This chart explains why the next move in Australian interest rates could still be lower rather than higher

Australian inflationary pressures are weak, lifting by just 1.9% in the year to December 2017, according to data released by the Australian Bureau of Statistics (ABS) this week.

However, according to analysis from Adam Boyton, Chief Economist at Deutsche Bank, had it not been for just five items — petrol, health, education, tobacco and utilities — inflation would not only have been weak, it would have been close to non-existent.

How weak, you ask?

This weak.

Source: Deutsche Bank

Based on his calculations, Boyton says consumer price inflation (CPI) would have risen by roughly 0.6% over the year without these items, well below the headline increase of 1.9%.

Helping to explain the difference between the two, Boyton says petrol, health, education, tobacco and utilities prices combined rose by around 7.5% over the same period.

Put simply, inflationary pressures were largely evident in only five specific areas, nicknamed the “fast five” by Boyton.

And that has implications for what may happen in the year ahead, he says.

“It’s possible that the ‘fast five’ may be less fast over 2018,” he says.

“If the pace of inflation everywhere else in the CPI basket were to remain unchanged, and the slowing across the ‘fast five’ were to occur, then the increase in the headline CPI over the year to December 2018 would be around 1.4%.”

1.4%.

If that were to occur, it would be hard to see the Reserve Bank of Australia (RBA) lifting interest rates. If anything, it would probably increase the chance of the bank cutting rates again.

Given the narrow breadth of inflationary pressures, Boyton says it’s possible that markets are underestimating the potential for a significant CPI undershoot.

“[It] appears to us that market participants — ourselves included — might be underestimating the risk of a slowdown in headline inflation this year,” he says.

“To hold headline inflation at 1.9% come end 2018 on the slowing in the ‘fast five’ would require the pace of inflation elsewhere to double.

“That latter outcome is possible to be sure — namely it is possible that inflation outside the ‘fast five’ could lift — although given wages growth is still around record lows and the AUD is little changed over the past year it’s not obvious what a strong catalyst for higher inflation ‘across the board’ is.”

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