Core inflation nudges higher

Despite the headline (seasonally adjusted) CPI data coming in a good deal lower than expected, the more significant (so far as potential RBA rate decisions is concerned) core inflation measures nudged very slightly higher in the June quarter.

The headline CPI came in as +0.2% q/q for a +1.9% y/y rate. Expectations had been for +0.4% q/q to leave the annual rate about unchanged at +2.1%. However, the more closely-watch core measures (Trimmed Mean and Weighted Median) both came in at +0.5% q/q for an annual increase of 1.8%; a slight increase from the +1.75% rate of the previous quarter and broadly in line with expectations.

Given that the A$ on a trade weighted basis has risen by 4.8% over the past year, it is little surprise that Tradables inflation is a major reason for low price increases. Over the year we see Tradables inflation running at just +0.4% y/y (down from +1.3% y/y last quarter) while Non-tradables hit a new 3 year high of +2.7% in June. If the RBA can actually get their way and drive the A$ lower then we should see the Tradables inflation numbers start to edge higher, and that in turn will no doubt push CPI back up. The ultimate result of that, of course, would be the RBA having to push rates higher which would counter the decline (if there is one) in the A$!

Gulf opening up between actual and expected inflation

Each month the Melbourne Institute release their Survey of Consumer Inflationary Expectations. This gives a good indicator where people believe inflation is heading. The chart below compares those expectations (on a quarterly basis) with the actual average core inflation data. What we see is that generally people’s expectations are, on average, higher than reality. Over the course of the past 17 years inflationary expectations have averaged 0.4% higher than the actual.

It also highlights that, where actual inflation moves significantly outside of the RBA target band (as happened through late 2007 to mid 2008), expectations tend to overshoot reality. Likewise, when the GFC struck and inflation started to fall quickly expectations again overshoot, this time on the downside.

What the 12 quarter moving average lines tell us is that since early 2014 when actual inflation started to fall away, expectations have remained consistently high. Indeed over the past few quarters we have seen an unprecedented divergence in these two measures opening up. Essentially consumers are saying “I don’t believe that inflation will stay this low for long”. Given the RBA’s success with inflation targeting over the long term (average core inflation over 17 years of 2.78%) we might understand why.

This is a very real example of the idea of rational expectations and a good reason as to why any potential lowering of the RBA’s inflation target should be treated with extreme caution. If the RBA acknowledges that core inflation, over the longer term, has settled into a lower range and they will therefore be targeting that lower range then in all likelihood consumers will start to adjust downwards their own expectations of inflation. This then compounds the very problem the Bank has been facing; trying to actually push inflation somewhat higher. There is a very real danger that we would then enter into a potentially deflationary spiral with lower expectations making further cuts in the Cash Rate less and less effective. Let’s not forget that the RBA’s supply of rate cut ammo is running ever lower as we head closer to zero.

Those advocating for a cut in the target rate might also like to ask themselves, “Would you be calling for an increase in the target if we happened to be experiencing 5% inflation at the moment?”

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Cost of Living falls further still

After the release last week of the low CPI numbers, and the RBA’s subsequent decision to cut rates by 25 bps yesterday (see below), it comes as no surprise to see the quarterly Cost of Living Indexes confirming the lack of any inflationary pressure.

The COL Indexes are designed to answer the question “By how much would after tax money incomes need to change to allow households to purchase the same quantity of consumer goods and services that they purchased in the base period?” They consider this question for a variety of household types (given the different expenditure patterns of households). For the March quarter we see that prices fell or remained the same from the previous quarter for all household types with annual changes dropping for most. Indeed all household types saw cost of living increases over the year below even the low Headline CPI print and well below the RBA’s preferred core inflation measure which stood at 1.55% for the year.

Q/Q Yr/Yr
Q4 Q1 Q4 Q1
Pensioner & beneficiary 0.4 0 1.3 1.1
Employee 0.5 0 1.1 1.1
Age Pensioner 0.2 0 1.2 0.8
Other Govt Transfer Recipient 0.6 -0.1 1.4 1.1
Self-funded retiree 0.7 -0.4 1.6 1.1
Headline CPI  0.4 -0.2 1.7 1.3

Yesterday’s reduction in the Cash Rate by 25 bps to a new record low of 1.75% (which came as something of a surprise to us, if not to many others!..see commentary from last week) can be pinned squarely to not just the surprise fall in inflation. As the RBA made clear in its statement following the decision, the changes to regulatory control of lending in the property market was also a major factor allowing the Bank to move without fears of stoking an unwanted burst of property price inflation (as has been a past worry).

“In reaching today’s decision, the Board took careful note of developments in the housing market, where indications are that the effects of supervisory measures are strengthening lending standards and that price pressures have tended to abate. At present, the potential risks of lower interest rates in this area are less than they were a year ago.”

The Bank will be pleased that the fall in the A$ which occurred last week on the back of the CPI data, and the rise in expectation of a rate cut, has been extended further by the cut itself. The A$ is now trading more than 2.5 US cents lower than it was prior to the CPI data last week. As the Bank notes in its statement..

Monetary policy has been accommodative for quite some time. Low interest rates have been supporting demand and the lower exchange rate overall has helped the traded sector. Credit growth to households continues at a moderate pace, while that to businesses has picked up over the past year or so. These factors are all assisting the economy to make the necessary economic adjustments, though an appreciating exchange rate could complicate this.” (my emphasis)

RBA Minutes confirm easing bias still in place

Any concerns that the market might have had two weeks ago about the May 5th cut to the Cash Rate can be laid to rest by the Minutes of the meeting released this morning (and available here). The take-away message from the Minutes can be found in one of the later paragraphs…

“In their discussion of the appropriate course for monetary policy, members noted the revised staff forecasts for the domestic economy. Although the recent flow of data had been generally positive, there had also been indications that future capital spending in both the mining and non-mining sectors would be weaker than expected. Overall, compared with the previous set of forecasts, growth was now expected to take longer to strengthen and the unemployment rate was likely to remain elevated for longer. This change, and generally subdued growth of domestic costs, including wages, implied that inflation was expected to be slightly lower than in earlier forecasts though still consistent with the target. On the face of it, this meant that it would be appropriate to consider an easing of monetary policy.”

The Board also discussed the fact that the statement released after the decision would not explicitly signal future directions, saying…

“Members agreed that, as at the time of the reduction in the cash rate in February, the statement communicating the decision would not contain any guidance on the future path of monetary policy.”

Of particular note was the final sentence…“Members did not see this as limiting the Board’s scope for any action that might be appropriate at future meetings.”

Although the forex market has responded to the Minutes by selling down the A$ slightly, it will be galling to the RBA that the Aussie remains well above where it was trading 2 weeks ago when they announced the 25bps cut!

Cash Rate cut to 2%; no surprise to anyone

As had been almost universally expected, the RBA today decided to shave another 25 basis points off the official Cash Rate to take it to a new low of 2.0%.

In the press release announcing the decision (available here) the Board notes that commodity prices remain low, and CAPEX is likely to remain low for the coming year. Despite better household demand and stronger employment data the Bank believes that spare capacity remains in the economy and the inflation genie remains well and truly in its bottle. Thus, “so as to reinforce recent encouraging trends in household demand“, the cut today.

What is perhaps telling is that the announcement gives no sign at all of any further cuts into the future. The Bank will be rather disappointed that, post the decision, the A$ has strengthened somewhat against the US$. This is almost certainly simply a “sell the rumour, buy the fact” response to a move that had been widely expected. The Bank will certainly be hoping that this cut. combined with pressure for the Fed to start moving on US rates later this year, will shift the Aussie back down, given that “further depreciation seems both likely and necessary“.

CPI meets expectations but core slightly higher. A$ weakness keeps core above 2%

The headline inflation measure (Consumer Price Index, CPI) for the second quarter has come in bang-on market expectations at +0.2% q/q for a 1.3% increase over the year. The increase comes courtesy of a 2.6% yr/yr increase in non-tradables being offset by a 0.9% yr/yr fall in tradables.

The more closely watched (at least by the RBA and all those who care about the future direction of interest rates) measures of core inflation were marginally higher than expected. Trimmed Mean was +0.6% q/q, +2.3% yr/yr while the Weighted Median also rose 0.6% q/q for a 2.4% yr/yr gain. These slightly higher numbers, which see core inflation sitting just below the middle of the RBA’s 2-3% target range, led to a US 0.4 cent rise in the A$ and a decline in the market’s pricing for a May Cash Rate cut from about 52% to 44% at the time of writing. The graph below highlights the current divergence between CPI and core inflation measures. These periods of divergence are not unusual, but perhaps make the need to keep our eyes on the core measure clearer.

 

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The variation in the tradable and non-tradable rates of inflation highlight the impact that the value of the A$ can have on headline inflation. The general rule of thumb has been that a 1% appreciation in the value of the A$ subtracts about 0.03% from core inflation (and vice-versa). In the graph below we have used deviation of the A$ value from a 2 year (8 quarter) moving average to calculate the “adjusted” core inflation figure. What we see is that the core inflation adjusted for the current weakness of the A$ below its 2 year moving average has moved below the 2% bottom of the RBA target; were it not for a weaker A$ adding to import price inflation we would probably be looking at core inflation below 2%.

Note that, despite tradables prices showing a 0.9% decline on the year, this measure is NOT a core figure and therefore incorporates some highly volatile import goods (notable petrol) which have fallen sharply; were it not for the weakness in the A$ we could have expected tradables inflation to have been even more negative.

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RBA cut Cash Rate to 2.25%. Just shows how much we know!

Just a few days ago we posted explaining why we thought the RBA would not be cutting the Cash Rate today (you can read it here), but we have been proven sadly wrong with the RBA cutting 25bps from the Cash Rate to 2.25% at today’s Board meeting. Clearly Terry McCrann’s credibility, unlike ours, will be taking a sharp spike upwards.

In the rate decision (available in full here) the Bank note that “growth is continuing at a below-trend pace, with domestic demand growth overall quite weak” and that “(t)he economy is likely to be operating with a degree of spare capacity for some time yet.” The Board also note that, although the A$ has weakened against a rising US$ in recent months that the Aussie has strengthened “less so against a basket of currencies.” and that, “It remains above most estimates of its fundamental value, particularly given the significant declines in key commodity prices. A lower exchange rate is likely to be needed to achieve balanced growth in the economy.

The final paragraph of the announcement (so often studied closely for signs of what might happen next) gives no real clues as to whether this is the first of a series of cuts, or if this is all there is. “For the past year and a half, the cash rate has been stable, as the Board has taken time to assess the effects of the substantial easing in policy that had already been put in place and monitored developments in Australia and abroad. At today’s meeting, taking into account the flow of recent information and updated forecasts, the Board judged that, on balance, a further reduction in the cash rate was appropriate. This action is expected to add some further support to demand, so as to foster sustainable growth and inflation outcomes consistent with the target.

We remain rather surprised by the decision and will wait to see in coming months whether our rather more sanguine outlook on the Aussie economy proves to be reasonable. The forex markets have sold the A$ off by just over one US cent since the cut, thereby helping, at least in part, with the forex revaluing the Bank are wishing for.

Will rates be cut on Tuesday?

Tuesday sees the first of the RBA Board meetings for the year and therefore the first opportunity for the Bank to move on interest rates…if it wants to. There has been much speculation in recent days suggesting that the Bank might be looking to cut the Cash Rate by 25bps (to 2.25%); its first move since August 2013. A lot of this speculation has been driven by an article from respected “RBA-watcher” Terry McCrann suggesting that a cut (with more to come) was virtually a done deal next week. The futures market is currently pricing a 25bps cut next week at about a 64% chance and has fully priced in a 25bps cut by Mar; and a full 50bps by mid-year.

So what’s the likelihood of the Bank moving from its previously stated policy of “a period of stability in interest rates“?

The RBA is tasked with regulating interest rates so as to “to maintain price stability, full employment, and the economic prosperity and welfare of the Australian people. To achieve these statutory objectives, the Bank has an ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term.” So with those objectives in mind, let’s look at how we’re tracking.

Inflation data released earlier this week (and confirmed by sluggish Producer Price Indexs today) clearly show us that inflation is not a problem at the moment. Headline CPI is currently running at just +1.7% (below the stated target range). However, as we pointed out in our previous post, it is the “core” inflation measures that the RBA will be focused on; here we see average core inflation of 2.25%. This is within the target range but has fallen from 2.6% a year ago and from 2.75% just 6 months earlier.

The Bank’s aim is to maintain inflation within its 2-3% target range “over the medium term”. If we consider the average quarterly core inflation data for the past year we see inflation at 2.54%, this is actually up from 2.45% by the same measure a year earlier. Clearly inflation is not a concern. However, we would suggest that the idea that inflation is collapsing and therefore demands a rate cut is flawed.150130

When we consider employment the picture is also confusing. The unemployment rate has risen, although perhaps not as sharply as some have suggested. A year ago the Trend unemployment rate stood at 5.9%, today it is 6.2%. However, as the graphs below make clear, employment growth (whilst hardly stellar on a pre-GFC basis) is actually reasonably healthy. It is very early days, but it also appears that the Trend unemployment rate may be topping out. Whether the employment picture warrants a cut from the RBA looks very marginal at best.

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If we define the “economic prosperity” element of the RBA’s objectives as meaning Australian GDP then the graph below makes it clear that economic growth has slowed. However, annual growth remains at 2.7% which is only slightly lower than the 15 year average of 3.0%. Again, the data is hardly definitive in support of a rate cut. 

 

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On balance, and given that we are certainly not as au fait with RBA thinking as many in the markets in Sydney, we believe that the data does not support an urgent need for the RBA to begin cutting rates at this stage. If there is pressure to do so from within the Board then we think it far more likely that the decision announcement next Tuesday will start to make some effort to shift expectations away from the “period of stability” rhetoric with a view to potential cuts in coming months.

Headline CPI weak but the “core” is stronger

Today saw the release of the Q4 inflation date.  Headline CPI was up just 0.2% q/q for an annual increase of +1.7% (down from +2.3% in Q3), this was a little weaker than the market had been expecting and falls outside the RBA’s 2-3% target range. However, the measures more closely watched by the RBA (namely the Trimmed Mean and Weighted Medians) were stronger and slightly above the market expectations at +0.7% q/q and +2.2% y/y and +2.3% y/y respectively (average +2.25% y/y). Whilst these increases were down from the previous quarter (+2.5% y/y average) they remain within the RBA’s target range. The stronger than expected “core” data is the focus for the markets and is the reason that the A$ has rallied almost a full US cent on the news, as a rate cut from the RBA looks rather less likely in the near term following the stronger than expected core data.

So why the big difference and what is “core” inflation as defined by the RBA? To answer those questions we need to understand a little about what the headline CPI measure is.

CPI in Australia measures quarterly price changes in a “basket” of goods and services that makes up a high proportion of the expenditure of the “CPI population group” – this is metropolitan households. Different weightings are then attached to the various groupings within the basket and an average calculated. Price changes measured in this way will contain two components. Persistent inflation and “noise”. The noise component refers to price changes that can be volatile but do not have an impact on persistent, trend inflation. Examples of this kind of noise might be changes in food prices caused by weather variables, or the infrequent setting of tax levels on goods or services (see the example of GST in the graph below). Of course some of this “noise” may end up being persistent but much will not.

What policy makers need is a measure of inflation that distinguishes between persistence and noise. In other words, a measure with a high “signal to noise” ratio. One way of doing that might simply be to remove the more volatile components from the CPI basket (the so-called exclusion method). These components tend to be food and energy. This method has two main drawbacks. The first being that some of these volatile component price changes will be persistent and yet are excluded. The second is that for any one period there may be other volatile components within the basket that are not excluded.

A method that has become popular amongst a number of Central Banks, including the Reserve Bank of Australia, is known as “trimmed mean”. Simply put this entails removing (or trimming) the extremes (both high and low) of price changes in any one period and then recalculating the weighted average. Which items are trimmed are not pre-selected, but are determined based purely on their relative position within the total spread of price changes. The RBA’s Trimmed Mean measure excludes both the top and bottom 15%. The sometimes quoted Weighted Median is simply a trimmed mean excluding both the top and bottom 25%.

Of course some prices vary consistently on a seasonal basis and this needs to be accounted for. For instance if a particular component’s price is always increased just once a year in March, then that component might be always trimmed since its one-off price rise would put it in the top 15% for that quarter. However, the measure needs to account for that component’s price change over the year. To get around this problem the Trimmed Mean measure uses seasonal adjustment. In the case above, although the nominal price rise might put that component into the top 15% (and therefore trimmed), once seasonally adjusted the increase becomes more “normal” and would fall out of the top 15% and therefore remain within the measure. So what does all this mean in terms of the inflation level?

Whilst the “headline” CPI number may well be the number splashed across the front pages of the newspapers, the Reserve Bank will be looking more closely at their Trimmed Mean and Weighted Median measures to try and get a better “signal” from the data as to actual inflationary trends.

The graph below gives some indication of the variation between the headline CPI and the RBA’s Trimmed Mean measure. As we can see, whilst headline CPI fell sharply during the economic slow-down in late 2008 and 2009, the Trimmed Mean measure remained resolutely high; outside the RBA’s inflation target level. Much of the slowdown in price growth at that time could therefore be seen as “noise”.

Since that time the Trimmed Mean has remained relatively stable within the RBA’s target range despite occasions when the headline CPI measure has either been above or below the target range (as now).

What we also notice from the graph is that the Cash Rate and inflation measures are currently at very similar levels (i.e. when inflation-adjusted by the average of the Trimmed Mean and Weighted Median, the “real” Cash Rate is virtually zero). As we can see this is historically a rather rare occurrence; today’s data sees the real Cash Rate at +0.25% and suggests that the Cash Rate is already at a very low level given the rate of core inflation. Having said that, the real Cash Rate has actually moved slightly more positive in recent quarters, having been negative for the three quarters from Q4 2013, suggesting a possibility of some (slight) room for Cash Rate cuts if the RBA deem them necessary in the future.

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Unemployment rate jumps; QLD looks awful

Today’s labour force data from the ABS for July is a shocker. Jobs, which had been expected to rise by about 12,000, actually fell 300 (and June’s increase was revised lower to +14.9). The headline seasonally adjusted unemployment rate jumped to 6.4% (from 6.0% in June); the increase slightly mitigated by the fact that the Participation Rate increased to 64.8 (from 64.7). However, it is worth noting that full-time jobs were actually up strongly (+14,500) and so far this year are up 110,000; which is more than total jobs created for the year. We are seeing a significant shift from part-time to full-time jobs nationwide.

Queensland’s data is even less inspiring. Total jobs fell by 12,600 in July (with June’s small increase revised down to just +1,700). Unlike at the national level, Queensland full-time jobs accounted for almost all the decline (down 12,000) this month and have now  fallen by 2,300 this year while total jobs are up 24,200. In the Sunshine State jobs creation has all been part-time. The headline unemployment rate in QLD came in at 6.8% (up from 6.3% in June) and this is made all the more disappointing by a fall in the Participation Rate to 66.2.

The scale of the surprise in the seasonally adjusted data is already making some commentators suggest that we should be looking at the ABS Trend data instead. Doing so paints a less dramatic, but still weak, picture. Trend employment growth nationally was its lowest in 9 months (+4,600) while the Trend unemployment rate remains stuck at 6.1%, up from 5.7% a year ago. The Trend data for QLD shows employment up 1,300 (its slowest rate of growth in 8 months) and the Trend unemployment rate increased to 6.5% from 5.9% a year ago.

The weakness of this data has reignited the possibility of further rate cuts from the RBA and, as a result, seen the A$ fall sharply against the US$. The Aussie fell about half a cent on the release and is now trading just below US$0.93.

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