Last week we referred to international forecasting agencies and several central banks starting to consider that inflation may make a cyclical come-back over the next year or two. Yet in Australia most forecasters still see only slow and modest lift in local inflation at most over the next two years. A relatively firm Australian dollar exchange rate and an unusually long phase of very low wages growth are both regarded as forces likely to suppress Australian inflation and provide leeway for the RBA to leave Australia’s cash rate at 1.50% for a while longer even as its central bank peers overseas start to factor future higher inflation in to their monetary policy settings.
Yet there are factors that could push Australian inflation up in to danger zone more rapidly than most forecasters and the Australian bond market expect. It is an outside possibility some of these factors are already in play and will show up in the Q3 CPI report due this week. If the Q3 CPI comes in above consensus forecasts of 0.8% q-o-q, 2.0% y-o-y together with average underlying inflation (the average of the weighted median and trimmed mean) above 0.5% q-o-q, 2.0% y-o-y. It would place considerable pressure on the RBA to adjust higher its inflation forecasts over the next two years making the current 1.50% cash rate untenably low. The first of a series of 25bps cash rate hike would probably be delivered on Melbourne Cup Day, November 6th.
We view the likelihood of above consensus Q3 CPI and underlying inflation outcomes as being relatively small, but there is a risk. The components of the CPI that are likely to rise sharply in the Q3 report include housing (higher house purchase prices, rents, rates and household energy costs) and transportation (higher petrol prices). There is also some chance that household equipment and operation and clothing and footwear will show moderate increases in part reflecting pressure from the pronounced lift in factory gate prices overseas over the past year.
Importantly, even if the Q3 inflation readings are at consensus it will leave annual inflation at 2.0% y-o-y across the board and looking ahead there is a high likelihood that annual inflation will rise from this base because of an accumulation of inflationary factors.
The most immediate of those inflationary factors is one that has been mentioned already, factory gate or producer prices overseas. The most recent September producer price reading from China, the supplier of the bulk of manufactured goods in to the Australian market, was up 6.9% y-o-y. Two years ago China’s producer prices were deflating 5% y-o-y. Producer prices are rising almost generally elsewhere in Asia, in the US and in Europe mostly a consequence of a global economic recovery that has advanced to the point of using up what productive capacity there is to spare.
Australia is highly dependent upon the rest of the world to supply manufactured products for the Australian market and it is only the persistent strength of the Australian dollar that has muted the impact of higher overseas factory gate prices so far. The Australian dollar, however, has been relatively stable rather than appreciating through much of this year. The Australian dollar trade weighted index is currently at 66.2 the same as where it ended September, a touch higher than 65.5 at the end of June, but identical with where it ended March. The currency has been providing little or no buffer against rising overseas’ factory gate prices through most of this year.
Looking ahead if the RBA tries to maintain its 1.50% cash rate for much longer as overseas central start following the lead of the US Fed and raise their rates there is increasing risk that the Australian dollar starts to depreciate compounding the inflationary pulse emanating from overseas factory gate prices.
Inside Australia housing costs and energy costs are becoming inflation flash points. Also, the continuing strength in the labour market – another 19,800 jobs in the latest September report with the national unemployment rate down to a cycle-low 5.5% (down to 4.6% in New South Wales) adds to the case why it is very unlikely that wages growth will stay weak for much longer.
Between now and mid-November there is a chance that the Q3 CPI shows more than 2% annual inflation across it various measures and that the Q3 wage price index moves above 2% y-o-y as well. Clearly the RBA’s cash rate would need to be higher and soon in this circumstance. Even if the Q3 CPI comes in as expected and Q3 wages are no higher than 2% y-o-y the RBA would seem to have only a limited time, say until February next year before starting to hike the cash rate.
The only circumstance that may allow the RBA to leave the cash rate lower for longer is if the Q3 surprises on the downside of expectations. It is possible, but the consensus, or an upside surprise look more likely. The message remains prepare for higher interest rates.
An excellent article on a critical topic - will inflation pick up or not? Central banks having interest rates so low is a critical problem for society, and has resulted in all sorts of asset market distortions. The cyclical path of inflation from here is going to matter a lot. For one, highly elevated Australian house prices arguably rely upon inflation staying low just to stay roughly where they are - a shock interest rate increase could provide a serious and necessary "reality check" to this market.