Low underlying inflation pressures drive chance of rate cut this year

GUEST OBSERVER

 

Australian consumer prices rose by 0.5 percent in the March quarter and annual growth in prices rose to 2.1 percent - a little bit below market expectations (of a 0.6 percent lift over the quarter).

 

The groups that recorded the most significant prices rises were as expected – higher fuel and electricity prices, a lift in some broader housing-cost measures and health prices (seasonal impact of changes in the Pharmaceutical Benefits Scheme). Price falls were based in international holiday travel (a seasonal effect), fruit and furniture (post-Christmas sales).

 

The Reserve Bank of Australia’s (RBA) underlying  measure of inflation (the average of the trimmed mean and weighted median) which takes out extreme price fluctuations was up by 0.4 percent in the March quarter (also a little below expectations of a 0.5 percent lift) but annual growth lifted to 1.8 percent (from 1.5 percent in the previous quarter). The RBA targets inflation of 2-3 percent over time (see chart below), so the latest upward move in underlying inflation would certainly be welcomed by the central bank given that the RBA rate cuts in 2016 were largely in response to very low inflation readings.

 

The rise in both headline and underlying inflation are also consistent with the RBA’s own inflation forecasts (which see headline inflation of 2% and underlying inflation of 1.75 percent by the June quarter).

 

 

 

However, it is noteworthy that outside of volatile items like petrol prices (up 5.7%qoq) and government influenced prices like health (2%qoq), tobacco (+1%qoq), utility charges (up 2.2%qoq) and education (up 3.1%qoq), pricing power in the economy remains very weak. This is evident in prices for “market goods and services excluding volatile items” being flat in the quarter and up just 1% year on year and underlying price weakness in areas like rents (up just 0.1%qoq), clothing (down 1.4%qoq), furnishing and household equipment (down 1%qoq) and holiday travel and accommodation (down 1.9%qoq).

 

While the March quarter inflation result slightly disappointed expectations, the RBA would be happy that inflation is moving in the right direction (into its 2-3% target band). But, underlying inflation is still too low and will probably remain below the RBA’s target band for the majority of 2017. Wages growth still remains around record lows, the economy is running below-trend which indicates that spare capacity exists and the $A remains too high all which will keep a lid on underlying inflation. 

 

There are some near-term upward pressures to headline  inflation over the next few months including higher electricity prices and the impacts of Cyclone Debbie in Queensland (which should only add around 0.2 percentage points to headline inflation). But, besides these disruptions, we still see underlying inflation remaining weak for some time. 

 

Our base case is that with inflation moving in the right direction and given the RBA’s increased emphasis on an inflated Sydney and Melbourne housing market and rising household debt the RBA is unlikely to make any adjustments to interest rates any time soon and we expect it to keep the cash rate at 1.50% for the next year at least. However, low underlying inflation pressures mean that there is still more chance of a rate cut this year than a rate hike.