Australian inflation for the December 2022 quarter was 7.8%. Retail categories have had similar price increases, propping up retail sales growth. Retail volumes are already flat to declining based on our analysis. Packaged grocery inflation accelerated further to 7.0%. We expect the rate of retail inflation has peaked and volumes will start to decline at a faster rate this year.  This is more likely the risk in supermarkets, furniture, appliances and auto parts. Nonetheless, overall nominal retail sales growth will continue to be underpinned by price inflation over the next six months.

It is inevitable that Australian retail sales growth will be much weaker in 2023 compared with 2022. We forecast industry sales growth at 2%, down from 11% last year. Many are anticipating that retail spending will fall off a cliff. However, volumes are already weak. It is price inflation that is supporting above trend spending. We expect inflation to taper off gradually, which means a more visible downturn in retail sales in the July-December 2023 period in our view. The categories most vulnerable to an earlier slowdown are furniture, hardware and recreational goods where we forecast a decline this year. In the food sector, elevated inflation will support growth of 5% in 2023. The risks to our retail forecasts are to the upside if inflation is higher and households dip into their excess savings built up over the past three years.

Coles Group reported 1Q23 sales growth of 1.3%. This is a low rate of growth, but an aberration compared with likely growth over the remainder of FY23e. The first quarter was lapping lockdowns. We expect Coles Supermarket comp sales growth to recover to 5.9% in 2Q23e and Liquor should recover to be almost flat. All of the sales growth over coming quarters will be price inflation with some modest volume declines.

Coles reported FY22 EBIT of $1,869 million, down 0.2%. The result had some lower quality features to deliver net profit growth including low deprecation growth, a lower tax rate and the unwind of some provisions. We expect Supermarket and Express to see an improvement in EBIT margins in FY23e. The unwind of COVID-19 costs is the most significant driver, accounting for well over half the earnings growth.

A thought to challenge conventional wisdom about price inflation in retail. Perhaps inflation is now within a sweet spot where retailers have price rises to address rising costs, but inflation is not high enough to crimp demand. On our analysis, more than half the outsized sales growth in retail over the past three years was a function of price inflation. In other words, less than half of the sales growth was heightened demand (volume). See the chart below. Inflation is portrayed as evil. Yet deflation is an even bigger headache for retailers. As it stands, retail inflation is between 0%-5% depending on category. This is lower than the general level of inflation in Australia. We expect more price rises over the next six months, which may contribute to better retail sales growth than some expect even as interest rates rise and broader living cost pressures hurt households.