The March quarter Inflation Report printed a much lower result than had been expected by the market and the Reserve Bank.
The core measures, which are seasonally adjusted, rose 0.48 per cent for the trimmed mean and 0.57 per cent for the weighted median -- an average of 0.525 per cent. Westpac had been expecting a rise of 0.66 per cent in the weighted median and 0.67 per cent in the trimmed mean -- an average of 0.665 per cent.
The low read on the trimmed mean, which is arguably the most reliable of the two core measures, is particularly significant given that the three previous prints: June (0.6 per cent); September (0.7 per cent) and December (0.9 per cent) had shown a worrying upswing.
In particular, the print will come as a positive surprise for the Reserve Bank. Recall that following the 0.9 per cent quarter print for underlying inflation for the December quarter the Bank raised its forecast for underlying inflation in the year to the June quarter 2014 to 3 per cent per year from 2.5 per cent year. That implied they expected a probable 0.8-0.9 per cent print for March quarter underlying inflation.
The implication is that the Bank expected that there would be second to third-quarter inflationary impulse from the fall in the Australian dollar in 2013. The Bank's view on the state of underlying demand allowed for a comparable pass-through or margin widening that was observed in the December quarter continuing in the first quarter of 2014.
However the RBA maintained its assumption that the pace would ease back to 0.6 per cent per quarter for the second half of 2014. That meant they expected the impulse effect from the Australian dollar to linger for at least one more quarter but not to become embedded in the system. Weak wages growth encouraged that expectation.
Specific evidence around the ‘fade out’ of the Australian dollar effect can be found in household goods, recreation (both domestic & overseas holidays) and clothing and footwear.
To put that into perspective, Westpac assumed a more moderate dollar effect than in the December quarter but still made some allowance for the weaker dollar to impact inflation in the March quarter. Our forecast for clothing and footwear (-1.3 per cent) compared with the actual of -2.1 per cent; household goods (-0.8 per cent) compared with the actual of -1.5 per cent; holiday travel (-0.2 per cent) compared with the actual of -2.4 per cent; highlights how the impulse effect had faded quickly.
The Reserve Bank has also been expecting some easing in the pressures from non-tradable inflation to offset the fall in the dollar. With wages growth at its slowest pace since the mid-1990s, that has been a reasonable expectation. It was finally delivered in the March Report. Health, education and utilities all printed lower numbers than expected.
Overall the 0.7 per cent increase in non-traded goods and services compared with an average over the last 2 years of 0.9 per cent. If we extract from the "administrative"components such as health, education and utilities we saw a fall of 0.2 per cent -- the first recorded fall in these components since the March quarter 2009.
Of course there are some qualifications to the Inflation Report. House purchase (the cost of building a house including wages and building materials), which is the largest individual component of the CPI, rose by only 0.1 per cent. During the housing boom in 2005-2007 that component was known to increase by 2 per cent in some quarters; with a building boom in prospect in both Sydney and Melbourne in particular it can be expected to move back towards at least the 1 per cent/quarter growth pace we saw in the December quarter. A curious 1.4 per cent fall in Melbourne prices was largely responsible for this particularly low read.
There was also a substantial lagged dollar effect in car purchase , rising by 0.4 per cent compared to our forecast of a fall of 0.3 per cent.
Nevertheless, the Inflation Report will have a number of important implications for the RBA:
1) There is going to be limited implication for inflation if the dollar was to ease back down towards $US0.90 from current levels ($US0.92-0.93).
2) The economy might not be as strong as they had expected. Note that IMF growth forecasts (largely provided by Treasury) are lower than recent RBA forecasts. IMF is forecasting GDP growth (year average) at 2.7 per cent in 2015 compared to the RBA forecast of 2.5-3.5 per cent. The RBA is forecasting through the year growth in 2015 of 3-4 per cent, implying a 3.25 per cent 'pace' in the first half and a 'cracking' 3.75 per cent pace in the second half.
3) There would appear to be little risk in restoring a stronger rhetoric about the Australian dollar. Recall that following the 0.9 per cent print for core inflation in the December quarter, the Bank dropped its “uncomfortably high” description of the dollar. It lifted from $US0.87 to near $US0.94 over the subsequent six weeks. (In December, when the dollar stood at $US0.91 it was described as “uncomfortably high”, yet prints of $US0.92 and above elicited only a "high" description.)
4) We expect that the Australian dollar will revert back to our $US0.91 target by June. If the dollar is not on that track over the next few weeks, the governor may well restore the “uncomfortably high” language in the Statement following the May 6 board meeting. However, given the more encouraging domestic data on consumer spending, housing and employment, the RBA will not restore its easing bias.
Prospects for rate hikes later in 2014 have taken a significant nosedive with this Inflation Report. Markets had never seriously contemplated a 2014 rate hike, so pricing out to end 2014 is largely unaffected. The big change in market pricing is around 2015. Prior to the Inflation Report, markets had priced in a 100 per cent probability of a rate hike by May 2015 -- that probability has now halved.
Westpac retains its call for interest rates to remain on hold until the second half of 2015.
Bill Evans is Westpac's chief economist.