Australia: Core CPI unexpectedly rose 0.9%

Core CPI unexpectedly rose 0.9% - biggest rise since June 2006

The increase in Australia's Q2 CPI was unexpectedly high at 1.2%q/q, which is the largest rise since the corresponding quarter of 2006. This was well above market expectations of a 1.0% rise (JPMorgan 0.9%), although the annual rate dropped to 2.1% owing to high base effects from last year's spike in petrol and banana prices. Crucially, the core measures of inflation also were unexpectedly large - the trimmed mean, for example, rose 0.9%q/q (JPMorgan and consensus 0.7%) - which means the annual rate of core inflation (after revisions) held steady at a worrying 2.7%oya. Both measures of core inflation now are back in the upper half of the RBA's 2-3% target range.

The unexpectedly large rise in core inflation, coupled with an upward revision to the last quarter's rise in the weighted median (now 0.6%q/q from 0.5% previously), is likely to trigger an RBA rate rise in early August. Previously, the forecast was that the RBA would wait until 2008 before twice tightening policy, mainly on the basis that a rate hike immediately after a drop in the annual rate of headline inflation would have been awkward to explain, particularly just months ahead of the federal election. The outsized bounce in core inflation over the quarter, however, the still elevated annual rate of core inflation, and the unexpected upward revision to the back data, prompted the forecast change. We still expect a second tightening, probably later in 2007, although the timing of the federal election (which is likely to be held in November) could delay the second move until early 2008.

Although the headline inflation prints in the June quarter were unexpectedly large, the main drivers of inflation in the quarter were broadly as expected. The biggest price rises were for automotive fuel (up 9%), hospital and medical services (up 3%), fruit (up 8%), rents (up 2%), vegetables (up 6%), furniture (up 4%), and house purchases (up 1%). There were large price falls for domestic holidays (down 3.5%), and (imported) electronic equipment (down 2%).

Before today, our forecast for two rate hikes in the first half of 2008 was based on the likely emergence of significant inflation pressure over the second half of 2007. These inflation risks remain and, if anything, are building more quickly than expected. To make things worse, the starting point for inflation now is unexpectedly high. The drought will trigger sharp rises in electricity and gas prices, food prices will continue to rise owing to poor crops and lower irrigation flows to key growing areas, petrol prices remain elevated, and the three-decade low jobless rate is generating broad-based wage pressure. The only material offset is likely to come from lower import prices owing to the soaring AUD, but this disinflationary impact is unlikely to last for long.

With core inflation likely to be similarly elevated in Q3 and even Q4 (which, on our forecasts, will leave the annual rate of core inflation at 3.0% by year-end - above the RBA's current forecast of 2.75% - the dominant risk is that the RBA has to tighten more than twice more in the current cycle.

Financial market reaction: Significant. Implied yields on front-month bank bill futures contracts bounced 10-12bp after the data, and the AUD rose 35pts.

The details:

The headline CPI rose 1.2%q/q in Q2 (JPMorgan 0.9%, consensus 1.0%), after a 0.1% rise in Q1. The annual change, however, dropped owing mainly to last year's high base - annual headline inflation fell to just 2.1%oya - near the bottom of the RBA's target range - from 2.4%oya in Q1.

The main drivers of inflation in Q2 were a 9.1% rise in petrol prices, a 3.4% rise in hospital and medical services (reflecting a rise in private health insurance premiums), an 8.4% rise in fruit prices, a 1.6% rise in residential rents and a 6.1% rise in vegetable prices.

The principal offset came from lower prices for domestic holiday and travel costs (-3.5%) and a 2.4% drop in the price of audio, visual and computing equipment. The latter was due partly to the soaring AUD, which rose 5% in trade weighted terms over the quarter.

The all-important core measures of inflation were unexpectedly large. Both the trimmed mean and the weighted median measures rose 0.9%q/q, and the annual rates rose 2.7%oya and 2.8%oya respectively. The Q1 weighted median print was revised up from 0.5%q/q to 0.6%.

ENDS

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