4Q CPI outcome locks in RBA rate hike next week

4Q CPI outcome locks in RBA rate hike next week

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The absence of significant downside surprises in today’s 4Q inflation detail locks in the RBA for a fourth straight rate hike next Tuesday. Only a material downside surprise would have kept the RBA sidelined, and even then it would have been a stretch. Indeed, we have for some time been forecasting a February rate hike, a view supported by the run of unexpectedly firm domestic economic data releases since the last RBA decision in early December. Today’s inflation print and further anecdotal and survey evidence indicating that the inflation outlook has worsened merely confirm that the cash rate is too low.

The 4Q headline printed as we had expected at 0.5%q/q (consensus 0.4%), half the 1.0%q/q rise in the September quarter. The smaller quarterly rise, though, pushed the annual rate of headline inflation up to 2.1%oya (from 1.3%), with unfavourable on-year-ago base effects (eg. headline CPI fell in 4Q08) playing a significant role here. The all-important core inflation prints averaged 0.65% in 4Q (trimmed mean 0.6%, weighted median 0.7%), the lowest outcome for two years. The average annual rate of change on the core measures, however, was unchanged at 3.4%oya, above the RBA’s 2-3% target range for the ninth straight quarter.

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The main drivers of inflation in the quarter were a 16% rise in the price of fruit, a near 7% rise in the price of domestic holidays, a 1% rise in house purchase costs, and a 2.1% rise in the price of beer (ouch). Partly offsetting these rises were a 2.8% drop in automotive fuel prices, a 7.1% plunge in the prices of electronics (most of which are imported) and a 5.2% drop in drug prices. Imported inflation rose 0.1%q/q despite the prolonged strength of AUD over the last three months, but non-tradables prices rose a worryingly-high 0.8%q/q.

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The medium term inflation outlook looks troubling. Indeed, on our forecasts, inflation is close to troughing for this cycle, and may already have done so. The economy has rebounded with what appears to be limited spare capacity, and there already is evidence that some sectors, like mining, are bumping up against the same constraints that blighted the previous period of expansion. In particular, skill shortages mean that wage pressures are building. Moreover, recent changes to Australia’s industrial laws mean there is increased risk of the outsized pay increases being claimed in sectors like mining spilling over into broader sectors of the economy, particularly with the unemployment rate seemingly having peaked below 6%.

With consumers seemingly having brushed off the RBA’s three rate hikes in the closing months of 2009, and surplus stocks having been pared back, there is unlikely to be the same level of retailer discounting that we saw over year-end. Similarly, commodity prices remain well-supported, which means raw material prices probably will feed into higher industrial costs structures. Moreover, the favourable base effects that helped drive headline inflation lower over recent quarters will move in the opposite direction from here. Also, much of the imported disinflation has run its course In fact, AUD has fallen against key cross-rates in recent weeks.

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This outlook implies RBA officials have significant further work to do in returning the cash rate target closer to a neutral setting. This process is likely to be completed in small (i.e. 25bp), steady steps. With the RBA’s Deputy Governor indicating last month that the monetary policy setting had returned to a “normal range” (i.e. policy is expansionary, but no longer in emergency territory), the pace of tightening inevitably will slow after next week’s hike.

That said, with growth in the economy exceeding official expectations and inflation poised to accelerate from elevated levels, there is a risk that the RBA may pull the policy trigger in March as well as February. Five straight rate hikes, though, would risk over-egging the pudding. Not all sections of the economy are firing (i.e. tourism, manufacturing, and some sections of the construction industry are in the doldrums), and the RBA has time on its side, particularly with, on our forecasts, the major central banks on hold for a considerable period.

The cash rate target will be 5% or higher by the end of this year. By then, monetary policy will be restrictive – RBA officials will have lifted their collective foot off the accelerator and started depressing the brake.

ENDS

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