Statement on Monetary Policy – August 2007 Inflation Trends and Prospects

Recent developments in inflation

The consumer price index (CPI) rose by 1.2 per cent in the June quarter, and by 2.1 per cent over the year (Graph 70, Table 14). The largest contributions came from increases in petrol and fruit & vegetables prices, which together contributed around 0.5 percentage points to the quarterly inflation rate. However, the strength of price increases in the quarter was broad-based, with around 60 per cent of items in the CPI basket rising by more than 2.5 per cent when measured on an annualised basis (Graph 71).

Tradables prices increased sharply in the quarter; abstracting from petrol and food prices, they grew by 0.8 per cent in the quarter and by 1.0 per cent over the year, the fastest pace since 2002 (Graph 72). While the import-weighted exchange rate appreciated by 4½ per cent in the June quarter, which could be expected to reduce tradables prices over time, it is unlikely to have had a significant effect on the CPI data to date; the pass-through of exchange rate movements into final prices in recent years has tended to be prolonged and relatively moderate. Non-tradables inflation decreased slightly in the June quarter, to 0.7 per cent, but this reflected seasonal influences. In year-ended terms, non-tradables inflation was little changed, at 3.4 per cent, driven by price increases in services such as education, health and especially housing. The strength in housing costs is reflected in both house purchase costs and rents; rents increased by 1.6 per cent in the quarter, which is the largest rise since the September quarter 1989.

The broad-based nature of inflationary pressures in the quarter was also reflected in measures of underlying inflation. Based on a range of measures, the pace of underlying inflation is estimated at around 0.9 per cent – around the levels seen in the first half of 2006 – with the annual rate around 2¾ per cent (Graph 73). This follows two quarters when measured underlying inflation was surprisingly low, at 0.5 to 0.6 per cent in the December and March quarters, and appeared a little at odds with the observed strength in the real economy and the labour market.

Final-stage producer prices increased by 1.0 per cent in the June quarter and by 2.3 per cent over the year. The June quarter results mainly reflected higher non-residential construction prices and housing construction costs, which are closely related to house purchase costs in the CPI. In year-ended terms, the increase in the prices of property & business services was also high (Graph 74). More generally, liaison contacts note that they are experiencing persistent and strong cost pressures due to high commodity prices and upward pressure on foodstuffs affected by the drought. Wholesale electricity prices have also increased sharply in recent quarters, although retail electricity prices have remained more contained.

Labour costs

Recent data suggest that wages growth remained firm in the March quarter. The wage price index (WPI) increased by 1.0 per cent in the March quarter, to be 4.1 per cent higher over the year, around the same year-ended pace that has prevailed during the past 18 months. In recent years, wages in industries experiencing the most severe shortages of skilled labour, such as mining and construction, have increased more rapidly than the average, while industries such as accommodation, cafes & restaurants and retail trade have recorded more subdued wages growth (Graph 75).

Other wage indicators also suggest the recent pace of wages growth, while high, has not been accelerating. The average annualised increase for new federal enterprise bargaining agreements (adjusted for industry composition) certified in the March quarter was 3.7 per cent, slightly lower than the increase in the December quarter. Increases under all currently active agreements have remained little changed at around 4 per cent. More broadly, average earnings from the national accounts – which includes both wage and non-wage labour costs – rose by 1.2 per cent in the March quarter, to be 4.7 per cent higher over the year. This is within the range experienced over recent years, though towards the higher end of this range. With the pick-up in measured labour productivity over the year to the March quarter, the annual increase in unit labour costs over this period was more moderate than in the preceding year.

Looking ahead, the Australian Fair Pay Commission's second minimum wage ruling, handed down in July, will become effective from October 2007. This decision granted a 2.4 per cent increase in annualised terms in the Federal minimum wage, which is somewhat lower than the increase awarded in previous decisions, although the Commission reports that this decision directly affects only around 12 per cent of all employees. More broadly, the pace of average wages growth is likely to reflect conditions in the labour market, which have remained tight. The number of job vacancies, as measured by the ABS, is at a high level, with service sectors such as retail trade, property & business services and accommodation, cafes & restaurants making strong contributions to year-ended growth. According to the NAB survey, finding suitable labour is cited as a greater constraint to increasing output for businesses than lack of demand, as has been the case for several years (Graph 76).

Inflation expectations

The various measures of inflation expectations have remained somewhat elevated. According to the Melbourne Institute survey of households, the median expectation for CPI inflation over the year ahead fell to 3.5 per cent in July, although expectations remain above their average over the inflation targeting period, of 3.0 per cent. Market economists surveyed by the Bank following the release of the June quarter CPI have increased their inflation forecasts, with the median expectation for headline inflation over the year to the June quarter 2008 at 2.7 per cent (Table 15). Inflation expectations of union officials have remained unchanged, at 3.0 per cent. In addition, the proportion of businesses increasing their prices in the June quarter or expecting to increase their prices in the near term remains above its long-run average according to business surveys.

Inflation outlook

Assessing the current level of underlying inflation is a key input into the Bank's inflation forecasts. There is inevitably some uncertainty around any such estimate, but taking either the information for the first half of 2007 or for the year to the June quarter, underlying inflation appears to be running in the upper part of the target range, at an annual rate of around 2¾ per cent.

The Bank's forecasts assume that oil prices and the exchange rate remain around current levels through to the end of the forecast period (June quarter 2009). This represents a modest appreciation (around 3 per cent) in the exchange rate since the May Statement and an upward revision for oil prices. Global growth is assumed to remain strong over 2007 and 2008, in line with IMF forecasts, which have been raised since the time of the last Statement. The terms of trade are assumed to decline modestly from their current high level, but the magnitude of the expected decline is smaller than at the time of the last Statement, reflecting upgrades to forecasts for coal and iron ore contract prices.

The outlook for growth in activity has been revised up modestly in the near term, the net effect of stronger-than-expected domestic and external conditions, an appreciated exchange rate and a higher level of interest rates. Domestic demand is expected to grow at a little above trend, while exports are expected to pick up, reflecting the increase in resource export capacity and the expected improvement in the rural sector. Non-farm GDP is expected to expand at an annual rate of around 3½ per cent over the years to June 2008 and June 2009. Overall GDP growth is expected to pick up to 4¼ per cent over the year to June 2008, before easing to 3½ per cent over the following year. The unemployment rate is forecast to remain fairly close to the current low level.

The inflation forecast has been revised up relative to the forecast contained in the last Statement. The central forecast is for year-ended underlying inflation – which was around 2¾ per cent over the year to the June quarter – to rise to around 3 per cent over the year to June 2008 (Table 16). Headline CPI inflation has been held down over the past year by the unwinding of the increase in banana prices that occurred in mid 2006, but is expected to rise over the next year towards the forecast rate for underlying inflation. For the year to June 2009, the central forecast is for both underlying and headline inflation to remain near the top of the target range.

The upward revision to the forecast takes into account the stronger-than-expected inflation outcome for the June quarter, the upward revision to the activity forecast (which implies continuing pressure on resource utilisation in the economy), and the expected effect of the recent adjustment to monetary policy. The ongoing tightness of the labour market is expected to result in a moderate pick-up in wages growth from current levels, while sustained high levels of capacity utilisation raise the likelihood of a strengthening in inflationary pressures from current levels. The appreciation of the exchange rate – the import-weighted exchange rate is now around 7 per cent above the average level in late 2006 – will mitigate the rise in overall inflation to some extent, but consistent with the experience from earlier movements of the exchange rate, the effect on inflation is likely to be modest and fairly drawn out.

These forecasts are subject to risks in both directions. The main upside risk is that pressures on resource utilisation could feed through more strongly into inflation. Most measures suggest that the labour market is as tight as it has been for a generation and that capacity utilisation is stretched. The growth rates of domestic demand and activity are expected to remain strong, as are labour market conditions. These factors could result in more upward pressure on wages growth and inflation than has been incorporated in the forecasts. On the downside, the main risk at present appears to be that of a further slowdown in the US economy. If that were to eventuate, it would reduce global growth and hence would help to dampen inflation around the world, including in Australia.