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Price relief for households, but no interest rate relief yet
Australians rejoiced this week on news that inflation had slowed to within the RBA’s 2-3% target band in the September quarter for the first time since 2021. Having hit 7.8% in late 2022, inflation slowed to 2.8% in September through the pursuit of a tight monetary policy stance by the Reserve Bank. With inflation now within the band, the RBA could be expected to cut rates and provide support to struggling households and businesses. One would be forgiven for translating this into market pricing for a near term easing of monetary policy, possibly as early as next week’s RBA “Melbourne Cup Day” Board meeting.
Instead, market pricing has pushed out the timing for the first rate cut to May next year, beyond our expectation for a February rate cut. While this market move seems to be largely in response to US developments and the stronger Australian labour market, the CPI release did nothing to bring it forward. So why did markets discount the positive news on inflation?
The answer lies in the difference between what inflation means for households and the central bank.
Lower inflation is great news for households, as it means an increase in the purchasing power of their income, and likely translates into rising, rather than falling, real wages. It matters little to households whether the fall in inflation comes from lower electricity bills and fuel costs, or lower prices from their favourite restaurant or hairdresser. Headline inflation, which measures price changes in a basket of goods and services consumed by a typical household, was just 0.2% in the September quarter, with annual growth slowing sharply from 3.8% in June to 2.8% in September.
But for central banks, who are trying to target a future inflation rate, the source of inflation matters. Temporary falls in electricity bills due to government subsidies might reduce inflation today, but when the subsidy rolls off and electricity bills go back up, inflation will rise in the future. Such temporary changes to inflation are largely “looked through” or discounted by central banks. Automotive fuel typically falls into the temporary category too.
Central banks care more about ongoing or the underlying rate of inflation for goods or services that is driven by the broader economic fundamentals of supply and demand. Underlying inflation typically has more inertia than the headline rate and is driven by costs like wages rather than policy changes or temporary supply disruptions. The RBA’s key measure of underlying inflation is known as the Trimmed Mean. As the name suggests, this measure trims out the top and bottom 15% of price moves. Trimmed mean inflation rose by 0.8% in the September quarter, and by 3.5% over the year, down from 4.0% in June. This was in line with our expectations and was also close to market and RBA forecasts. With the RBA’s preferred measure of inflation in-line with their expectations and still substantially above the upper bound of their target range of 3%, we do not expect any change in monetary policy by the RBA at their meeting next week.
Our forecasts suggest these trends continued into the December quarter; i.e., large falls in fuel and electricity prices reducing headline inflation. Fuel prices have been trending lower since April, as oil prices have fallen due to weaker global demand. Electricity prices have been broadly stable but electricity bills paid by consumers are falling due to subsidies from Federal and State governments. In the September quarter, electricity prices in the CPI fell by 17.3% which knocked 40bps off the headline rate of quarterly inflation, while fuel prices fell by 6.7% and knocked off another 25bps. The combination of lower electricity and fuel prices (both excluded from the Trimmed Mean measure) explains the difference between headline inflation (0.2% q/q) and underlying inflation (0.8% q/q).
In the December quarter, we expect the price falls for electricity and fuel to be somewhat smaller than in September, but still large enough that they will be removed from the Trimmed Mean calculation. We expect underlying inflation to slow marginally to 0.7% q/q in December as wage growth eases, with around 40bps combined impact of electricity and fuel price falls reducing headline inflation to 0.3% q/q.
So, the real news from the inflation numbers this week is the benefit to households from the slower price growth associated with falling electricity and fuel prices. This, combined with Stage 3 tax cuts that came into effect in July, is helping real disposable incomes recover. Not all of the income gains will be spent immediately, however, and the boost to consumption will take time. Encouragingly though, we saw a small lift in retail sales volumes in the September quarter alongside a recovery in consumer confidence in October, both of which support our long-held view that the middle of 2024 would be the trough in the Australian economy.
Getting inflation in the target band is no mean feat; in the last 20 years, inflation has spent almost twice as much time outside the target band as inside. And it is roughly equally split between being above the band and below it. However, the achievement in the September quarter is only partly due to the tight policy stance pursued by the RBA, with the remainder delivered by government policy that will prove to be temporary. In addition, the dollar value of the subsidies such as those on electricity provide a stimulus to demand, which places some modest upward pressure on underlying inflation. Hence, the RBA will not be rejoicing quite as much as households when they meet next week to decide on the direction of interest rates.