Inflation not a problem for the RBA


Matthew
 Peter, Chief Economist 

Next week, we receive an update on Australian inflation when the Australian Bureau of Statistics (ABS) releases its CPI estimates for the September quarter. While it is expected that higher energy costs and tobacco excise duties, as well as seasonal factors will lead to a strong quarterly inflation print, underlying (or core) inflation (which policy makers such as the Reserve Bank of Australia (RBA) look to as a better measure of inflation trends) is expected to remain relatively subdued. QIC estimates that headline inflation was 0.8% over the quarter, up from a tepid 0.2% in the June quarter. This will lift slightly the annual rate of inflation from 1.9% to 2.0%; the bottom of the RBA’s target range of 2% to 3%.

Driving prices higher over the quarter have been rising electricity and gas prices and increases in tobacco excise taxes. Between them, these two components alone account for half of the price rises experienced over the quarter. Partially offsetting the rise in electricity, gas and tobacco prices have been subdued growth in rents and other household expenditures such as food and clothing & footwear as intense competition among retailers continues to cap price rises on these items. In addition, prices at the petrol bowser fell slightly over the quarter in response to a rising Australian dollar.

In contrast to headline inflation, underlying inflation is expected to register a softer 0.5% for fourth consecutive quarter, lifting the annual rate from 1.8% to 2.0%. Despite remaining at the bottom of the RBA’s target range, the steadying in the quarterly pace of underlying inflation is an encouraging sign that inflation has turned the corner and is stabilising at an annual pace of around 2.0%. The question now facing the RBA is, where to from here? Does inflation continue to trend higher towards the RBA’s target rate of 2.5% or does it languish at the bottom of the target range? Our view is that the disinflationary forces of falling oil prices and falling wage growth are most likely behind us. But neither are we forecasting an outbreak of inflation from the lower end of the RBA’s target range, as competing forces keep the rate of underlying inflation in check at around current rates.

We expect upward pressure on inflation to come from a turnaround in wage growth and a fall in the exchange rate. As this week’s labour market report showed, robust employment growth is whittling away at the unemployment rate. A gradual tightening of labour market conditions will arrest the slide in wage growth, which we are forecasting to turn around over the course of 2018. Adding to the upward pressure from rising wage growth will be the impact of a falling exchange rate.

The global economy looks set to stabilise at around trend growth over 2018. This is leading to more hawkish policy stances by the world’s major central banks. The US Federal Reserve has been sticking to its forecast path of rate hikes and balance sheet reduction, the Bank of England has signalled the likelihood of rate hikes and the European Central Bank is likely to start tapering its asset purchase program next year. The quicker pace of central bank policy tightening abroad, combined with the retracement in iron ore and coal prices (and the subsequent fall in Australia’s terms of trade), will continue to pressure the Australian dollar, which we are forecasting to shift down to US$0.73 by the end of 2018.

However, headwinds to inflation will persist over 2018. The large boost to the housing supply likely to hit the eastern seaboard capital cities over the first half of the year will continue to pressure rental growth, while ongoing competition in the retail sector will limit price growth of food and provide an offset to the impact of a falling AUD on predominantly imported items of household expenditure such as clothing & footwear, household appliances and audio-visual & computing equipment.

Fortunately for the RBA, the inflation environment over 2018 will prove to be benign. Enough inflation to avoid the necessity of a rate cut, not enough inflation to necessitate a rate hike over the first half of the year. This is a benign scenario for the RBA because rate cuts at this point risk undermining financial stability through stimulating the housing market just at a point where a soft landing looks possible, while rate hikes risk snuffing out the green shoots that are emerging in non-mining business investment and turning a soft landing in the housing market into a hard landing.

Table 1: Financial market movements, 12 - 19, October 2017

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,562.1

0.4%

US

2.32%

0.0 bps

US Dollar Index (DXY)

93.27

0.2%

Nikkei 225

21,448.5

2.4%

Japan

0.07%

0.0 bps

USD-JPY

112.54

0.2%

FTSE 100

7,523.0

-0.4%

UK

1.28%

-10.2 bps

GBP-USD

1.316

-0.8%

DAX

12,990.1

0.1%

Germany

0.40%

-5.0 bps

EUR-USD

1.185

0.2%

S&P/ASX 200

5,896.1

1.8%

Australia

2.76%

-3.9 bps

AUD-USD

0.788

0.7%


Source: Bloomberg

Economic Update

United States

Energy prices send inflation higher in the US
  • Headline CPI inflation strengthened further in September, following a spike in August. Inflation was again affected by the earlier hurricanes, with energy prices (most notably gasoline) jumping due to hurricane-related disruptions to oil refineries in the Gulf Coast. As a result, monthly headline CPI inflation increased to 0.5% in September, the highest rate since January, after prices rose 0.4% in August. Monthly inflation had averaged 0% in the three months before August. In year-ended terms, headline inflation rose to 2.2% from 1.9% in August. Core inflation (excluding food and energy) underwhelmed however, falling back to 0.1% in monthly terms in September from 0.2% in August. Year-ended core inflation remained at 1.7% for the fifth straight month.
  • Retail sales rebounded strongly in September, with data also reflecting effects of Hurricanes Harvey and Irma. Retail sales grew by 1.6% in September from the month before, after August saw a -0.1% monthly decline. This was the strongest rate of monthly growth in 2½ years, supported by sales of autos and building materials most likely due to consumers replacing damaged cars and rebuilding in the wake of the hurricanes. Sales at service stations also spiked due to higher gasoline prices. Excluding autos, gasoline, building materials and food services, ‘control’ retail sales rose 0.4% in September after 0% monthly growth in August, suggesting that underlying retail sales growth was positive.
  • Consumer confidence has risen to new highs in October according to the University of Michigan’s preliminary survey, after pulling back in September in the wake of multiple hurricanes. The index rose to 101.1, the highest since January 2004, from 95.1 in September.

Weekly Economic Brief

Weekly Economic Brief

Weekly Economic Brief

Euro area / United Kingdom

Inflation remains high in the UK
  • Headline CPI inflation rose further in the UK in September, reaching 3% in year-ended terms, the fastest rate of annual price inflation since 2012. Prices rose 0.3% in monthly terms, following a 0.6% jump in August. Core inflation (excluding energy, food, alcohol and tobacco) remained high at 2.7% y/y in September, and retail price inflation was also unchanged at 3.9% y/y.
  • The UK’s unemployment rate remained at 4.3% in August, which may give the Bank of England more confidence to raise rates before the end of the year.

Weekly Economic Brief

China / Japan

China’s growth slows slightly in Q3
  • China’s economy grew by 6.8% in year-ended terms in the September quarter, a slight slowdown from the 6.9% annual rate of growth recorded in the first two quarters of the year, but still above the government’s annual GDP target of around 6.5%. Data also showed a pick-up in year-ended growth of industrial production and retail sales in September. The positive data was released while China’s top leaders are meeting for the 19th National Congress of the Communist Party of China, where China’s leadership will see significant change.
  • The value of Japan’s exports grew by 14.1% from a year earlier in September, down from 18.1% in August with lower growth in exports to the US.

Weekly Economic Brief

Australia / New Zealand

Unemployment rate falls in Australia
  • Employment increased by 19,800 in September in Australia, following a strong 53,000 increase in August. Full-time employment increased by 6,100 after strong growth in August, while part-time employment grew by 13,700 in September. Employment has grown 3.1% from the same time last year. The unemployment rate declined to 5.5% in September from 5.6% in August.

Weekly Economic Brief

Sources: Thomson Reuters, ABS

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