24 October 2011

CPI Preview - September Quarter 2011

The RBA has become increasingly dovish over recent months, maintaining its focus on the challenging international financial and economic environments and the impact that uncertainty is having on confidence globally. The RBA has acknowledged that an improved inflation outlook would increase the scope for monetary policy to provide some support to demand, should that prove necessary. While recent data has not shown demand slowing indeed there appears to have been some acceleration in demand (as per the Nab September Survey) and a stronger labour market much still depends on the core inflation outcome. To get a November cut we would argue that inflation would need to surprise on the low side (say less than 0.5%). This note aims to sets out our expectations for the CPI (both core and headline) and makes some additional comments on the near term inflation prospects. Since the ABS revised the methodology used to seasonally adjust underlying CPI we have also re-estimated the equations for the new core CPI. The models are still broadly consistent with Nabs near term forecasts - predicting a 0.7% increase in core inflation in the September quarter. They have not, however, changed the medium term outlook. Turning to headline inflation, we expect a much lower September CPI result with large falls in fruit and vegetables offsetting higher utility prices. See table below While near-term domestic activity (i.e. ex coal) remains soft, there are some signs that that may be changing a la the Nab September Monthly Survey (and the differences between early / later responses to the full Quarterly Survey). Looking forward we see a medium-term rebound in the Australian economy, aided by mining exports and investment resources and infrastructure. We expect GDP growth of 1.9% in 2011, rising to 4.1% in 2012. Core inflation (ex carbon pricing) is expected to remain close to 2% over the next year before drifting above 3% by mid-2013. As such, we expect the RBA will need to lift rates by late 2012, and may therefore be more reluctant to cut rates in the near-term. While the chance of the RBA cutting rates in coming months remains elevated, our forecasts suggest that the RBA will remain on the sidelines for a long period and has a potential elevated inflationary problem in 2013 which could well see a response in late 2012. CPI Forecasts
Quarterly % change Mar-11 Jun-11 Sep-11 (f) 1.6 0.6 0.3 0.9 0.6 0.7 Year to December quarter % change 2010 2011 (f) 2012 (f) 2013 (f) 2.7 2.5 3.5 3.2 2.3 2.7 2.9 3.1

Headline CPI Core CPI (ex carbon tax)*

* Data have b een adjusted using ABS seasonal adjustment methodology that will b e implemented from Sept quarter 2011. Core CPI is the average of trimmed mean and weighted median CPI

Revised methodology The ABS revised core inflation has not fundamentally altered the history of the underlying CPI (see here for details). However it has significantly lowered the stepping off point to 2011 and 2012 forecasts. In that sense, it has lessened near term inflationary concerns. Thus June quarter CPI is now estimated to have risen by 0.6% (previously 0.9%), to be 2.5% higher over the year (previously 2.7%). Based on the recent adjustments by the ABS, our forecast projections now imply that core inflation will remain between 2% and 2% until 2013; this is much softer than our previous forecasts, which showed the core inflation rate accelerating to the top of the target band by the end of 2011 and remaining elevated for the remainder of the forecast horizon.

Underlying Inflation
Through the year percentage change
%

% 4 ABS adjusted (new)

3 RBA adjusted (old) 2

0 2002 2004 2006 2008 2010 2012

Sources: ABS; RBA

More Detailed Comments The RBA targets an underlying rate of inflation, which is measured using the trimmed mean and the weighted median inflation rates. Indeed, the RBA uses both of these series. The former is defined as the average rate of inflation after trimming away 15% of price changes at both ends of the distribution; the latter is the rate of change in the item in the middle of the distribution. After adjusting for changed methodology, underlying rates of inflation were at the lower end of the target band in the June quarter, with the average underlying quarterly rate just 0.6%. Consistent with the NAB Quarterly Survey retail price index which has historically had a reasonably strong relationship with core inflation underlying inflation may be expected to remain fairly moderate in the September quarter.

Core CPI & NAB retail prices

Quarterly percentage change % 0.8 Core CPI (RHS) 0.6 0.4 0.2 0.0 NAB retail prices (LHS) -0.2 2002 2004 2006 2008 2010 0.2 1.0 0.8 0.6 0.4 % 1.2

What do the models say re core inflation? NABs models of underlying or core inflation are better at explaining movements in the newly adjusted measures of core inflation than they were the RBA adjusted measures. Our models of underlying or core inflation are based on such factors as the size of the output gap, labour cost growth, productivity growth, currency movements, fuel prices and error correction mechanisms. In addition to our own models, we also monitor a model based on published RBA research, which includes a model based principally on the linkages from unemployment to prices. We have reestimated the equations for the new history but the changes are marginal (as could be expected). As can be seen in the following chart, the fit of NABs forecasts to the average of our models and the RBAs is reasonably robust more so since the ABS revised the history of underlying CPI. The models suggest that underlying inflation will remain reasonably contained in the near-term, with little, if any, pick up in inflation until mid-2012. It is this, which continues to drive our view that the cash rate will need to be lifted in late 2012 to prevent inflation from overheating.

Core CPI vs. models

Quarterly % 1.2 Average of models 1.0 0.8 0.6 Actual 0.4 0.2 0.0 2005
Source: ABS

Forecasts

% 1.2 1.0 0.8 0.6 0.4 0.2 0.0

2007

2009

2011

2013

Economists often use a Taylors rule to estimate appropriate monetary policy settings. The rule is a simple model for determining the appropriate setting of monetary policy, based on the divergence of the inflation rate from target and the gap between actual and potential output for the economy. Based on our forecasts, a Taylors rule perspective suggests that in the near term, cuts to the cash rate could be justified based on the current demand and (revised) core CPI outlook. However, as demand strengthens over the next year or so, and inflation rises, it is likely that further policy tightening will be necessary towards the end of next year.
Australian Cash Rate & Taylors Rule
%
Cash - Taylor's rule dd Cash - actual + forecasts Cash - Taylor's rule gdp

8
Cash to loans spread widens to 125 points from Nov 2010

Based on 100 point widening of the spread from cash to loan rates - effective from early 2008 and is maintained

2 2004 2006 2008 2010 2012

Other specific factors impacting the September headline CPI result Housing costs are forecast to have softened in the September quarter (note that only rents and new project house costs are relevant to the CPI). Housing price data has been weakening for much of this year, while the NAB Residential Property survey suggests that house prices fell further in the September quarter and rental prices continued to soften. In contrast utility prices are expected to have increased strongly in the quarter, although are likely to be trimmed out of underlying measures of CPI. Consumption goods import price growth has been fairly subdued over recent quarters, though may be expected to rise in the September quarter reflecting the depreciation of the AUD. However, soft price inflation in Australias trade-linked countries in the September quarter may ease inflationary pressure on consumption goods. A rise in consumer goods price growth would be consistent with some improvement in retail trade over recent months, and stabilising retail margins in the NAB Monthly Business Survey.

Consistent with a softening in employment growth in the September quarter, the unemployment rate also began to rise, taking some steam out of the labour market. However, NAB business surveys show that the availability of suitable labour remains a significant constraint on firms, and capacity utilisation has edged higher in recent months. This is also consistent with a pick up in labour costs presumably reflecting an increase in average wages which may suggest wage pressures have begun to emerge. Fruit & vegetable price inflation remained fairly robust in the June quarter, following a very sharp rise in the March quarter, which reflected supply side shocks to food agriculture resulting from the January floods. Wholesale fruit and vegetable price data show that prices generally declined in the September quarter, with fairly sharp falls recorded for some varieties. It is likely that the overall degree of price declines will be significant. While the fall in fruit & vegetable prices in the quarter should contribute to a softening in headline CPI, these prices will most likely be excluded from the core inflation measure in the September quarter.

Wholesale Fruit and Vegetable Prices*

% 20 0 -20 -40 -60
Ba na na Pa rs le y ni on Po ta to Ap pl e Br oc co li au lif lo w Le m el on oc km he rry to m O at o er on

July August September September quarter

% 20 0 -20 -40 -60

* Monthly growth rates are calculated using average of weekly data for each month; quarterly growth rates calculated using end-quarter data Sources: Datafresh; NAB

The depreciation of the Australian dollar may contribute to a rise in import price growth in the September quarter, although this effect may take some time to flow through to consumer prices. NABs Quarterly Business Survey points to a softening in purchase costs growth in the September quarter, which supports the theory that the impact of the depreciation of the dollar may not yet have flowed through to higher prices. Furthermore, NABs measures of final product prices remained fairly subdued in the September quarter. Transportation costs are likely to have eased a little in the September quarter, reflecting a 0.9% reduction in fuel prices.

Assessment September quarter inflation is expected to have been fairly soft, reflecting continued weakness in economic data over recent months. There is clearly a divide between the performance of various sectors of the economy with the mining and services related industries continuing to outperform retail, manufacturing, wholesale and construction which the RBA will need to take into serious consideration when determining the most appropriate setting for monetary policy. While current global influences may provide the RBA with more motivation to cut rates in the near-term, we expect the economy to continue to strengthen from the flood-induced slowdown, while the mining investment boom will place added pressure on resources and demand. We envisage that a boost to domestic demand will strengthen the labour market, and therefore add to wage and costs pressures. As such, while near-term pressures appear relatively mute, the medium-term outlook appears to be consistent with rising price pressures, and it is this which supports our expectation that further policy tightening will be necessary to contain inflation eventually. For more information contact: Alan Oster Rob Henderson Group Chief Economist Chief Economist Markets 03 8634 2927 Australia (Mobile 0414 444 652) 02 9237 1836 4

Rob Brooker Head of Australian Economics & Commodities 03 8634 1663

Macroeconomic, Industry & Markets Research

Australia Alan Oster Jacqui Brand Rob Brooker Alexandra Knight Vacant Michael Creed Dean Pearson Gerard Burg Robert De Iure Brien McDonald Tom Taylor John Sharma Tony Kelly James Glenn Group Chief Economist Personal Assistant Head of Australian Economics & Commodities Economist Australia Economist Australia & Commodities Economist Agribusiness Head of Industry Analysis Economist Industry Analysis Economist Property Economist Industry Analysis & Risk Metrics Head of International Economics Economist Sovereign Risk Economist International Economist Asia +(61 3) 8634 2927 +(61 3) 8634 2181 +(61 3) 8634 1663 +(61 3) 9208 8035 +(61 3) 8634 8602 +(61 3) 8634 3470 +(61 3) 8634 2331 +(61 3) 8634 2788 +(61 3) 8634 4611 +(61 3) 8634 3837 +(61 3) 8634 1883 +(61 3) 8634 4514 +(61 3) 9208 5049 +(61 3) 9208 8129

Global Markets Research - Wholesale Banking Peter Jolly Head of Markets Research Robert Henderson Chief Economist Markets - Australia Spiros Papadopoulos Senior Economist Markets David de Garis Senior Economist Markets New Zealand Tony Alexander Stephen Toplis Craig Ebert Doug Steel London Tom Vosa Vacant Chief Economist BNZ Head of Research, NZ Senior Economist, NZ Markets Economist, NZ Head of Market Economics - Europe Market Economist Europe Foreign Exchange Fixed Interest/Derivatives Sydney Melbourne Wellington London New York Singapore +800 9295 1100 +800 842 3301 +800 64 642 222 +800 747 4615 +1 800 125 602 +(65) 338 0019

+(61 2) 9237 1406 +(61 2) 9237 1836 +(61 3) 8641 0978 +(61 3) 8641 3045 +(64 4)474 6744 +(64 4) 474 6905 +(64 4) 474 6799 +(64 4) 474 6923 +(44 20) 7710 1573 +(44 20) 7710 2910

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