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Chief economist update: Cheaper prices not a bargain

Down, down, prices are down ... big time!

The Australian Bureau of Statistics (ABS) reported that the country's headline inflation dropped by 1.9% in the June quarter - the largest quarter on quarter decline in the 72-year history that the statistician had been tracking consumer prices.

This takes the annual inflation rate down from plus 2.2% (almost at the mid-point of the RBA's 2%-3% target band) in the March quarter to minus 0.3% by the end of the June quarter - only the third time Australia has been in deflation.

"The previous times were in 1962 and 1997-98," the ABS said.

For sure and for certain, you, I and Irene and our uncles love a bargain. This is the reason why online trade has taken off (they're cheaper than bricks and mortar stores), why consumers the world over are buying cheap-er "Made in China" products and services, and why western countries have established manufacturing and call centres in countries where wage costs are cheap-er.

It may seem counterintuitive but falling prices are bad news bears for the economy, any economy. Just like John Maynard Keynes' Paradox of Thrift, savings by individuals during recessions lead to a general decline in aggregate demand and therefore, even slower overall economic growth - deflation has nasty consequences for the economy.

This is because cheapening prices of goods and services, if it goes on long enough, would spark decreasing inflation expectations.

Unless a necessity (like toilet paper in the current pandemic), consumers of whatever colour, creed or political affiliation would postpone purchasing new everything (home furnishings, clothes, shoes, TV, even houses) on expectations that tomorrow and the day after, prices would be cheaper.

Consumer spending accounts for around 60% of the economy - most economies. Declining inflation expectations will discourage consumer spending that, in turn, becomes a drag on overall economic growth.

But have no fear, Australia's headline deflation may just be a one-off.

As ABS chief economist Bruce Hockman explains: "The June quarter fall was mainly the result of free child care (-95.0 per cent), a significant fall in the price of automotive fuel (-19.3 per cent) and a fall in pre-school and primary education (-16.2 per cent), with free pre-school being provided in NSW, Victoria and Queensland ... Excluding these three components, the CPI would have risen 0.1 per cent in the June quarter."

Similarly, while the annual headline CPI measure has fallen into deflation, core inflation measures remain positive - trimmed mean inflation slowed to 1.2% in the year to the June quarter from 1.8% in the March quarter; the weighted median measure eased to 1.3% from 1.6%.

This is good news, suggesting that the June quarter's deflationary conditions are temporary and should prevent a persistent drop in inflation expectations.

Then again, the 'Victorian wave' of the coronavirus pandemic - which has spread to the state of New South Wales and recently, Queensland - would weaken consumer spending through the re-imposition or tightening of social distancing and shutdown restrictions.

For those interested, applying the 'Taylor Rule' - "a monetary-policy rule that stipulates how much the central bank should change the nominal interest rate in response to changes in inflation, output, or other economic conditions" - given the relative deviations of inflation (1.25% average of trimmed mean and weighted median) from target (2.0%-3.0%), GDP growth (1.4% in Q1 2020) from potential (2.75%) and the neutral cash rate (1.25%), the nominal official cash rate should now be at around minus 0.05%.

The Reserve Bank of Australia (RBA) has already stressed that it won't go negative but as US Federal Reserve chair Jerome Powell reiterated overnight: "The path of the economy will depend significantly on the course of the virus."

Read our full COVID-19 news coverage and analysis here.

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