Underlying Inflation Looks Sticky

Q3 underlying CPI measures printed above expectations and posted quarterly increases greater than 1%. Favourable base effects helped the annual rates to moderate further but the monthly data suggested that inflation may be easing at a slower rate than the RBA was forecasting and needs to meet its target by mid-2025. Our alternative measure of underlying inflation is looking sticky, adding to the upside risks to prices and the chance of another rate hike.

• We have calculated a measure of underlying inflation using principal components analysis (PCA) based on Bank of Canada research. PCA is useful for a large number of variables, as it finds common patterns that explain most of the variance in the data. In this case, it extracts the common movement in prices and thus creates a measure that reflects underlying developments in inflation and not sector-specific shocks.
• The PCA core CPI is smoother than the official trimmed mean and has consistently posted readings below since H2 2021. In Q3 2023 it rose 4.3% y/y down from Q2’s 4.6% but still historically high, consistent with other measures of underlying inflation pressures. Even though it didn’t rise as high as other core measures, it is only down 0.4pp from its Q4 2022 peak.
• In the past, often when the trimmed mean exceeds the PCA CPI, the RBA tightens policy and vice versa. With the PCA CPI continuing to run below and rates unchanged in Q3, another hike in Q4 is possible.