All right, with something in reserve

In these days of budget deficit melodrama, the consumer price index result for the March quarter is a sign that Australia is still getting some things right. The Reserve Bank's interest rate decision when it next meets will probably be another.

The central bank wants to see inflation within a range of 2 per cent to 3 per cent and, if it is, it has room to cut rates further if necessary. Headline inflation in the March quarter was 0.4 per cent, bringing the annual rate to 2.5 per cent. The two most closely watched underlying CPI measures put inflation at 2.2 per cent and 2.6 per cent.

Underneath the headline result, tradeable prices fell by 1.2 per cent in the quarter and by 0.2 per cent in a year, and non-tradeable prices rose by 1.3 per cent in three months, and 4.2 per cent in a year.

The non-tradeable inflation result was led by a 3 per cent rise in healthcare prices and a 5.7 per cent jump in education prices, but both included seasonal elements. School fees are reset at the start of each year, for example, and in the second half of the June financial year individual caps on pharmaceutical benefits become a factor, pushing some users of prescription drugs onto higher prices.

There is a longer-term inflation signal hidden inside the trading price result, however. Prices of traded goods are down mainly because the Australian dollar is stubbornly high: they will rise when the $A falls.

Wednesday's CPI numbers were much better than expected - market economists were expecting a 0.7 per cent March-quarter rise - and they give the central bank plenty of headroom.

The Australian dollar fell by about half a US cent just after the CPI result came out on that thinking, but a rate cut when the Reserve next meets on May 7 is far from assured.

As HSBC economist Paul Bloxham noted this week, there are growing signs that the central bank is getting traction after cutting its cash rate from 4.75 per cent to 3 per cent between October 2011 and December last year.

There are concerns that a crunch could come next year if the resources sector retreats before activity in the rest of the economy has picked up.

It could happen if Woodside's decision to shelve the $40 billion-plus Browse LNG development in the face of cost blowouts, a high $A and soft prices is a harbinger of coal seam LNG export project deferrals in Queensland, or if the rest of the economy is slow to accelerate.

The non-resources economy does have a better feel about it than it did late last year.

Retail sales rose by a seasonally adjusted 1.3 per cent in February, and are up 3.2 per cent in a year. Building approvals rose by 3.1 per cent in February and by 12.8 per cent in a year. House prices rose by 1.7 per cent in the March quarter, and by 3.2 per cent in a year.

The housing picture changes from city to city. Australian Property Monitors estimates that Melbourne house prices are still 4.2 per cent below their mid-2010 peak, for example, while Sydney prices are 4 per cent above their mid-2011 high. Brisbane prices are still 7 per cent short of a mid-2010 peak, and Adelaide is 6.1 per cent below its mid-2010 peak.

Clearly the housing market is recovering from the hangover that came after the boom in 2009 and the first half of 2010 when rates were tumbling and global crisis stimulus including first home buyer grants were on offer.

Melbourne house prices rose by a ridiculous 30 per cent during that time, and Sydney prices rose by 20 per cent. The current steady rate of growth is healthier, and more rate cuts might actually push demand and prices up too hard.

There are caveats, of course. The retail turnover numbers may be being boosted by carbon tax household assistance, for example. Corporate reinvestment in the non-resources economy has not taken off, and right across the economy employment prospects are less secure than they were last year as companies chase productivity growth. But the trend seems to be improving and, after this inflation result, there is no doubt the Reserve can cut rates at least twice if it changes.

China shop bullish

The Reserve Bank also kicked a goal on Australia's behalf on Wednesday with deputy governor Philip Lowe's announcement in Shanghai that the central bank will invest about 5 per cent of its foreign reserves in Chinese government bonds.

The move follows last year's negotiation of a currency swap facility between the Reserve and China's central bank, and this month's announcement that the $A would join the US dollar and the yen in being directly traded with the yuan. The moves make sense given the size of the trading relationship between the two countries: and by buying Chinese government bonds the Reserve is taking a position in a currency that should appreciate over time, on its way to becoming one of the world's key reserve currencies.

mmaiden@fairfaxmedia.com.au