CPI Preview Sept 2011

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24 October 2011

CPI Preview - September Quarter 2011

The RBA has become increasingly dovish over recent months, maintaining its focus onthe challenging international financial and economic environments and the impact thatuncertainty is having on confidence globally. The RBA has acknowledged that an

improved inflation outlook would increase the scope for monetary policy to provide somesupport to demand, should that prove necessary.

While recent data has not shown demand slowing indeed there appears to have beensome acceleration in demand (as per the Nab September Survey) and a stronger labourmarket much still depends on the core inflation outcome. To get a November cut wewould 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) andmakes some additional comments on the near term inflation prospects.

Since the ABS revised the methodology used to seasonally adjust underlying CPI wehave also re-estimated the equations for the new core CPI. The models are still broadlyconsistent with Nabs near term forecasts - predicting a 0.7% increase in core inflation inthe September quarter. They have not, however, changed the medium term outlook.

Turning to headline inflation, we expect a much lower September CPI result with largefalls 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 thatthat may be changing a la the Nab September Monthly Survey (and the differencesbetween early / later responses to the full Quarterly Survey). Looking forward we see amedium-term rebound in the Australian economy, aided by mining exports and investmentresources and infrastructure. We expect GDP growth of 1.9% in 2011, rising to 4.1% in2012. Core inflation (ex carbon pricing) is expected to remain close to 2% over the nextyear before drifting above 3% by mid-2013. As such, we expect the RBA will need to liftrates 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, ourforecasts suggest that the RBA will remain on the sidelines for a long period and has apotential elevated inflationary problem in 2013 which could well see a response in late

2012.

CPI Forecasts

Mar-11 Jun-11 Sep-11 (f) 2010 2011 (f) 2012 (f) 2013 (f)

Headline CPI 1.6 0.6 0.3 2.7 2.5 3.5 3.2

Core CPI (ex carbon tax)* 0.9 0.6 0.7 2.3 2.7 2.9 3.1

Quarterly % change Year to December quarter % change

* Data have been adjusted using ABS seasonal adjustment methodology that will be 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 2012forecasts. In that sense, it has lessened near term inflationary concerns. Thus June quarter CPIis 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 nowimply that core inflation will remain between 2% and 2% until 2013; this is much softer thanour previous forecasts, which showed the core inflation rate accelerating to the top of the targetband by the end of 2011 and remaining elevated for the remainder of the forecast horizon.
http://www.nab.com.au/wps/wcm/connect/cc4c3080488d4a5ba90bb9fa033d4942/ABSCPIrevisionSep2011.pdf?MOD=AJPERES&CACHEID=cc4c3080488d4a5ba90bb9fa033d4942http://www.nab.com.au/wps/wcm/connect/cc4c3080488d4a5ba90bb9fa033d4942/ABSCPIrevisionSep2011.pdf?MOD=AJPERES&CACHEID=cc4c3080488d4a5ba90bb9fa033d4942


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Underlying InflationThrough the year percentage change

0

1

2

3

4

2002 2004 2006 2008 2010 2012

%

0

1

2

3

4

%

RBA adjusted

(old)

ABS adjusted (new)

Sources: ABS; RBA

More Detailed Comments

The RBA targets an underlying rate of inflation, which is measured using the trimmed meanand the weighted median inflation rates. Indeed, the RBA uses both of these series. The formeris defined as the average rate of inflation after trimming away 15% of price changes at both endsof the distribution; the latter is the rate of change in the item in the middle of the distribution. Afteradjusting for changed methodology, underlying rates of inflation were at the lower end of thetarget band in the June quarter, with the average underlying quarterly rate just 0.6%. Consistentwith the NAB Quarterly Survey retail price index which has historically had a reasonably strongrelationship with core inflation underlying inflation may be expected to remain fairly moderate inthe September quarter.

Core CPI & NAB retail pricesQuarterly percentage change

-0.2

0.0

0.2

0.4

0.6

0.8

2002 2004 2006 2008 2010

%

0.2

0.4

0.6

0.8

1.0

1.2

%

NAB retail prices (LHS)

Core CPI (RHS)

What do the models say re core inflation?

NABs models of underlying or core inflation are better at explaining movements in the newlyadjusted measures of core inflation than they were the RBA adjusted measures. Our models ofunderlying or core inflation are based on such factors as the size of the output gap, labour costgrowth, productivity growth, currency movements, fuel prices and error correction mechanisms. Inaddition to our own models, we also monitor a model based on published RBA research, whichincludes a model based principally on the linkages from unemployment to prices. We have re-estimated 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 andthe 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 thatthe cash rate will need to be lifted in late 2012 to prevent inflation from overheating.

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Core CPI vs. modelsQuarterly

0.0

0.2

0.4

0.6

0.8

1.0

1.2

2005 2007 2009 2011 2013

%

0.0

0.2

0.4

0.6

0.8

1.0

1.2

%

Source: ABS

Forecasts

Average of models

Actual

Economists often use a Taylors rule to estimate appropriate monetary policy settings. The ruleis 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 forthe 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 CPIoutlook. However, as demand strengthens over the next year or so, and inflation rises, it is likelythat further policy tightening will be necessary towards the end of next year.

Australian Cash Rate & Taylors Rule

2

4

6

8

2004 2006 2008 2010 2012

Cash - Taylor's rule dd

Cash - actual + forecasts

Cash - Taylor's rule gdp

Based on 100 point widening

of the spread from cash to

loan rates - effective from

early 2008 and is maintained

Cash to loans spread

widens to 125 points

from Nov 2010

%

2

4

6

8

%

Other specific factors impacting the September headline CPI result

Housing costs are forecast to have softened in the September quarter (note that onlyrents and new project house costs are relevant to the CPI). Housing price data has beenweakening for much of this year, while the NAB Residential Property survey suggests thathouse prices fell further in the September quarter and rental prices continued to soften. Incontrast utility prices are expected to have increased strongly in the quarter, although arelikely 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 theAUD. However, soft price inflation in Australias trade-linked countries in the Septemberquarter may ease inflationary pressure on consumption goods. A rise in consumer goodsprice growth would be consistent with some improvement in retail trade over recent

months, and stabilising retail margins in the NAB Monthly Business Survey.

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Consistent with a softening in employment growth in the September quarter, theunemployment 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 asignificant 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 increasein 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 foodagriculture resulting from the January floods. Wholesale fruit and vegetable price datashow that prices generally declined in the September quarter, with fairly sharp fallsrecorded for some varieties. It is likely that the overall degree of price declines will besignificant. While the fall in fruit & vegetable prices in the quarter should contribute to asoftening in headline CPI, these prices will most likely be excluded from the core inflationmeasure in the September quarter.

-60

-40

-20

0

20

Apple

Bana

na

Broccoli

Cauliflo

wer

Parsley

Lem

on

Onion

Potato

Rockmelon

Cherry

tomat

o

* Monthly growth rates are calculated using average of weekly data for each month; quarterly

growth rates calculated using end-quarter data

Sources: Datafresh; NAB

Wholesale Fruit and Vegetable Prices*

-60

-40

-20

0

20

% %JulyAugust

September

September quarter

The depreciation of the Australian dollar may contribute to a rise in import price growth inthe September quarter, although this effect may take some time to flow through toconsumer prices. NABs Quarterly Business Survey points to a softening in purchasecosts growth in the September quarter, which supports the theory that the impact of thedepreciation 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, reflectinga 0.9% reduction in fuel prices.

Assessment

September quarter inflation is expected to have been fairly soft, reflecting continued weakness ineconomic 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 outperformretail, manufacturing, wholesale and construction which the RBA will need to take into seriousconsideration when determining the most appropriate setting for monetary policy.

While current global influences may provide the RBA with more motivation to cut rates in thenear-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. Weenvisage that a boost to domestic demand will strengthen the labour market, and therefore add towage and costs pressures. As such, while near-term pressures appear relatively mute, themedium-term outlook appears to be consistent with rising price pressures, and it is this whichsupports our expectation that further policy tightening will be necessary to contain inflationeventually.

For more information contact:

Alan OsterGroup Chief Economist03 8634 2927(Mobile 0414 444 652)

Rob HendersonChief Economist Markets Australia02 9237 1836

Rob BrookerHead of AustralianEconomics & Commodities03 8634 1663

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Macroeconomic, Industry & Markets ResearchAustralia

Alan Oster Group Chief Economist +(61 3) 8634 2927

Jacqui Brand Personal Assistant +(61 3) 8634 2181

Rob Brooker Head of Australian Economics & Commodities +(61 3) 8634 1663

Alexandra Knight Economist Australia +(61 3) 9208 8035Vacant Economist Australia & Commodities +(61 3) 8634 8602

Michael Creed Economist Agribusiness +(61 3) 8634 3470

Dean Pearson Head of Industry Analysis +(61 3) 8634 2331

Gerard Burg Economist Industry Analysis +(61 3) 8634 2788

Robert De Iure Economist Property +(61 3) 8634 4611

Brien McDonald Economist Industry Analysis & Risk Metrics +(61 3) 8634 3837

Tom Taylor Head of International Economics +(61 3) 8634 1883

John Sharma Economist Sovereign Risk +(61 3) 8634 4514

Tony Kelly Economist International +(61 3) 9208 5049

James Glenn Economist Asia +(61 3) 9208 8129

Global Markets Research - Wholesale Banking

Peter Jolly Head of Markets Research +(61 2) 9237 1406

Robert Henderson Chief Economist Markets - Australia +(61 2) 9237 1836

Spiros Papadopoulos Senior Economist Markets +(61 3) 8641 0978

David de Garis Senior Economist Markets +(61 3) 8641 3045

New ZealandTony Alexander Chief Economist BNZ +(64 4)474 6744Stephen Toplis Head of Research, NZ +(64 4) 474 6905Craig Ebert Senior Economist, NZ +(64 4) 474 6799Doug Steel Markets Economist, NZ +(64 4) 474 6923

London

Tom Vosa Head of Market Economics - Europe +(44 20) 7710 1573Vacant Market Economist Europe +(44 20) 7710 2910

Foreign Exchange

Fixed Interest/Derivatives

Sydney +800 9295 1100 +(61 2) 9295 1166

Melbourne +800 842 3301 +(61 3) 9277 3321

Wellington +800 64 642 222 +800 64 644 464

London +800 747 4615 +(44 20) 7796 4761

New York +1 800 125 602 +1877 377 5480

Singapore +(65) 338 0019 +(65) 338 1789

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CPI Preview Sept 2011