The inflation wildcard

Interest rates may be on hold, but any rise in the June quarter inflation figures is likely to see another rate hike.

This month the Reserve Bank (RBA) thankfully decided to keep interest rates on hold, and the wide spread speculation is that the cash rate will remain on hold until early next year.  Australia’s average standard variable mortgage rate is sitting at 7.4% – just slightly higher than the ten year average (7.24%).

In a statement from RBA Governor Glen Stevens (http://www.rba.gov.au/media-releases/2010/mr-10-11.html), the Bank cited concerns about the effect of deteriorating health in the European economies and financial markets on the global economy.  In balance, the Governor also highlighted that prices for Australian commodities remained high and global growth is likely to track at trend levels.

The final statement in the release sums it up nicely:  “Taking all the available information into account, the Board views this setting of monetary policy as appropriate for the near term.”  – or in plain English, we can expect the cash rate to remain on hold for the next couple of months at least.

One of the most important factors the Bank will be monitoring is the rate of inflation in Australia.  The RBA has a mandate to maintain trend inflation between 2 and 3 percent (read more here).  No matter what measure of inflation is used (and there are quite a few – four of the most popular are tracked in the graph below), the rate of annual growth is at the upper limit of the RBA’s comfort zone.

Measures of inflation SMALL

The Reserve Bank’s preferred measures of inflation are the weighted median and the trimmed mean, both of which have been trending downwards.  Based on the March quarter CPI data, the average of trimmed mean and weighted median provides an ‘underlying’ inflation measure of 3.1% – down from a recent peak of 4.7% over the year ending September 2008.

The next set of CPI data will be released July 28 and the results will be critical in determining where interest rates are heading from here.  If underlying inflation continues to trend downwards it is a safe bet that interest rates will remain on hold for until.  On the flip side, if inflation moves upwards further rate rises are likely to be on the cards.

The components of inflation are varied, however housing comprises the largest weighting in the index, accounting for 19.5% of the overall Consumer Price Index calculation.  The slowdown in home values should provide some relief to CPI growth, however the housing component goes well beyond just house prices – it includes rents, utilities (electricity, gas, water and sewerage) as well as property rates and charges and house repairs and maintenance costs.  We are likely to see some large movements in the utilities component of housing to compensate for infrastructure investment.

Other big rises are expected in healthcare (up 4.7% over the March quarter) and education (up 5.6% over the March quarter).

The RBA is forecasting some further moderation in underlying inflation over the quarter, however the low rate of unemployment and limited spare capacity in the economy, together with the likelihood of price pressures as outlined above will probably see inflation bottom higher than previously thought before once again trending upwards.

Some additional inflationary pressure is also likely to stem from the general improvement in local economic conditions as well.  A trade surplus of $134m (seasonally adjusted) in April was well ahead of expectations thanks mostly to increases in coal and iron ore.

That scenario fits with the futures market expectation of where interest rates are likely to be heading.  As shown in the graph below, the cash rate yield curve derived from the ASX 30 Day Interbank Cash Rate Futures shows the market expects rates to stay on hold until February next year.

Interest Rates SMALL

About Tim Lawless

Tim heads up the RP Data research and analytics team, analysing real estate markets, demographics and economic trends across Australia

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