Carr's Call: Inflation lift looms over cash

PORTFOLIO POINT: Even when the carbon tax and volatile movements are stripped out of the latest inflation data, it still points to a greater-than-expected rise. Investors should urgently consider what this means for cash returns.

The stronger-than-expected inflation numbers this week have caused a bit of a stir. Indeed a number of banks have subsequently withdrawn their forecasts for a follow-up rate cut on Cup day. Now it’s not my intention to discuss the rate view in Carr’s Call this week. Robert Gottliebsen has that covered and I think he’s got it right – the strong Australian dollar seems to be a key concern for business, government, unions, everyone – so we’ll probably get that rate cut at some point.

But the issue of inflation is critical – cash held in deposit by investors has surged, both in absolute terms and as a proportion of funds invested. Inflation matters. So I want to take the opportunity this week to make some observations on recent inflation trends. Following on from my piece of July 30, Prepare for a cash crash there are three key points I wish to highlight to investors.

1. The carbon tax did not drive the lift in Q3 inflation – its impact was modest;
2. Underlying inflation was and likely still is being understated;
3. This, in part, is due to the waning influence of the strong dollar and also because of the correction in food prices currently underway. Both are occurring faster than I had expected.

If readers recall, I was sceptical of the headline and published core numbers suggesting inflation was at 1.6% and 2.1% respectively. As it turns out, underlying inflation was being understated as I had discussed. The combination of a pick-up in inflation momentum for the quarter plus some revision to previous data, now sees core inflation back at 2.5%, where it was prior to what now looks like an anomalous dip. Inflation all of a sudden is no longer at the bottom of the target but now comfortably in the middle of the band.

I know many would like to dismiss this lift as a temporary phenomenon due to the carbon tax. Quite frankly I just don’t see any evidence of it yet – although I do think the carbon tax will lift inflation materially. That said, the impact this quarter seems to be quite limited given the absence of any unusual price moves.

Take electricity prices – up 15% for the quarter. In September 2009 they rose 11% quarter-on-quarter. Last September they were up 7% in one quarter. How much of that 15% gain was carbon tax? I would say a little over half would be generous. It’s the same elsewhere – fruit and veg had a price surge that wasn’t unusual in the slightest, while the cost of overseas travel (which surged 6%) was largely due to seasonal northern hemisphere influences. Nothing to do with the carbon tax. In fact if you strip out the influence of the carbon tax on electricity and gas, and other volatile price moves (like fruit and veg and the fall in petrol prices, insurance) you still get a lift in headline inflation of over 1%. Core would still be between 0.7% and 0.8%. Price gains were so broad based it doesn’t matter if you take out the carbon tax and volatile moves, the result is the same – a pick-up in inflation that was stronger than expected.

What I did find was a much larger impact from the two key structural changes that I discussed in my July 30 note. The factors many people continue to overlook are the waning impact of the strong dollar and a normalisation of food price pressures. These are the two reasons why those who suggest inflation is, and will remain modest, are in my opinion mistaken.

Chart 1: How the strong Australian dollar has been lowering inflation

Click to enlarge

Dealing first with the Australian dollar, have a look at Chart 1 above. You can see the decline in inflation over recent quarters was largely due to the price of tradable items – that is currency impacted prices. Now that the dollar has steadied, we’ve seen these prices rise, on average, by 0.7% over the last two quarters. This is actually above average (0.4%) and is one of the key reasons why inflation was much stronger than expected this quarter. And, importantly, price hikes had nothing to do with the carbon tax. Furniture, household appliances and clothes – all of these things which we import are now rising in price whereas previously they were falling. Some items that are falling in price – computers and the like – are doing so at a slower rate. This process is being aided by the slow suffocation of online price competition – for example growing restrictions from major brands on international online retailers selling into the Aussie market.

To see how serious this is, if tradable inflation had increased by 0% over the three quarters (September 2011 to March 2012) instead of falling 1% per quarter, then headline inflation would now be at 3%. If currency impacted prices had increased at the average pace that they normally do, then inflation would be at 3.5% now. See the problem? Once tradable inflation normalises, and without an offset in non-tradable inflation (which we haven’t seen), headline CPI is going to be back at 3.5%.

And that’s not taking into account food prices. The price turnaround here was even more rapid. Food prices rose by almost 2% in the quarter which is the biggest increase since the surprise inflation spike we saw in early 2011. The thing is these price gains are not unusual. What was unusual was the fall in food prices that we saw in previous quarters – the biggest fall in food prices in about 40 years (see Chart 2 below). Indeed the only fall in food prices – that’s quite something.

Chart 2: Domestic food prices

Click to enlarge

Unfortunately the bounce this quarter wasn’t just fruit and vegetables either, although they were a big chunk of it – it was broad-based. Breads and dairy were up about 1% each – takeaways, and ‘other’ foods not far behind that.

What the data are showing us are prices normalising after heavy rains lead to bumper crops for cereals, fruit and vegetables. Normally you would see prices for food rise about 1% per quarter – over the last year they had been falling nearly 0.5%. That was never sustainable especially with global food prices surging.

Putting it all together, the data this week showed me that there is no carbon smokescreen and that food and tradable inflation is normalising faster than expected.

I suggested in my July 30 piece that investors need to seriously think about alternatives to cash and think about hedging against inflation. After this week’s numbers I think this process has taken on more urgency. With current term deposit rates and assuming the RBA cuts at least 25 basis points, your average terms deposit will pay just over 4%. On modest CPI assumptions, headline inflation will be between 3 and 4% by the middle of next year, perhaps before. I know many readers are overweight cash at the moment and there are valid reasons for that – but if you want to stay in cash now, you need to be prepared for zero returns. Personally, I think there are much better options out there, and this week’s inflation data – in fact the global data flow more broadly and stock market rally – has really hammered that home. Combined with the strong chance of further rate cuts there is a double imperative to look for alternatives.