WEEKEND ECONOMIST: An inflation intrusion
With growth forecasts downgraded in the MYEFO the question is whether inflation should be too? With housing costs weighing on the price index, there could now be scope for a November hold.
We think that the Reserve Bank has a broad plan. That plan is, subject to the inflation constraint, to provide support to the non-mining sectors of the economy by easing financial conditions in light of the likely downturn in mining activity from 2014.
This week we saw evidence of how fiscal policy is tightening further and increasing the need for appropriate policy easing from the Reserve Bank. The government's new fiscal initiatives, as set out in the Mid Year Economic and Fiscal Outlook showed a clear move to the further tightening of fiscal policy in 2013-14. Plans to move corporate tax payments to a monthly basis are estimated to raise $5.5 billion (0.4 per cent of GDP) in 2013-14. This large "one off" boost to revenue is due to the need for companies to pay 14 months of tax in 2013-14 to establish the new system. This is a specific fiscal tightening with a short term increase in the tax burden on the corporate sector.
On the other hand, initiatives to restore the surplus in 2012-13 in the face of a reduction in the expected corporate tax take of around $4 billion are not contractionary given that they are focussed around increased dividends from government authorities and claiming the proceeds of inactive superannuation accounts earlier than under previous arrangements.
In addition, we have seen financial conditions tighten, with the Australian dollar rising from $US1.02 to $US1.038 through the week and three-year swap rates increasing from 2.9 per cent to 3.1 per cent.
So the key issue is whether the September quarter CPI will constrain the Reserve Bank from delivering another cut on November 6. Our view is that, while some developments in the report are "unwelcome" there is not sufficient evidence in the CPI to constrain the RBA from delivering on its plan.
Markets are now giving a 50 per cent probability to a 25 basis point cut at the meeting. That is down from 80 per cent prior to the CPI release.
The CPI printed 1.4 per cent headline inflation for the September quarter (versus Westpac's forecast of 1.2 per cent and the market consensus of 1.0 per cent) and annual inflation of 2.0 per cent.
Because there were substantial one-off effects in the headline print, the policy decision will be based around the core measure.
The core print (average of trimmed mean and weighted median) was 0.74 per cent (versus Westpac forecast of 0.7 per cent and consensus of 0.6 per cent). The forecast for annual core inflation was 2.25 per cent (Westpac) and 2.1 per cent (consensus). The annual measure printed at 2.5 per cent. That compares to 2 per cent in the year to June as reported in the June quarter CPI. This print has since been revised to 2.1 per cent due to concurrent seasonal re-analysis.
The arithmetic behind this unexpected increase in the core measure is that 0.4 percentage points is explained by 0.35 per cent dropping out of the September quarter measure from 2011 to be replaced by
0.74 per cent (increase of 0.4 percentage points) and the upward revision to the annual measure to June of 0.1 percentage points.
While consensus (0.6 per cent) and Westpac (0.7 per cent) only 'missed' the core quarterly print by 0.14 percentage points and 0.04 percentage points respectively, the 'miss' was compounded by a 0.2 percentage point downward revision to the September quarter 2011 print (due to seasonal re-analysis) to 0.35 per cent from 0.55 per cent, compounding the apparent size of the market miss. The question is whether the Reserve Bank is likely to see this upside surprise in annual core inflation as eliminating any flexibility it has to further ease rates in November.
Recall the key commentary in the minutes to the October board meeting: "Nonetheless, the information that had become available suggested there was an increased likelihood of growth over the coming year being somewhat weaker than earlier forecast. At its previous meeting, the Board had observed that ... the outlook for inflation was consistent with the target over the next one to two years. Members concluded that the current assessment of the inflation outlook provided scope to adjust policy in response to the softer growth outlook. Therefore, at this meeting the Board judged that it was appropriate for the stance of monetary policy to be a little more accommodative, thereby providing some additional support to demand over the period ahead."
A clue to the degree to which the RBA might downgrade its growth forecasts came with the MYEFO where the government downgraded its 2012-13 growth forecast from 3.25 per cent to 3 per cent but held its forecast for 2013-14 steady at 3 per cent. The RBA is currently forecasting 3 to 3.5 per cent for 2012-13 and 2.5 to 3.5 per cent in 2013-14.
On that basis, we can expect the RBA to downgrade its 2012-13 forecast to 3 per cent, from 3 to 3.5 per cent.
Of more importance is whether the RBA sees a need to upgrade its inflation forecasts as a result of the September quarter CPI. Note that the RBA is currently forecasting underlying inflation at 2.5 per cent in the year to the December quarter, up from 2 per cent in the year to the June quarter. The September Inflation Report shows that the 2.5 per cent has "arrived" a quarter earlier than expected. However, that is unlikely to cause an upward revision to the 2012 estimate because a large print (0.76 per cent) is dropping out from December 2011. Forecasts for 2013 and 2014 of 2–3 per cent are also likely to remain intact.
While the major impact on the CPI of the carbon pricing mechanism has been on headline (we assess around 0.3 percentage points directly and 0.1 percentage points indirectly), there has also likely been an impact on core inflation as well, capturing the accumulated indirect effects on the major core components (including house purchase). We assess that as around 0.1 percentage points.
Note that the RBA included such an estimate in its May Statement on Monetary Policy imputing that 0.25 percentage points of core inflation could be attributed to the CPM by December 2012. If we distribute that as 0.15 percentage points for the September quarter and 0.1 percentage point for the December quarter, we expect that the RBA would be assessing the annual (ex CPM) current core inflation as having increased from 2.0 per cent to 2.35 per cent.
With a further 0.1 percentage point contribution to the core CPI in the December quarter from the CPM and a 0.75 percentage point quarterly print from the December quarter in 2011 dropping out, a 2.25 per cent annual core measure (ex CPM) in 2012, 2.5 per cent (incl CPM), is likely to still be the RBA's inflation expectation – not representing any particular inflation scare.
However, nothing is ever straight forward. There is one possible 'nasty' in the inflation report. "New dwelling purchase by owner occupiers" has the highest weighting of any component in the CPI. This measure captures the overall retail cost of purchasing a house. It is driven by building materials' costs (excluding land), labour costs, and the margins of developers. It has typically represented 12 per cent of the trimmed mean. In the whole year to June, it increased by 'only' 1.2 per cent, indicative of the moribund housing construction sector. However, in the September quarter it rose by 0.9 per cent, implying some recovery in housing activity.
A possible, and still plausible, explanation for this increase was an indirect impact from the CPM, but the wide disparity across states tends to discount that argument. Sydney (1.3 per cent) and Brisbane (2.4 per cent) explained all the increase, with prices flat in the other cities. It is true that just how much of the CPM is passed on to new home prices will depend on the pricing power of developers in each market. So while you can argue that it is plausible that some, or all, of the CPM increase was passed on in Sydney, it is hard to explain the strong rise, let alone CPM pass, through in the very weak Brisbane property market.
This 0.9 per cent increase is about half the increase in the component that we saw in the 2006-2008 period when the housing construction sector was booming, so there is no real implication that the inflationary pressures from a strong housing recovery are apparent. The issue is more that a key factor behind the benign inflation prints of recent times has shown signs of recovery – this signal is consistent with other data on auction clearance rates and house prices. However, the boost in Brisbane does appear to be somewhat surprising given that a sustained housing recovery story is very much centred on Sydney to date.
Superficially, there may also be some concern around the tradable- non tradable mix. The tradable component increased by 0.6 per cent while the non tradeable component was up by 3 per cent – reflecting the impact of 15 per cent increases in electricity, gas and other household fuel prices (due to CPM), and the one off increase in medical and hospital services associated with the reduced tax rebate for private health insurance. While there are acceptable explanations, largely associated with 'one off' effects for non tradable inflation, the apparent end to the tradable goods and services deflation associated with the rising Australian dollar has always concerned the RBA. However, the issue is whether non tradable inflation is slowing to accommodate a 'more normal' tradable effect and, apart from the points raised above around housing, there is way too much 'one off noise' in the non tradable components to draw any conclusions.
Recall that the 'big picture' approach from the RBA has been to use monetary policy to ensure a pick up in demand conditions outside the mining sector given the impending slowdown in mining and the ongoing uncertain global environment. Other data, particularly around the labour market where the unemployment rate has increased from 5.1 per cent to 5.4 per cent, is indicating that further monetary stimulus is appropriate.
Finally, we need to assess the current stance of monetary policy. The 'neutral' cash rate is estimated to be around 3.9 per cent – that compares to 5.5 per cent at the beginning of the Global Financial Crisis. In the previous two easing cycles, rates bottomed out at 150 basis points (in 2009) and 125 basis points (in 2001) below the neutral rate. A cut to 3 per cent would still only see the cash rate around 90 basis points below neutral.
Given the current contractionary stance of fiscal policy, and rigidities in the Australian dollar in the face of falls in the terms of trade (we estimate 10 per cent in the six months to end December), there are strong arguments to support a further easing despite the 'mild surprise' from the September CPI.
Overall, we have to conclude that the right policy will be to cut rates again in November. That policy remains our view.
Bill Evans is Westpac's chief economist.