CBA: Australian inflation is likely to accelerate, reducing the odds of more rate cuts

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Despite a massive 25% drop against the US dollar since mid-2014, Australian inflationary pressures are near non-existent thanks to lower petrol prices, subdued domestic economic conditions and slower growth in rents.

According to the ABS June quarter CPI release, inflation increased by just 1.5% from June 2014, the third consecutive quarter the annual rate remained below 2%. Stripping out volatile items that can distort the headline figure, core inflation, crucial to the RBA in helping determine interest rate settings, rose by 2.3%, towards the lower-end of its 2-3% target band.

Even the separate TD-MI inflation gauge, a monthly release that provides a more timely indicator of inflationary trends, increased by just 1.9% in the year to September.

Clearly there are no inflationary pressures at present, despite the huge drop in the Australian dollar.

However, according to Gareth Aird, senior economist at the CBA, benign inflationary conditions are unlikely to persist in the coming quarters, suggesting that an expected lift in the inflation rate will likely have implications for monetary policy ahead.

“Our forecasts have headline inflation lifting from 1.5%pa in Q2 2015 to near the top of the RBA’s target band (2.8%pa) by Q1 2016. Underlying inflation is also forecast to step up,” he says.

Aird offers three reasons why he expects the inflation rate to rise: tradables inflation – determined by global factors – should lift as exchange rate passthrough continues and retailers increase prices where possible to limit margins being eroded; the impact of lower petrol prices diminishing in significance along with improved domestic economic conditions for export orientated sectors on the back of a lower Australian dollar, something that he believes will contribute to a pickup in nontradable inflation (determined by domestic factors).

The chart below suggests there is a risk that tradable inflation will increase. It tracks the Australian dollar trade-weighted index, advanced by two quarters and shown in brown, against movements in core tradable inflation shown in green.

Should the acceleration in inflation occur as Aird suspects, it could see the RBA upgrade its inflation forecasts and diminish the likelihood of further rate cuts, something markets are currently fully priced for by the end of the first quarter of 2016.

“From a monetary policy perspective our views on inflation certainly don’t necessitate any policy tightening. But they do suggest that there may be less wriggle room to cut rates further,” he says.

“We see the risks of near term rate cut as low and have the RBA on hold at 2.0%.”

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