Statement on Monetary Policy – May 2006 Inflation Trends and Prospects

Recent developments in inflation

The Consumer Price Index (CPI) rose by 0.9 per cent in the March quarter, to be 3.0 per cent higher over the year (Graph 60, Table 12). Although petrol prices had little direct impact on the quarterly inflation outcome, they did boost the annual rate of inflation, following their increases of around 20 per cent over the last year. As is usual, there was some variation across the different indicators of underlying inflation. The Bank's assessment is that underlying inflation was around ¾ per cent in the quarter and around 2¾ per cent over the year to the March quarter.

The relatively large CPI increase in the March quarter partly reflected seasonal price resetting for education and health, as well as increases in prices for vegetables and motor vehicles. These increases were offset somewhat by falls in the prices of clothing & footwear, furniture & furnishings, and deposit & loan facilities.^[1] Over the year, fuel prices, house purchase costs, and food items made the largest contributions to inflation. Price declines were most significant in audio, visual & computing equipment, telecommunication charges, and clothing & footwear. There was some evidence of indirect effects from higher oil prices on a range of items affected by higher fuel and transport costs. There was no effect on prices of fruit and vegetables from Cyclone Larry in the March quarter, but the June quarter outcome is likely to be boosted by this factor.

The prices of tradables rose by 2.8 per cent over the year to the March quarter, boosted by rises in petrol prices; abstracting from petrol and food prices, the annual increase was just 0.3 per cent, partly reflecting the ongoing disinflationary effect from China and other low-cost producers (Graph 61). Non-tradables prices grew by 3.1 per cent over the year. This rate has fallen significantly from the levels seen a few years ago, partly reflecting a slowing in the growth of prices of new homes.

Producer price data suggest firm upstream inflationary pressures in the March quarter. This was especially the case at the preliminary and intermediate production stages where price increases were mainly due to rises in oil and metal prices (Table 13). The pace of quarterly growth in prices at the final stage of production remained unchanged at 0.8 per cent (Graph 62).

Labour costs

Wage indicators for the December quarter showed continued firm growth in labour costs. The wage price index grew by 0.9 per cent in the quarter, and by 4.2 per cent over the year (Graph 63). The average annualised wage increase for federal enterprise agreements certified in the December quarter increased to 4.5 per cent, the highest level in eight years. This strength was partly due to a bunching of large wage increases in the education sector: when reweighted according to the composition of the labour force, the average increase was closer to earlier levels, at around 4.2 per cent. Other measures of the wage bill and average earnings are volatile, but reinforce the view that wage growth has remained somewhat above its average rate over the inflation targeting period. Additionally, according to the December quarter national accounts data, unit labour costs (total labour costs per unit of output) are estimated to have been growing at a year-ended rate of around 4 per cent for the past couple of years.

More recently, business surveys and the Bank's liaison with businesses point to continued tight labour market conditions and shortages of skilled labour. The NAB survey suggests that labour scarcity remains a greater constraint on activity than the more traditional concerns about lack of demand (Graph 64). Firms across a wide range of private-sector industries are using non-wage forms of remuneration that are not fully captured in the standard wage measures, such as bonus payments and more flexible working arrangements, to attract and retain employees. Wage and non-wage cost pressures are most pronounced in industries facing strong labour demand and acute skill shortages, such as mining and non-residential construction, although solid labour costs growth is evident in most industries.

Inflation expectations

Business surveys indicate that expectations of future price growth remain broadly contained. In the ACCI-Westpac survey, the net balance of manufacturing firms expecting to raise their prices in the next three months increased in the March quarter, to be slightly above its average level over the past decade. A similar result was reported in the most recent Dun & Bradstreet survey. However, the NAB quarterly business survey measure of expected inflation in final product prices has been broadly steady in recent quarters.

Forecasts of market economists surveyed by the Bank following the release of the March quarter CPI indicate that headline CPI inflation is expected to remain close to current levels in the near term. The median expectation for inflation over the year to December 2006 is 2.9 per cent, little changed from last quarter. Thereafter, inflation is expected to fall back, to be 2.6 per cent in the year to December 2007 (Table 14). Union officials expect inflation to be 3.3 per cent for the year to December quarter 2006 and to remain at around this level over 2007.

The implied medium-term inflationary expectations of financial market participants have traditionally been calculated as the difference between nominal and indexed bond yields. This measure has continued to edge higher since the February Statement, to be around 3.2 per cent in early May. However, this rise in part reflects developments in the indexed bond market that are unrelated to inflation expectations. In particular, the limited supply of indexed securities and increasing institutional demand for these securities has pushed down their yields relative to those on conventional bonds.

Inflation outlook

Headline CPI inflation rose to 3.0 per cent in the year to the March quarter, and underlying inflation is estimated to have increased to around 2¾ per cent after an extended period when it was close to 2½ per cent. This increase provides evidence that the modest pick-up in underlying inflation that has been forecast for some time is now starting to occur.

The factors affecting the inflation forecast are broadly as discussed in previous Statements. With a tight labour market, an economy close to full capacity and rising commodity prices, there are a number of forces contributing to domestic inflation. At the same time, the prices of imported manufactured goods are holding down inflation. Furthermore, domestic wage outcomes have remained more contained than would have been expected in the past, given the tight labour market. And profit margins in a broad range of sectors appear quite healthy, providing some scope for businesses to absorb cost pressures without the need to raise prices.

The inflation forecast presented in the February Statement envisaged that underlying inflation would remain in the 2½–3 per cent range over the forecast period to end 2007, with a central forecast that underlying inflation would rise to 2¾ per cent in the second half of 2006 and stay around this level in 2007. The March quarter outcome, which was higher than expected, together with the recent run-up in commodity prices and other domestic and international data, suggested that the risks to the earlier forecast had shifted to the upside. However, taking into account the expected impact of the May policy tightening, the forecast for underlying inflation through 2007 is broadly unchanged.

The Bank's revised forecasts are based on the assumption that oil prices and the trade-weighted index of the exchange rate remain broadly around current levels, at US$70 per barrel and 63, respectively. GDP growth is forecast to accelerate to an annual rate of 3–3½ per cent over the forecast period to the end of 2007, helped by stronger export growth. The unemployment rate is forecast to stay around its recent low level, and wage growth is likely to remain firm, but is not expected to accelerate further. Underlying inflation should remain in the 2½–3 per cent range. Headline CPI inflation is likely to be above 3 per cent in the near term, affected by higher petrol prices, but also reflecting some effect from Cyclone Larry on fruit and vegetable prices. In due course, CPI inflation would be expected to decline gradually, back to 2½–3 per cent. However, for the realisation of this forecast, it will be important that inflation expectations remain anchored through a period when higher petrol prices are likely to substantially boost headline CPI inflation.

Footnote

The CPI expenditure class for deposit and loan facilities measures the fees and margins paid by households on their loans, deposits and credit cards. [1]