TD Securities is looking for an upside surprise from Australia's inflation report -- and a rate hike from the RBA in May

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Australia’s underlying inflation rate, of more importance in terms of the outlook for interest rates, has been below the Reserve Bank of Australia’s (RBA) 2-3% target band for the past two years.

But that could be about to change.

According to Annette Beacher, Chief Asia-Pacific Macro Strategist at TD Securities, Wednesday’s inflation report is about to deliver an upside surprise, providing the backdrop to allow the RBA to lift interest rates for the first time since late 2010.

“We look for the December quarter trimmed mean [CPI reading} to increase by 0.6% in the December quarter, or 1.97% year-on-year, and combined with our expected 0.55% quarterly lift for the weighted median measure, annual underlying inflation is expected to creep higher to 1.99% year-on-year,” Beacher wrote in a note ahead of the CPI release.

“If underlying inflation reaches 2% year-on-year as we expect, this is an upside surprise for the RBA as it projected 1.75% year-on-year last November.”

It would also be above the 1.9% median increase forecast by economists, and would mark a small-yet-significant acceleration on the 1.88% underlying inflation rate reported in the September quarter.

Such an outcome would help bolster confidence that inflationary pressures are rising, not falling, something Beacher says will move financial markets as expectations for an earlier-than-expected rate hike grow.

“A sticker shock upside surprise could give the AUD/USD a further tailwind [and see it rally past .8140, and the OIS strip bring forward the first rate hike closer to August [rather than] November,” she says.

TD Securities thinks a rate hike will occur even sooner than that, currently forecasting a 25 basis point increase in May.

Beacher says only a softer-than-expected underlying inflation figure, along with an equally soft Q4 Wage Price Index report next month, will be enough to see the RBA hold off increasing rates on May 1.

Financial markets are fully priced for a 25 basis point increase to arrive in November this year.

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