing power has been evaporating in recent
years. This has caused some businesses to focus more on
differentiating their offering as well as other non-price
methods of competition.

Just as pricing power is nirvana for business, it is also a
magnet for sharemarket investors. But with fewer companies
possessing some degree of pricing power, it means that
investors have to work harder to structure a portfolio of
stocks to generate desired capital and dividend returns.
‘So what?’: the implications for interest rates and
investors?

Interest rates are at record lows and poised to go lower.
While good news for borrowers, it means that savers have to
work harder to generate returns that provide a margin above
inflation. One implication is that investors will need to take on more risk in their portfolios. Rather than leave funds
in bank accounts or government bonds, investors may need to invest a higher share of their savings in corporate
bonds, property or sharemarkets.

In the past, the purchase of bank shares had been regarded as one of the ‘safer’ equity investments. But unless
banks consider offering (charging?) negative interest rates on deposits, then further falls in official interest rates
could lead to further compression of margins (the gap between borrowing and deposit rates), lower revenues and
potentially slower growth in profits and share prices.

Property is still an attractive asset class, but ‘above-normal’ returns are likely to become less common as supply
lifts to meet the demand by owner-occupiers and investors.

While disinflation is occurring in many parts of the globe, the main worry is that this could extend to deflation –
falling prices. The worry with deflation is that people could put off purchases on the prospect they will continue to
get cheaper. And this scenario means less consumer spending, lower business revenues and lower employment
with the loop closing to cause economic downturn or recession.

Certainly low inflation rates serve to support the purchasing power of savings, but the challenge is to prevent
deflationary tendencies from taking hold.

For governments, lower inflation rates mean slower growth of company revenues, slower growth of wages and
thus slower rates of taxation. In 2014/15, nominal GDP growth in Australia (real growth plus inflation) grew by just
1.5 per cent – the slowest growth in 53 years. Australia hasn’t been the exception – all advanced nations are
struggling to generate taxation revenue. And as populations age that creates the potential for higher budget
deficits and higher debt levels.

While central banks have fought hard over the years to keep inflation under control, now a situation is developing
where the challenge is to generate slightly higher and ‘healthier’ rates of inflation.

So how should the Reserve Bank respond if inflation remains below the 2-3 per cent target band? Should it slash
rates to 1 per cent or below? But if consumers
fail to respond by taking on more debt and
lifting spending, then what is the point?
Effectively it could make a worrisome situation
even worse. The Reserve Bank has made a
virtue of having higher interest rates than other
advanced nations, thus giving it scope to act if
the economy did in fact weaken so that lower
interest rates were necessary.

Given its low inflation forecast, the Reserve
Bank remains poised to cut rates again. The
low inflation/low rates environment is positive
for the equities market. But with pricing power
eroded, investors will need to set their sights on
securing annual total returns of between 2-7
per cent rather than 7-12 per cent as in the
past.
Craig James, Chief Economist, CommSec
Twitter: @CommSec
Source: Rystad
May 11 2016
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