Why the RBA will keep its cool on inflation

Inflation on tradable goods is at the mercy of commodity prices and the exchange rate. But there are a few compelling reasons why the Reserve Bank won't fight against the upward pressure.

Soft wage growth will ensure that inflationary pressures remain contained in 2014. The dollar provides the greatest risk for inflation in both directions, but the Reserve Bank will be reluctant to fight foreign influences of inflation -- the exchange rate and commodity prices -- since it is a fight that it cannot win.

On a seasonally-adjusted basis, consumer prices rose by 0.5 per cent in the March quarter, missing market expectations, to be 2.9 per cent higher over the year. Annually, inflation has pushed towards the top of the Reserve Bank of Australia’s target band for inflation of 2-3 per cent but it is unlikely to be troubled by today’s data.

The major contributors to inflation in the March quarter were tobacco (up 6.7 per cent), automotive fuel (up 4.1 per cent), education (up 5.1 per cent) and healthcare (up 2.6 per cent). Offsetting this -- albeit to a small degree -- were falls in furniture (down 4.3 per cent) and clothing and footwear (down 2.1 per cent).

Graph for Why the RBA will keep its cool on inflation

Core measures of inflation -- which remove volatile items -- suggest that inflation is perfectly placed. According to both the trimmed mean and weighted median measures, inflation rose by around 2.6 to 2.7 per cent over the year. Neither will give the RBA cause for concern.

Back in February, the RBA admitted that it was puzzled by the inflation data – which is not what you want to hear from your central bank – but the picture became much clearer in the March quarter.

All you need to know about the current state of inflation in Australia is contained in the following graph, which compares inflation on tradable and non-tradable goods.

Graph for Why the RBA will keep its cool on inflation

There are two interesting dynamics going on here.

First, inflation on non-tradables has moderated over the past year. This series is driven primarily by domestic factors and can largely be considered a proxy for domestic wage growth.

This is the category of inflation that the RBA has the greatest effect on. But to date low rates have failed to generate wage pressures; the labour market remains soft and wage growth has slowed to its lowest level in at least 16 years. Consequently, inflation on non-tradable goods should continue to moderate over the next few quarters.

Second, inflation on tradable goods has picked up significantly. This series is driven by two factors: commodity prices and the exchange rate. We can safely conclude that the declining dollar is to blame for recent inflation pressures.

A crucial characteristic of tradables inflation is that it is volatile – both commodity prices and the exchanges rate can vary significantly from quarter-to-quarter (and day-to-day for that matter). As a result, price changes are often temporary and the RBA has traditionally had limited success fighting this form of inflation.

Inflation on tradable goods will likely trend higher (though at a slower pace) over the next few quarters, but that will largely depend on whether the Australian dollar maintains its recent gains or begins to slide again.

The RBA will be pleased with the current state of inflation. It has ensured that it will leave rates unchanged for a least a few more months. The outlook for inflation is tentatively placed but mostly benign; soft wage growth should keep inflation contained over 2014.

However, even if the dollar begins to fall again, pushing inflation above 3 per cent, there is little the RBA can do to fight foreign sources of inflation. Furthermore, it is not clear that they will want to -- with a low dollar necessary to facilitate a successful rebalancing of the Australian economy. Consequently, inflation is unlikely to pose a significant rise for interest rates over 2014.

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