Margin pressures – no relief
04 May 2011
The strength of mining profits is masking the considerable pressure on profits in other parts of the economy. But while the upward pressure on costs remains intense, the recent slowdown in consumer spending is making it even more difficult for firms to pass on these cost increases and maintain margins. Moreover, even if there were signs of a tentative recovery in consumer demand which would provide a better environment to boost prices, the Reserve Bank would no doubt lift interest rates to restore the price discipline.
The squeeze on business margins is being driven by two main factors. First, cost pressures are intensifying in many sectors. Second, despite facing much higher costs, firms are unable to pass these costs on to their customers. There are, however, several reasons why firms can’t pass on these higher costs. For example, manufacturing firms have been hit by higher input prices, but when faced with stronger import competition, they are being forced to absorb much of the increase in costs.
A large part of the explanation, however, revolves around the quiescent consumer. And in our view, this reflects that it is not just businesses that are getting squeezed; there is also a squeeze on individual households as wages aren’t keeping up with growing cost of living expenses.
The notion that households are being squeezed is often scoffed at given that household disposable income (HDI) has been growing at a reasonable clip. However, HDI reflects both work intensity as well as wage rates. For example, HDI could increase because more people have shifted into employment, or because someone is working longer hours to meet the higher mortgage repayments. But that would not be a good reflection of the ‘typical’ worker who has remained in employment for several years and is simply getting an annual wage increase.
For that reason, when considering the ‘typical’ worker’s financial situation, we think it is more relevant to use the wage cost index than disposable income. And looking at this measure shows that annual wages growth (currently 3.9%) is still relatively modest. Again, we are not suggesting that employment growth isn’t important for consumer spending, but simply that it isn’t relevant when considering the typical household which has had an employed wage earner for the last 5 years.
With only moderate wage growth in recent years, but with elevated inflation levels and also rising interest payments, it is possible that the ‘typical’ income earner has seen the value of their real wage decline in recent years. Obviously, the period of the GFC was a notable exception, when interest rates plummeted and the ‘typical’ wage earner became much better off.
A closer examination of where the inflation is coming from is also informative. Some components of the CPI have been growing at a consistently rapid clip, while others have been more subdued. Now, this is relevant because the sources of inflation tend to be in areas where cost-push pressures are prevalent, such as health, insurance, education, and housing costs. In other words, health care costs aren’t rising rapidly because everyone suddenly wants to visit the dentist, but because the cost of drugs has risen sharply. Insurance costs have risen because the cost of re-insurance has increased. Education costs are rising because of the cost of new technology and facilities.
The areas of the CPI that are falling – or experiencing subdued price growth – are, however, mainly discretionary goods, such as clothing, household goods and electronic items. And this is a function of demand. In fact, one way of looking at this situation is that the only way the RBA can achieve its 2-3% inflation target is to ensure that these discretionary goods continue to fall sharply in price as higher interest rates will have little effect on electricity price increases or education prices.
Looking at the break-up of pricing pressures has significant implications for businesses as well as households.
Another way to look at this break-up of inflationary pressures is that public authorities have put through strong price increases for largely non-discretionary services at the same time as booming commodity prices have increased input costs. Meanwhile private companies have not been able to pass on higher costs of inputs onto consumers, due to subdued demand conditions. The implication of this is that private companies end up facing a similar constraint to that of households, which is manifest in margin pressures.
Another key factor that is influencing producer costs and final pricing decisions is movements in the A$. In this respect, the impact on the corporate sector is very mixed and will vary depending on the core functions of each business. For example, if you are a large importer of capital equipment then the rise in the A$ will help drive a substantial reduction in costs, which would generate an expansion in margins. But, at the same time, this move provides considerable competitive pressures for those firms competing with much cheaper imports, which can result in discounting and margin contraction. An obvious example of this is the deflationary influence that the higher A$ has had on the tourism and manufacturing sectors.
It is through this mechanism that a higher A$ puts downward pressure on inflation and means that the Reserve Bank does not need to be as aggressive with monetary policy tightening than would otherwise be the case.
The other implication from this analysis of prices is that in an environment of rising costs, policymakers need to remain alert to the prospect of a sharper than expected improvement in consumer spending.
That is, if demand accelerates, private companies will look to take advantage of this by growing margins. Given that cost-push inflation is already elevated, this would quickly drive inflation above the RBA’s target band and require an increase in interest rates. And, this is why the Reserve Bank is intent on keeping households on the back foot with tight monetary policy conditions.