A temporary respite from inflation fears

02 February 2011

Underlying inflation ended last year well below market expectations, recording the lowest quarterly reading in 10 years.   But, while this result will be welcomed by the Reserve Bank of Australia (RBA), we expect that the December quarter figures likely marked the low point for inflation in the current cycle, rather than suggesting a new trend of more moderate price growth for 2011. 

Indeed, the impact of flooding on inflation will likely offset this softer outcome, which means that there should be minimal change to the inflation and monetary policy outlook.

Looking at the break-up of prices by sector in the December quarter provides some insight into the outlook for inflationary pressures in the months ahead.  There were two key factors holding prices back in the final three months of last year.

First is healthcare, which declined 1.2 per cent.  The fall in health costs was the result of a reduction in pharmaceuticals prices due to the seasonal effect of the Pharmaceutical Benefits Scheme.  This price fall occurs in the final quarter every year and will be followed by an increase in prices in the March quarter.

The second key factor was discounting in the retail sector, with the price of clothing and footwear (-1.6 per cent), household contents (-0.6 per cent) and audio visual equipment (-4.8 per cent) all dropping in the quarter.  

This suggests that retailers have responded to subdued domestic demand conditions by passing on the lower price of imports, which was the result of a stronger A$.  

So, the weaker inflation reading was the result of one-off factors at the end of last year, rather than setting a new trend of more moderate price increases.  Indeed, there is the potential for inflationary pressures to come roaring back in the March quarter.

As we have noted, the fall in healthcare prices will be reversed in Q1, while the deflationary force from the stronger A$ will not be present in the coming months, assuming the A$ does not move considerably higher than US$1.00.  At the same time, there will be a seasonal increase in education fees and the recent flooding will push food prices sharply higher for the second consecutive quarter.

Supply disruptions were reportedly responsible for driving a 13.2 per cent increase in fruit and vegetable prices in the December quarter, but the increase in these prices is likely to be more severe in the current quarter, given the escalation in flood waters through Queensland and Victoria early in the year.

There will also be more lingering upward pressure on prices later in the year, with the floods likely to place upward pressure on a range of items, including insurance premiums, rents and building costs.  And this comes on top of original policymaker concerns surrounding wages growth, which is the result of capacity pressures in the mining and construction sectors.  That is, the downside from lower inflation in Q4 is likely offset by the upside risk to prices from the floods.

As a result, this lower Q4 number will buy policymakers some time on monetary policy tightening, but it should not be sufficient to shift the RBA away from its tightening bias.