Australia’s September quarter consumer price inflation (CPI) report will be released next week.
It’s arguably the most important data release in Australia, often heralding changes in interest rate settings from the Reserve Bank of Australia (RBA).
It also has the ability to offer up surprises.
Look back to April last year, when the ABS released the March quarter CPI report, for evidence of how it can change the narrative around the outlook for interest rates in an instant.
Headline CPI fell by 0.2%, leaving the annual increase at just 1.3%. Not only was that quarterly decline the largest since the 2008 December quarter, it left the annual increase at the lowest level since the June quarter 2012.
Underlying inflation, of far more importance to the RBA when it comes to the outlook for monetary policy settings, was also incredibly weak, lifting by just 0.15% for the quarter, leaving the annual increase at a record-low level of 1.55%.
Such was the scale of the weakness, it saw the RBA cut interest rates twice over the next three months, taking the cash rate to just 1.5%, the level it remains today.
It was a shock not only to the RBA but also financial markets.
Bill Evans, Chief Economist at Westpac, thinks that another one could be on the way.
In a note released today, Evans says that underlying inflation will undershoot expectations yet again in the September quarter, leaving the RBA little option but to keep interest rates steady next year.
He says the Australian Bureau of Statistics’ (ABS) two underlying inflation measures — the trimmed mean and weighted median figures — will increase by just 0.27% and 0.32% for the quarter, creating significant downside risks to the RBA’s current forecasts.
“Our estimates indicate that momentum in these core measures is slowing,” says Evans.
“The six month annualised rate would slow from 2.1% three months ago to 1.7%. Underlying inflation for the first 9 months of the year would be printing 1.3%, making it likely that the actual result will settle below the mid-point of the Reserve Bank’s forecast range of 1.5-2.5%.”
The RBA targets an annual inflation rate of between 2-3% per annum.
Evans says that a combination of margin pressures in the retail sector, falling health care costs and a softening in the Sydney and Melbourne housing markets, leading to a reduction in construction costs, are factors underpinning his call.
He also notes that second-round effects from higher energy costs are unlikely to be seen in the underlying inflation measures.
“We also note that in the minutes of the October meeting of the Reserve Bank Board it was noted that ‘liaison with businesses had suggested that a number of firms, particularly in the retail and manufacturing sectors, were largely absorbing increases in energy costs into margins rather than passing them through to final prices’,” he says.
And with the momentum in underlying inflation set to weaken, Evans says that upcoming revisions to the ABS’ CPI basket of goods and services will also place downward pressure on inflation readings in the quarters ahead.
“The net impact is typically negative since consumer spending tends to rise for items where relative prices have declined and vice versa,” he says.
“Our preliminary estimates point to a reduction in the measure of the CPI of a little more than this benchmark with the headline rate being reduced by up to 0.4% and the underlying by 0.3%.”
Evans says this will create a problem for the RBA, meaning that there is a “significant risk” that underlying inflation will undershoot the RBA’s forecasts.
“The Bank will face a challenge in credibly maintaining its 1.5-2.5% forecast for underlying inflation in 2018 and its 2-3% forecast for underlying inflation for 2019,” he says.
Should Evans be on the money, it will almost certainly change the narrative about the prospect for interest rate increases next year.
As he points out, with inflation already weak it would not be an “attractive or necessary option”.
If anything, a rate hike would only create further downside pressure on inflation, curbing domestic demand and tradable prices through a firmer Australian dollar.
However, while Evans thinks that another inflation shock is likely to arrive over the coming quarters, he says the RBA is unlikely to respond by cutting interest rates given the risks that it will merely reignite house prices in Sydney and Melbourne as was seen in 2016.
“This would be a definitive lesson for the new Governor that rigid adherence to an inflation targeting policy is likely to create disturbances in asset markets if inflation is structurally slowing,” he says.
Under new RBA governor Philip Lowe, few will disagree that financial stability risks have taken on a more prominent role in policy deliberations than under the leadership of former governor Glenn Stevens.
Westpac doesn’t see the RBA lifting interest rates until 2020 at the earliest.