MNI ANALYSIS: Australia CPI Worries Grow On Q3 Miss; RBA Alert

By Sophia Rodrigues 

     SYDNEY (MNI) - Australia's inflation trend is facing a double-whammy hit,

with the downside surprise from third quarter data expected to be followed by

another subdued reading as re-weighting of the consumer price index basket drags

down the fourth quarter figure.

     The CPI data show market continues to overprice risk of hike in the Reserve

Bank of Australia's cash rate next year, with some economists likely too hawkish

in forecasting a rate hike as early as the first quarter of next year.

     What is more likely is that the RBA will keep the cash rate on hold at 1.5%

for a prolonged period before it hikes the rate, but there is a risk that the

next move will be lower.

     Data published by the Australian Bureau of Statistics (ABS) earlier

Wednesday showed Q3 CPI rose just 0.6% q/q, keeping y/y CPI below the RBA's 2%

to 3% target band for the second quarter in a row and for the 11th time in the

last 12 quarters.

     Underlying CPI rose just 0.35% q/q, taking y/y to 1.85% and keeping it

below the RBA's target band since Q4 2015. Both headline and underlying CPI fell

short of the MNI survey median forecasts that each would rise 2.0% y/y.

     While underlying CPI is more important for the RBA's monetary policy, the

importance of headline CPI cannot be dismissed because of the impact it has on

wage costs. On both counts, the Q3 CPI data was a significant downside miss.

     There are two reasons why this trend could continue -- competition in the

retail space, and re-weighting of the CPI basket.

     Intense competition in the retail sector has been one of the key drags on

CPI in recent years and this is expected to intensify with the entry of internet

retail giant Amazon into the Australian market. 

     Also, the ABS will be updating the weights assigned to each expenditure

class in the CPI basket as of the Q4 release, and this re-weighting is expected

to reduce measured inflation. The RBA has pointed to this risk but said it is

difficult to gauge what the exact impact will be.

     While this is mainly a measurement issue, its importance can't be

understated because of its significance for wage costs. The RBA's expectation is

that as spare capacity in the labor market declines, wage prices will rise

gradually. Among the various determinants of wage growth are actual inflation

and inflation expectations, but in recent years past inflation outcomes have had

more impact than before. So the longer the headline CPI remains subdued, the

greater the risk that wage growth will remain slow.

     In a special article discussing price changes in the CPI published with the

Q3 data, the ABS said the weakness in inflation since 2013 has been largely due

to a decline in the average size of changes in the prices of non-tradable goods

and services.

     Low wage inflation measured by the wage price index and average earnings

per hour from the National Accounts are both a cause and a symptom of these

lower price pressures, the ABS said. "The prices of non-tradable goods and

services are currently changing more frequently than average, but prices are

being adjusted by smaller amounts."

     For the RBA, an acceleration in wage growth is important for inflation to

return to its target band. A faster rise in wage growth is also important to

boost household income, which would support household spending and thus growth,

while also helping to lower the household debt-to-income ratio.

     If household income growth remains slow and puts household spending at

risk, then the risk of a RBA cash rate cut could increase, particularly if

mortgage interest rates rise even when the cash rate is left unchanged.

     This is the most likely scenario that would lead to a lower cash rate, and

the RBA appears alert to the possibility that it may be forced to cut.

     Three main conditions need to be met for this cut scenario to materialize: 

     --Factors beyond monetary policy, such as a rise in funding costs, force

banks to raise their mortgage interest rates;

     --Highly indebted households are not able to cope with higher interest

rates, and sharply cut their spending;

     --Other drivers of growth are not strong enough to offset the drop in

household spending.

     This may have been one of the scenarios Governor Philip Lowe had in mind at

an event in September when he didn't completely dismiss the possibility of a

move lower in the cash rate.

     In reply to a question "So, the only way is up basically (for interest

rates)?" at the Q&A session following a speech in Perth, Lowe said, "No, I

wouldn't say that. There are scenarios where I could imagine having to cut

interest rates. I hope those scenarios don't eventuate though. I think we will

be better off, and people don't like hearing this, but we'll all be better off

if the next move is up rather than down."

     This may also the reason why the RBA didn't explicitly suggest in the

minutes of its October board meeting that the next move in the cash rate would

be up.

     In the context of moves towards higher interest rates in other economies,

the RBA said in the minutes that they "were a welcome development, but did not

have mechanical implications for the setting of policy in Australia, where the

timing of any changes in interest rates would be dependent, as always, on

developments in domestic economic conditions."

     But domestic economic conditions could be hurt by tighter global monetary

conditions if wholesale funding costs of Australian banks rise and force them to

raise mortgage rates.

     Secretary to the Treasury John Fraser may have made a reference to this in

his opening statement to the Senate earlier Wednesday.

     Fraser said that higher debt levels have made households more sensitive to

any increase in interest rates in the future.

     "The Reserve Bank will be mindful of this when thinking about domestic

monetary policy, though global monetary conditions can also impact upon the

wholesale funding costs of Australian banks," he said.

     Since the start of this year, financial stability has figured extensively

in the RBA's monetary policy decisions as the central bank remains worried that

rising household debt amid slow growth in wages that could hurt the nation's

macroeconomic prospects.

     The focus on financial stability did result in macro-prudential steps from

the Australian Prudential Regulation Authority aimed at high-risk mortgages and

those steps led to an interest rate rise for some for these high-risk borrowers.

     From the RBA's point of view, this was desirable to lower the risks. But at

the same time, it has been closely watching the trends in mortgage rate in

recent months because it considers across-the-board rate rises undesirable for

the economy because it could hurt marginal borrowers. 

     In the minutes of the July board meeting the RBA noted that the cost of

funding for banks had declined further since late 2016. But over the same period

banks' lending rates had increased slightly, driven by increases in housing

lending rates for investors and on interest-only loans. 

     In a speech in August, RBA Assistant Governor for financial markets

Christopher Kent talked about changes in housing loans rate and concluded that

"the average interest rate paid on all outstanding loans has increased since

late last year, but only by about 10 basis points."

     Were rates to rise significantly further, the RBA might reconsider its

policy stance especially in an environment where inflation could remain below

the target band for longer.

--MNI Sydney Bureau; tel: +61 2-9716-5467; email: sophia.rodrigues@marketnews.com

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