Low inflation raises the chances of an RBA rate cut next week: CBA's Michael Workman
GUEST OBSERVER
Today’s extraordinarily low annual headline and underlying inflation rates reflect not only lower petrol prices but widespread price discounting by retailers. Six of the eleven CPI categories had price falls in the quarter.
The QI CPI fell by 0.2 percent, sharply lower than the market expectation which centred on a rise of 0.2 percent (CBA (f) 0.3%). The AUD fell about US1 cent and interest rate futures are now pricing in a 55 percent chance of an RBA rate cut next Tuesday. While the headline inflation rate in annual terms is low, at 1.3 percent, it is the underlying inflation rate which is the big issue. It is running at 1.5 percent, the lowest rate on record.
The 10% fall in petrol prices was largely expected. But the big expenditure categories also surprised with low results. Food prices (fruit, dairy, cakes and cereals) fell by 0.2% in the March quarter to be unchanged over the past year. It most probably reflects the competitive pressures between the big supermarkets and the new entrants. Housing costs, the largest expenditure category, rose by only 0.3 percent to be just 1.7 percent higher over the year. Even the highly regulated sectors, health and education, had relatively low QI rises (for them) of 1.9 percent and 3.1 percent.
The lower AUD over the past year has not, so far, produced the usual higher imported consumer goods and services prices. Tradables inflation fell by 1.4 percent in QI, reflecting the falls in petrol, furnishings, clothing, audio-visual equipment and international holiday travel.
We are reviewing our RBA rate call in light of the lower than expected inflation trends. Clearly the chances of a rate cut next week have moved a lot higher. But today’s numbers may still not “demand” a rate cut.
The RBA has tolerated below target inflation on a number of occasions. It is after all how the inflation targeting regime is supposed to work. The last time we saw inflation rates around the current figures was in 1997-98. Back then there were 6 out of 7 quarters where underlying inflation was below target. For most of that period the RBA left the cash rate at 5 percent.
There was a one-off 25bpt cut at the very end of 1998 (after 6 quarters of below target inflation). That cut was justified more on a deteriorating global outlook rather than low inflation. When thinking about what today’s CPI outcome will mean for RBA forecasts it is worth remembering that the Q4 GDP numbers were noticeably stronger than the RBA was expecting (2.5 percent expected versus 3 percent actual). Higher GDP and a lower unemployment rate, now 5.7 percent, mean the “if needed” components for a rate cut are not quite as pressing. With the release of today’s Australian CPI our replica of the RBA’s model suggests the Australian real TWI is less overvalued than previously estimated. In fact, the Australian real TWI is just inside the fair value band (+/- one standard deviation).
The detail
As anticipated, the volatile items had a major impact on the much lower than expected headline CPI outcome of a 0.2 percent fall. The QI CPI (excluding volatile items) rose by 0.2 percent (to be up 1.7 percent on a year ago). In other words, the volatile items sliced 0.4 percent from the headline QI CPI.
Leading the volatiles deflationary impact were petrol prices which dived by 10 percent over QI, to be 6.4 percent lower over the year. The QI petrol prices drop sliced 0.31ppts from the QI CPI outcome. The other key volatile item, namely fruit and vegetable prices sliced 0.11pts from the headline QI CPI. The key driver was an 11.1percent drop in fruit prices (down 6.9 percent pa) which made a 0.13ppt negative contribution to headline inflation. This impact was partially offset by a 1.5 percent rise in vegetable prices in QI (but which were down 4.3 percent in annual terms).
These volatile items account for most of the gap between underlying and headline inflation forecasts.
Price falls
Six of the eleven components of the headline CPI registered price falls in QI. As mentioned above and as expected, the sharp decline in automotive fuel prices was the most prominent factor deflating the quarterly headline CPI result.
Other CPI items weighing down on the headline outcome were clothing and footwear prices which dropped by 2.6 percent in QI and made a negative 0.1ppt contribution. The main contributor to the decline in this component was accessories prices which declined by 4.3 percent in QI.
The other CPI categories posting falls in QI were the recreation and culture group, (-1.0 percent), the communications group (-1.5 percent), and furnishings household equipment and services (-0.4 percent). The main contributors to the fall in the recreation and culture group prices were international holiday travel and accommodation (-2.0 percent) and domestic holiday travel and accommodation (-1.9 percent).
Elsewhere, a 1.7 percent drop in telecommunications equipment and services was the key driver of the 1.5 percent fall in communications group prices. Meanwhile, a 4.1 percent fall in household textiles prices and a 1.6 percent decline in furniture prices contributed to the 0.4 percent decrease in furnishings and household equipment and services prices.
Price rises
The largest offsetting price rises in QI were secondary education (+4.6percent), medical and hospital services (+1.6percent) and pharmaceutical products prices (+ 4.8percent). These outcomes are largely due to seasonal factors but were smaller than usual. Overall, these health and education groups contributed 0.2ppts to the QI CPI.
Also contributing in a positive way to the quarterly headline CPI outcome were increases in household fuels (+3.0percent) and new dwelling purchasing by owner occupiers (+0.2percent) suggesting housing activity may well be cooling but it certainly isn’t crashing.
Imported or “tradables” inflation
Tradables prices fell by 1.4percent in QI and were up by a modest 0.6percent over the year to March. The quarterly fall in tradables prices was due to a combination of the higher AUD in QI, falling fuel prices, and falling international holiday travel and accommodation prices. Tradable prices make up 40percent of the CPI basket and are a reflection of imported prices.
Domestic or “non-tradables” inflation
Domestic inflation or non-tradables inflation rose by a modest 0.4percent over QI and lifted by a tame 1.7percent on a year ago. This category accounts for around 60percent of the total CPI basket. The most significant contributors to the QI rise in non-tradables inflation were increases in gas and other household fuels and beer prices. Also, the non tradables services of secondary education and medical and hospital services prices helped the quarterly rise in this component. The key offsetting declines in
non tradables inflation were electricity prices and domestic holiday and accommodation and telecommunication equipment prices.
Plenty of spare capacity in the economy and softer wages growth has helped cap non-tradables inflation in recent quarters.
States
It is very unusual to see uniformly low inflation across all the capital cities. Prices rose in Canberra by 0.2percent in QI, were flat in Brisbane and fell in the other capitals.
The price falls were in Sydney, -0.2percent, Melbourne -0.1percent, Adelaide -0.3percent, Perth -0.6percent, Hobart -0.2percent and Darwin -0.9percent. Perth and Darwin had the largest QI price falls.
In annual terms, inflation was running highest in Melbourne and Brisbane at 1.7percent, then 1.3percent in Sydney and Hobart, 1.0percent in Canberra, 0.7percent in Perth and Adelaide, and -0.3percent in Darwin.
The capital cities with the weakest retail activity, like Perth, Adelaide and Darwin have the weakest inflation outcomes, indicating the widespread retail discounting pressure. But there are other issues underway. Perth’s residential rents have fallen 4.4percent over the past year.
Wages trends and inflation
Wages trends provide a major input to structural inflation in the Australian economy. The trend around private sector wages over the past few years is towards consistently lower than expected outcomes. There are also clear compressions in wages outcomes across industry sectors and regions which are relatively new phenomenon and have been a feature of the post-mining investment and construction boom landscape.
Annual private sector wages growth was running at a paltry 2percent in the year to December 2015, the weakest growth rate since the series began in 1997, and well below the 3percent to 4percent annual growth that has been the norm from the late 1990s until after the mining boom started to dissipate. Ongoing spare capacity in the labour market and job security anxieties are likely to continue to cap wages growth by workers limiting wage claims.
Nationally, QIV wages growth continued to track lower in a range of industries and all industries have experienced wages growth well below their decade averages. On an industry basis across all sectors (i.e. public and private) the strongest annual wages growth was posted in financial and insurance services at 2.8percentpa, and weakest in mining at 1.5percentpa.
The industry sector wages outcomes show that about 80 percent of industries are paying less than 2.5percent wage increases and the remaining 20percent are between 2.5percent and 3.0percent. The regional trends are also similar, with a trend towards State wage growth below 2.5percent. WA, the State with the highest wages growth for the decade up to 2013, now has growth of just 2percent. The end of the mining boom is having similar effects on wages trends in Queensland and NT.
The sectors with the strongest jobs growth over the past few years are health, accommodation, cafes and retail. They also tend to be ones where part-time employment is significantly higher than in other sectors. The sectors with mainly full-time employment, like mining, utilities and construction, are losing jobs. So the pressures in the labour market that favour more part-time employment are producing a period of distinctly lower wages outcomes.
A key reason behind ongoing tepid wages growth recently could be that a much more flexible labour market in recent years has enabled companies’ greater capacity to cap wages growth in a lacklustre labour market. In a period of labour market slack employees tend to be more satisfied to accept lower wages growth in return for more job security.
The resultant ongoing tame wages growth seems to have contributed to more jobs growth than normally would have been the case. Indeed, the latest employment data showed annual jobs growth of 2.0percentpa. (I.e. +235.3k or an average +19.6k a month) in March. The unemployment rate stood at 5.7percent in March.
Ongoing soft wages growth and labour costs have helped wind back non-tradables (or domestic) inflation in recent quarters. This is especially the case for services inflation (with its very high labour component). Thus modest wages growth is a very handy tool in maintaining the current low inflation environment.
Inflation expectations
Central banks and policy makers care about inflation rates and where they may be headed. But they also care about the inflation expectations held by businesses and consumers. These expectations influence how economic agents act, with a flow on to economic activity. And these expectations influence the support or restraint that a given level of interest rates provides.
The extended period of weak inflation in many countries has seen inflation expectations move lower. Some central banks have become concerned about the impact of low expectations. And certainly some recent policy easings in Europe, Japan and New Zealand reflect these concerns. Even in the US, where interest rates have been nudged higher, Fed Chair Yellen has recently expressed concerns about low inflation expectations. They are yet another reason for a caution approach to rate changes by the Fed.
Our thoughts on global inflation expectation trends and what they mean for policy directions can be found here.
The RBA monitors inflation expectations. But they are of less concern than for other central banks. They are rarely mentioned in post RBA meeting Statements. And comments are generally limited to a summary paragraph in the quarterly Statement on Monetary Policy (SMP).
More importantly, inflation expectations in Australia are low but look well anchored. They have not been influenced by low headline inflation rates and the general lack of business pricing power.
Policy makers are actually probably quite happy with aspects of the inflation expectations story. The decline in house price expectations as views on the housing market have softened will be seen as a desirable outcome. Especially given the concerns evident about rapid price growth and elevated expectations in 2015. The restraint in wage expectations is seen as a positive through the support it gives to labour demand.
Michael Workman is senior economist, Commonwealth Bank.
