Tempting Fate

Stephen Roberts

Financial markets and we are assuming that the Q2 CPI and underlying inflation readings due later this morning will be low again. By low we mean around 0.4% q-o-q which would reduce annual headline inflation to around 1.1% y-o-y and average underlying inflation (based on the trimmed mean and weighted median measures) to around 1.3% y-o-y, both tracking well below the bottom of the RBA’s 2-3% target band for inflation and probably raising the need for the RBA to adjust downwards its inflation forecasts for the remainder of 2016 and 2017 in its next quarterly Monetary Policy Statement due to be released on 5th August. If very low inflation is confirmed in the Q2 CPI report this meaning it also makes it very likely that the RBA will cut the cash rate another 25bps to 1.50% at its policy meeting on 2nd August....

It is fair to say that part of the rallies in the Australian share market as well as the continuing rally in Australian bonds over the past fortnight has been built on near 100% conviction that the Q2 inflation results will be low and the RBA will respond with a rate cut. We hope we are not tempting fate, but ahead of the CPI release, we look at four key reasons why Australian inflation looks set to stay low for an extended period.

The first reason is that disinflationary pressure is a global phenomenon so the prices of goods imported in to Australia continue to either fall or rise only slowly. Australia’s single biggest source of imported goods is China. Annual change in producer prices in China has been falling over the past four years and although the extent of the fall is moderating in 2016 the latest reading for June still showed producer prices down by 2.6% y-o-y. Apart from falling producer prices another factor has been coming in to play promoting cheaper landed prices in Australia of Chinese imports, the depreciating renminbi. China has been steadily depreciating its currency as a matter of policy this year and further currency depreciation seems one of the easier policy decisions for the Chinese authorities as they try to rebalance and grow their economy. Since the end of 2015, the Australian dollar has appreciated by 5.9% against the renminbi and most likely will appreciate more.

The combination of falling Chinese producer prices and an appreciating Australian dollar against the renminbi means low or falling prices for a wide range of goods imported from China in to Australia and the trend is showing no signs of easing. It may even intensify as China leans more heavily on currency depreciation to sustain economic growth.

A second reason why Australian inflation looks set to stay low is persistently soft growth in wages. Australian annual wages growth is running only a touch above 2% y-o-y (a touch below 2% for the private sector). The Q2 wage price index is due in mid-August and is unlikely to show any acceleration. Cost saving remains a strong force in both the public sector facing persistent budget constraints and especially the private sector as companies seek ways to grow profits in the face of squeezing margins. Persistently low wages growth is a powerful factor helping to keep inflation low.

A third reason for low inflation and one that is becoming much more pronounced is the price discount war affecting supermarket chains in Australia. Intensifying competition in the supermarket sector is spreading the price discount war over a much wider range of goods affecting items with a weighting of more than 16% in the CPI basket of goods and services.

A fourth and another growing reason why inflation is staying low is in a heavyweight component of the CPI that has seen relatively high price increases in the past, the rental part of the housing component of the CPI. The boom in investment housing demand over the past two years has led to burgeoning supply of rental properties. Bargaining power has shifted from landlords to tenants and tenants are likely to gain even greater bargaining power over the next year or two as a large number of newly constructed rental properties come on to the market, particularly in Melbourne and Sydney. The annual rate of increase in housing rents, already declining, is likely to fall further.

Whatever the Q2 CPI shows, there are four very strong reasons why inflation should stay low over the next 18 months or so. Financial markets have rallied on the basis of inflation staying low and Australian interest rates going even lower. There is risk of upside surprise with any particular CPI reading and market disappointment. Maybe we are tempting fate, but we do not believe that risk is high. We wait with the rest of the market for what the Q2 CPI shows.


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