Surprise, elevated inflation in Australia isn't going away

The Australian monthly consumer price index (CPI) reveals a re-acceleration in inflation. Headline CPI inflation is up to 2.8% for the year to July from 1.9% for the year to June. Importantly, the upside surprise is not just due to volatile items like electricity. Core (trimmed mean) CPI inflation also rose sharply, to 2.7% from 2.1%.

At the time of the last Reserve Bank of Australia (RBA) meeting, officials welcomed the weaker second quarter (Q2) CPI numbers and surprisingly soft June monthly CPI numbers, concluding that inflation would gradually decline to the mid-point of its 2-3% target band over the coming years. Officials came to this assessment despite reliable leading indicators pointing to inflation re-accelerating in the coming months. Now, all key measures of inflation are moving upward. 

 

The RBA is already running the cash rate below levels suggested by credible policy rules. Re-acceleration of underlying inflation suggests that:

1. capacity is not loosening significantly; and

2. the credible level of rates is likely to move further away from the RBA, especially if it cuts rates further in the coming months. 

Either the Bank responds to the data by talking less dovishly, therefore taking some rate cuts from money market pricing, or it absorbs a hit to its credibility, causing the risk premium in bond yields to rise. Having said this, there is an argument that protected global money markets continue to support leveraged bond buying and the so-called "basis trade", which in turn suppresses the risk premium in bonds. If the costs to credibility from excessive easing are not recognised by investors, central bankers might continue to see green lights to cut rates. This logic works in the short term. Ultimately, if bond yields rise because a central bank has tested the limits of credibility and driven up rate uncertainty, the delayed selling reaction of bond investors can be a particularly acute one longer term, as we witnessed in 2021.