The Australian Bureau of Statistics released the Consumer Price Index, Australia data for the June 2011 quarter today and it revealed a significant easing of the inflation rate on last quarter (0.9 per cent compared to 1.6 per cent in March 2011). The annualised inflation rate rose to 3.6 per cent up from 3.3 per cent in the 12 months to March 2011. While many commentators are calling this the start of a spiral in core inflation spike the data is still being driven by ephemeral factors associated with the impacts of the natural disasters (floods and cyclones) that our food growing areas endured earlier this year. The major factors driving the inflation rate are food (and that is mostly bananas) and world oil price movements. I still consider these impacts to be mostly of a transitory nature. Given that the core inflation rate is still well within the RBA’s targeting band, I do not consider there is a case for an interest rate rise next week (using their own logic). Bananas cannot keep increasing by 470 per cent every 6 months. And if they do, they are easily substituted away from.
The summary results for the June 2011 quarter are as follows:
- The All Groups CPI rose by 0.9 per cent in the June quarter 2011 down from 1.6 per cent in the March quarter 2011.
- The All Groups CPI rose by 3.6 per cent over the 12 months to the June quarter 2011 up from an annualised rise of 3.3 per cent over the 12 months to March quarter 2011. This is because the June quarter 2010 rise was 0.6 per cent compared to 0.9 per cent in the June quarter 2011.
- The largest price rises were fruit (+26.9 per cent), automotive fuel (+4.0 per cent), hospital and medical services (+3.4per cent), furniture (+6.0 per cent), deposit and loan facilities (+2.1 per cent) and rents (+1.1 per cent).
- The most largest price falls were vegetables (-10.3 per cent), audio, visual and computing equipment (-6.3 per cent), electricity (-1.5 per cent), domestic holiday travel and accommodation (-1.5 per cent), milk (-4.6 per cent) and toiletries and personal care products (-2.3 per cent).
Is the result an indication that the fears of rising inflation are on solid ground? Answer: not really. I might be called bananas but I think the inflation rise (it is not a surge as the press is claiming) will be relatively short-lived for reasons I will explain.
The reaction of the currency markets was immediate because they assumed that the rise in the annual inflation rate would force the RBA to push up interest rates next week. I don’t think that will happen given how sluggish the overall economy is.
The following graph shows the Australian dollar-US parity (time is GMT) for today (up until when I was writing this – lunchtime). The sudden jump in the exchange rate – to establish the highest AUD-US parity since we floated the Australian dollar in 1983 – followed swiftly on the heels of the ABS data release. The AUD reached $US1.1063 just after the CPI figures were released but by the end of lunchtime I notice it has eased to $1.1036 (on Sydney prices). The AUD also appreciated by against the yen (by 0.6 per cent) in the aftermath of the data release.
This is the classic announcement effect that econometricians find interesting.
And what might you ask is behind this? We might consider this to be a banana-driven inflation! Yesterday, the Sydney Morning Herald carried an article (July 26, 2011) – Inflation perceptions go bananas – as a lead-up to the release of today’s CPI data from the Australian Bureau of Statistics. The title was in reference to the astronomical price of bananas at present (due to floods and cyclones).
The article predicted that the inflation rate measured by the annualised change in the CPI would come in around 3.4 per cent (essentially unchanged from the previous quarter) but that the CPI was poor measure of the underlying rise in the cost of living.
Staying in theme, today’s ABC News Report (July 27, 2011) carried the title – Dollar goes bananas on rising inflation.
Yes, the humble banana!
Trends in inflation
The headline inflation rate increased by 0.9 per cent in the June quarter translating into an annualised increase of 3.6 per cent for the year to June which is up from the March quarter of 3.3 per cent.
What does it mean for monetary policy?
The Consumer Price Index (CPI) is designed to reflect a broad basket of goods and services (the “regimen”) which are representative of the cost of living. You can learn more about the CPI regimen HERE.
The ABS say that:
The CPI is a temporal price index for consumption goods and services acquired by Australian resident households. It is an important economic indicator, providing a general measure of price change … The principal purpose of the Australian CPI is to measure inflation faced by consumers to support macroeconomic policy decision making. This is achieved by providing a measure of household consumer inflation by the acquisitions approach.
There are various ways of assessing the general movement in prices depending on the purpose that the measure is being used for. The document I linked to above details some of the approaches. One of these approaches – the “acquisitions approach” – attempts to measure “household consumer inflation” and defines the basket of goods and services as “consisting of all consumer goods and services actually acquired by households during the base period.” The ABS use “market prices for goods and services” (including taxes etc) and make no imputations for “non-monetary transactions” (such as imputed rents). They also exclude “interest rate payments”.
So when the CPI increases by 0.9 per cent in a quarter we cannot deny that this is significant. But to see how significant we have to dig deeper and sort out underlying structural inflation pressures and ephemeral price facts. As the introductory summary shows the price rises are being driven largely by oil prices and food shortages arising from floods earlier in the year. It appears that the flood effect is diminishing given that the June quarter result was well down on the March 2011 outcome.
So while the cost of living has risen the implications for macroeconomic policy depend on a different measure of inflation. The RBA’s formal inflation targeting rule aims to keep annual inflation rate (measured by the consumer price index) between 2 and 3 per cent over the medium term. Their so-called “forward-looking” agenda is not clear – what time period etc – so it is difficult to be precise in relating the ABS data to the RBA thinking.
What we do know is that they do not rely on the “headline” inflation rate. Instead, they use two measures of underlying inflation which attempt to net out the most volatile price movements. How much of today’s estimates are driven by volatility?
To understand the difference between the headline rate and other non-volatile measures of inflation, you might like to read the March 2010 RBA Bulletin which contains an interesting article – Measures of Underlying Inflation. That article explains the different inflation measures the RBA considers and the logic behind them.
The concept of underlying inflation is an attempt to separate the trend (“the persistent component of inflation) from the short-term fluctuations in prices. The main source of short-term “noise” comes from “fluctuations in commodity markets and agricultural conditions, policy changes, or seasonal or infrequent price resetting”.
The RBA uses several different measures of underlying inflation which are generally categorised as “exclusion-based measures” and “trimmed-mean measures”.
So, you can exclude “a particular set of volatile items – namely fruit, vegetables and automotive fuel” to get a better picture of the “persistent inflation pressures in the economy”. The main weaknesses with this method is that there can be “large temporary movements in components of the CPI that are not excluded” and volatile components can still be trending up (as in energy prices) or down.
The alternative trimmed-mean measures are popular among central bankers. The authors say:
The trimmed-mean rate of inflation is defined as the average rate of inflation after “trimming” away a certain percentage of the distribution of price changes at both ends of that distribution. These measures are calculated by ordering the seasonally adjusted price changes for all CPI components in any period from lowest to highest, trimming away those that lie at the two outer edges of the distribution of price changes for that period, and then calculating an average inflation rate from the remaining set of price changes.
So you get some measure of central tendency not by exclusion but by giving lower weighting to volatile elements. Two trimmed measures are used by the RBA: (a) “the 15 per cent trimmed mean (which trims away the 15 per cent of items with both the smallest and largest price changes)”; and (b) “the weighted median (which is the price change at the 50th percentile by weight of the distribution of price changes)”.
While the literature suggests that trimmed-mean estimates have “a higher signal-to-noise ratio than the CPI or some exclusion-based measures” they also “can be affected by the presence of expenditure items with very large weights in the CPI basket”.
The authors say that in the RBA’s forecasting models used “to explain inflation use some measure of underlying inflation (often 15 per cent trimmed-mean inflation) as the dependent variable”.
The special measures that the RBA uses as part of its deliberations each month about interest rate rises – the trimmed mean and the weighted median – also showed moderating price pressures.
So what has been happening with these different measures?
The following graph shows the three main inflation series published by the ABS – the annual percentage change in the all items CPI (blue line); the annual changes in the weighted median (red line) and the trimmed mean (green line). The horizontal purple line (at 3 per cent) denotes the upper bound of the RBA’s target range.
The annual growth in the weighted median rose to 2.7 per cent in the June 2011 quarter (from 2.2 per cent in the March quarter). The trimmed mean rose from 2.3 per cent in the March quarter to 2.7 per cent in the June quarter.
First, the RBA-preferred measures are still well within the inflation-targeting band of 2-3 per cent. So there is no justification for a rise in interest rates to follow today’s release.
Second, the upward movement in the June quarter was driven largely by volatile factors which I will discuss in more detail next. Inasmuch as there were no underlying price pressures (say from wages) operating I do not call this quarterly rise (which after all was a fall on last quarter’s result) a price spike or a surge. There is every reason to consider the factors that are driving the headline rate to be largely volatile and ephemeral (food prices and petrol).
The underlying outlook remains relatively benign and the data remains well within the RBA’s targeting range. The swaps market which provides some indication of what the traders think will happen to interest rates is still (when I looked at 14:02) thinking rates will fall over the next 12 months.
My conclusion – there is no case that can be made for an interest rate hike in the foreseeable future notwithstanding the opinions of some of the more gung-ho financial market commentators.
To put the result in perspective consider the following graph which is the quarterly change (per cent) in prices for market goods and services excluding volatile items from the March quarter 1987 to the June quarter 2011.
This series excludes Fruit and vegetables and Automotive fuel and Utilities, Property rates and charges, Child care, Health, Other motoring charges, Urban transport fares, Postal, and Education. So not only the likely ephemeral price items but also government-imposed charges which usually represent step increases in the price level rather than on-going price pressures.
There is no doubt that these non-market impulses can spark a wage-price inflation but that is another story and not relevant for assessing what today’s results mean.
Even the most cursory examination of the graph suggests that today’s data is hardly alarming and signalling an impending inflation spiral.
What is driving inflation in Australia?
The following bar chart compares the contributions to the quarterly change in the CPI for the December 2010 (green), March 2011 (grey) and June 2011 (blue) quarters by component.
The ABS reports that for the June quarter, the most significant price rises were fruit (+26.9 per cent), automotive fuel (+4.0 per cent), hospital and medical services (+3.4per cent), furniture (+6.0 per cent), deposit and loan facilities (+2.1 per cent) and rents (+1.1 per cent).
If you consider the graph – it is clear that more items are now contributing to the underlying inflation outcome than say in December 2010. But the other point is that most of these components have reduced their overall impact on the headline figure.
In the commentary for the December quarter 2010 – There is no inflationary outbreak evident – the economy is slowing – I wrote that “we can see the start of the weather-related impacts on food prices here. That will get worse as the full losses to productive capacity in the farms arising from the floods is revealed.”
Those impacts consolidated in the March quarter and while still present in the June quarter have weakened. The fact that vegetable production is now rising again and prices are dropping quickly is evidence of that. The price pressures will further dissipate as the productive capacity of the farms arising from the floods is restored to more normal levels.
It is clear that food has been a significant contributor to the June quarter 2011 outcome.
The ABS said in relation to food:
The food group recorded an increase in the June quarter 2011. The most significant contributors were fruit (+26.9%) and restaurant meals (+1.3%). The rise in fruit prices was mainly attributable to an increase of approximately 138% in the price of bananas in the June quarter 2011 due to shortages created by Cyclone Yasi in February 2011. Banana prices increased 470% over the six months to the June quarter 2011. Vegetables (-10.3%) provided the most significant offset, due to favourable growing conditions.
That is why we are getting the “bananas did it” headlines. Take the food price rises out and you have a significantly different overall outlook. That is why I do not consider this to be an inflationary surge.
The other major contributor is petrol and these price movements are largely beyond the influence of the Australian economy. The problem is that each time there has been a surge in oil prices the world economy has recessed soon after.
The ABS said that:
Automotive fuel rose in January (+2.4%), February (+2.2%), March (+4.8%) and April (+1.4%), then fell in May (-0.1%) and June (-3.4%).
The ABS provided a very interesting graph which showed “the pattern of the average daily prices for unleaded petrol for the eight capital cities over the last fifteen months”. I reproduce that graph next.
The early part of the quarter was dominated by some hefty oil price rises but more recently there has been an easing. The OPEC barons are now much more aware of the damage that a recession can inflict on their revenues and tend to ease more quickly than say in the 1970s.
But there are two additional trends to consider. The non-OPEC oil producers will reach peak in the near future and the national composition of demand for oil (and energy in general) is shifting with the rise of China and India. While it is likely that the current surge in oil prices is ephemeral, the long-term trend in energy prices generally is up.
Please read my blog – Be careful what we wish for … – for more discussion on this point.
At present, there is no evidence that demand pull factors emanating from within Australia are driving the inflation trend.
The inflation rate has risen steadily this year mainly due to transitory factors such as natural disasters and external factors (petrol prices). Only the energy price issue is of concern. The farms damaged by the floods etc will be back into production before long and then the supply boost will see food prices fall sharply.
Related data shows there are no signficant generalised wage pressures in the economy at present. It is also clear that the overall economy is slowing and at least one major banks (and the swaps market) are betting on a fall in inflation. The retail sector is now probably in recession. I will write more about that another day because it introduces some interesting new developments as a result of the growth of the Internet.
The madness in Europe and the US at present is also conditioning a negative outlook.
That is enough for today!