Statement on Monetary Policy – May 2007 Inflation Trends and Prospects

Recent developments in inflation

The consumer price index (CPI) rose by 0.1 per cent in the March quarter, and by 2.4 per cent over the year (Graph 70, Table 11). The largest single contributor to the low headline CPI outcome was a fall in fruit prices, reflecting the further unwinding of the mid-2006 increase in banana prices: this effect is estimated to have subtracted 0.5 percentage points from inflation in the quarter. However, a range of other items also contributed to the low outcome. Petrol prices made only a relatively small positive contribution to inflation in the quarter.

Tradables prices continue to grow at a substantially slower pace than non-tradables prices (Graph 71). Abstracting from food and petrol, tradables prices were unchanged in the March quarter and higher by 0.4 per cent over the year. The ongoing low rate of tradables inflation has reflected price falls for a range of manufactured goods – for example, clothing & footwear, household contents such as furniture, and audio, visual & computing equipment – that are mostly imported and for which world prices are being held down by the expansion of supply from China and other emerging markets. Tradables inflation has not been significantly affected by movements in the exchange rate in the past year or so. However, there was a noteworthy strengthening in the currency near the end of the March quarter and early in the June quarter: this would not have had a significant effect in the March quarter, but is likely to have an effect in coming quarters if the higher exchange rate is sustained (Graph 72).

Non-tradables prices rose by 0.9 per cent in the March quarter and by 3.5 per cent over the year. The quarterly increase partly reflected seasonal increases in prices for education and health-related expenditures, although there was also a pick-up in rents and house purchase costs. Rents increased by 1.4 per cent in the quarter and by 4.4 per cent over the year, the strongest increases seen since 1991. With ongoing indications of a tight rental market, it is likely that the rate of rental inflation will remain high for some time.

Based on a range of measures, the Bank estimates that the pace of underlying inflation was around ½ per cent in the March quarter and 2¾ per cent over the year (Graph 73). Over the two quarters to March, underlying inflation appears to have been running at an annualised rate of around 2¼ per cent, compared with 3¼ per cent over the previous two quarters. The easing in the two most recent quarters has been reasonably broad-based: although traded goods inflation has eased more, after accounting for seasonality in some CPI items there has also been some slowing in non-tradables inflation. While there is some uncertainty in assessing these trends, they may in part reflect a slowing in cost pressures from raw materials, most notably the indirect effects of the fall in oil prices that occurred around September 2006; this fall however was partly reversed around the end of the March quarter, so oil prices may add to inflation in the June quarter. It is also possible that the apparent improvement in productivity growth in the latest national accounts and the implied slowing in growth in unit labour costs has helped to temper the pace of recent price increases.

Producer price data suggest an easing in upstream inflation pressures. Final-stage prices were unchanged in the March quarter, and the annual rate of increase slowed to 2.8 per cent. Part of this slowing was due to a fall in the price of bananas: excluding the ‘other agriculture’ component, the quarterly change was an increase of 0.4 per cent. The slowing also partly reflected movements in the prices of imported items, which have fallen by nearly 3 per cent over the past year. Inflation in domestically produced goods has been running at a much stronger rate, at around 4 per cent (Graph 74). However, the data for the March quarter also suggested a slowing: excluding the effects of oil and agricultural prices, prices of domestically produced items increased by 0.6 per cent in the quarter, about half the rate seen in the previous three quarters.

Labour costs

As discussed in the ‘Domestic Economic Conditions’ chapter, the labour market has remained tight and the unemployment rate is at a generational low. Business surveys and the Bank's liaison program confirm the tightness of current labour market conditions; according to the NAB survey, the share of firms reporting that the availability of suitable labour is constraining output remains around the highest levels in the 18-year history of the series (Graph 75).

Strong labour market conditions have been associated with a pick-up in aggregate wages growth over the past couple of years. In addition, information obtained through the Bank's liaison suggests the total growth of labour costs may be running somewhat higher than measured wages growth, reflecting businesses' increased use of non-wage remuneration to attract and keep staff in the current tight labour market. The wage price index (WPI) grew by 1.1 per cent in the December quarter, and by 4.0 per cent over the year (Graph 76). Interpretation of recent wage data needs to take account of the change in timing of the minimum wage decision last year, with the increase in minimum wages becoming effective from December rather than June as in earlier years. As a result of this departure from the usual seasonal pattern, the data for the second half of 2006 understate somewhat the annual growth in wages. After adjusting for this effect, the growth of the WPI over the year to the December quarter appears to have remained in the upper end of the historical experience for this series, at around 4¼ per cent, compared with around 3½ per cent prevailing a few years ago. However, the pace is not significantly above that seen since mid 2005. Care will also need to be taken in interpreting the reported quarterly increase for the March quarter (which will become available in mid May). This figure will be boosted by the particular timing of the minimum wage decision, and is therefore likely to overstate the level of underlying wage increases for that quarter.

Recent data for enterprise bargaining agreements (EBAs) should have been unaffected by the timing of the minimum wage decision. Adjusted for industry composition, the average annualised wage increase for federal EBAs certified in the December quarter was 3.9 per cent, around its average level of recent years. Overall, while these and other indicators continue to suggest that the pace of wages growth is running higher than the average seen over the past 10–15 years, there is little evidence of further acceleration in recent quarters.

Inflation expectations

The various measures suggest that inflation expectations in the economy generally remain relatively high. According to business surveys, the proportion of businesses expecting to increase prices in the near term is above long-run averages, though it must be noted that an above-average proportion also reported increasing their prices in the March quarter, which appears somewhat at odds with the PPI and CPI data.

According to the Melbourne Institute survey of households, the median expectation for consumer price inflation over the year ahead increased to 3.8 per cent in April, returning close to the levels seen over most of 2006. This is above the average expectation over the inflation-targeting period, of 3.0 per cent. The implied medium-term inflation expectation of financial market participants, as measured by the difference between nominal and indexed bond yields, was also somewhat elevated in early May, at a little over 3 per cent. However, as has been noted in previous Statements, this measure may overstate inflation expectations given the relative shortage of indexed securities.

Market economists surveyed by the Bank following the release of the March quarter CPI have lowered their inflation forecasts. The median expectation for headline inflation over the year to the December quarter 2007 is now 2.0 per cent, down from 2.5 per cent in February (Table 12). Over the year to December 2008, the median inflation expectation remained at 2.5 per cent. Union officials have also reduced their inflation expectations.

Inflation outlook

The data that have become available recently suggest there has been some easing in the trend in inflation, with consumer price inflation remaining low for the second quarter in a row and producer price inflation also easing in the March quarter.

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), and that global growth slows modestly but remains above its long-run average rate, in line with Consensus forecasts. The terms of trade are assumed to decline by around 7 per cent over the forecast period. In line with recent data that suggest a modest strengthening in activity, the outlook for growth in demand and activity has been revised up slightly, with non-farm GDP now expected to grow by around 3¼–3½ per cent per annum. Domestic demand is expected to grow at a rate close to trend, while resource exports should increase more rapidly over the forecast period as the recent strength in mining investment has expanded capacity. The drought will weigh on growth in the short term, but assuming a return to average seasonal conditions, the farm sector should add to growth thereafter.

The near-term inflation forecast has been revised downward slightly relative to the forecasts contained in the previous Statement, reflecting the recent lower outcomes for underlying inflation. The central forecast is for year-ended underlying inflation – which was around 2¾ per cent over the year to the March quarter – to fall back to around or a little below 2½ per cent in the next few quarters (Table 13). Headline CPI inflation is still expected to fall to a little below 2 per cent in mid 2007, largely reflecting the unwinding of the increase in banana prices that occurred during 2006. The recent appreciation of the exchange rate could contribute to some modest downward pressure on prices over coming quarters, although the experience from earlier movements in the exchange rate is that the effects on inflation have been relatively small and drawn out. The drought is not expected to have a significant effect on food prices in the CPI, although the longer it persists, the more likely it is that there would be some upward effect.

Longer term, underlying inflation is expected to rise a little, to about 2¾ per cent in 2008 and 2009, with headline CPI inflation expected to follow a similar path. The forecast gradual pick-up in inflation reflects the expectation of firm growth in demand and output and that capacity utilisation in the economy will remain high. Ongoing labour market tightness is also likely to keep overall wages growth at a firm pace. Risks to these forecasts appear to be broadly balanced.