Statement on Monetary Policy – May 2009 Price and Wage Developments

Recent developments in inflation

A range of information suggests that inflation pressures are beginning to ease in line with the weakening in the economy. Inflation expectations have fallen since mid 2008 to be at quite low levels and growth in labour costs appears to be slowing, as are upstream producer price pressures. While it will take some time for these factors to fully flow through to consumer prices, the CPI data for the March quarter suggest that inflation is easing, albeit from quite a high rate. This is consistent with the gradual moderation in price pressures that the Bank has been expecting.

The CPI increased by 0.1 per cent in the March quarter, to be 2.5 per cent higher over the year
(Table 14, Graph 73). The quarterly outcome was held down by particularly large falls in the prices of deposit & loan facilities and automotive fuel. Abstracting from these items, price pressures remained relatively broad-based. As a result, measures of underlying inflation were considerably stronger, at around 1 per cent in the quarter and 4 per cent over the year. However, this followed a lower-than-expected outcome of around ¾ per cent for underlying inflation in the December quarter and, looking through this volatility, a reasonable assessment is that the pace of quarterly underlying inflation has moderated to a little less than 1 per cent, compared with close to 1¼ per cent in the first three quarters of last year.

The main contributors to the rise in the CPI in the March quarter were higher prices for rents and a range of food items, alongside seasonal increases in prices for health, education and utilities. Rental accommodation prices, which have a weight of around 6 per cent in the CPI, have been growing strongly in recent years reflecting very low vacancy rates in all major cities (Graph 74). However, the pace of increase in rents has slowed in recent quarters, as conditions in the rental market have levelled out. The CPI measure of rents increased by 1.7 per cent in the March quarter, after increases averaging more than 2 per cent per quarter in 2008. Data from the state Real Estate Institutes indicate that rents for newly negotiated agreements have also moderated.

In contrast, automotive fuel prices fell by 8 per cent in the quarter due to declines in global oil prices, holiday travel costs declined sharply due to lower airfares and the price of new housing fell. The CPI outcome in the quarter was also held down by a 14 per cent fall in the ABS estimate of deposit & loan facilities prices, which has a weight of around 4 per cent in the CPI and subtracted 0.7 percentage points from the quarterly rate of CPI inflation. This component represents the ABS estimate of margins on deposit and loan products used by households (as well as the explicit fees and charges on these products) and appears to have been significantly affected by reductions in the cash rate. Over the past half year, mortgage rates have fallen significantly as the cash rate has fallen, while average deposit rates have fallen by less, reflecting both the inertia in some (low- or zero-interest) transaction accounts and strong competition for interest-bearing deposits (see the ‘Domestic Financial Markets’ chapter). The large fall in the March quarter – together with a small fall in the previous quarter – more than unwound the large increase in this component over the prior year. More broadly, this component has had a significant effect on CPI inflation over the past two years, but a relatively small impact on the statistical measures which downweight the impact of large changes in particular items.

Tradables inflation (excluding food and fuel) picked up in the quarter to 0.9 per cent and 2.0 per cent over the year, which is the fastest year-ended pace since mid 2002 (Graph 75). This reflected a broad-based boost to the price of imported items from the exchange rate depreciation in the second half of 2008, along with a reduction in discounting of motor vehicle prices. In contrast, non-tradables inflation has slowed from its earlier rapid pace. Abstracting from the sharp fall in deposit & loan facilities prices, non-tradables prices rose by 1.0 per cent, following a similar increase in the December quarter and rates of around 1½ per cent in previous quarters.

Costs and margins

According to official measures, labour costs continued to grow at a firm pace in late 2008. However, this likely reflects wage setting decisions that were taken before the extent of the economic downturn became fully apparent. More timely indicators from business surveys and liaison suggest a noticeable slowing in labour cost growth during 2009, consistent with the weakening conditions in the labour market.

The wage price index (WPI) increased by 1.2 per cent in the December quarter and by 4.3 per cent over the year. Growth in the public-sector component was particularly strong in the quarter at 1.4 per cent, compared with 0.9 per cent in the previous quarter (Graph 76). This is partly explained by timing issues, as some major public-sector agreements that had been delayed due to protracted negotiations took effect in the quarter. The private-sector component grew by 1.1 per cent in the quarter, around the rates recorded in the past couple of years, to be 4.2 per cent higher over the year. The strongest annual growth in the WPI continued to be in Western Australia, where wages grew by 5.7 per cent. Other measures of wages – the national accounts measure of average earnings, the average weekly earnings survey measures, and those in federal enterprise bargaining agreements – also grew at an above-average pace in the quarter.

Although these measures all suggest that wage growth was solid in the final quarter of 2008, a range of business surveys suggest that growth in labour costs is likely to fall in coming quarters, although these surveys may be capturing expected falls in the number of employees as well (Graph 77). The Bank's liaison with firms also suggests that wage pressures have begun to ease. This is consistent with reports of some firms restraining labour costs by postponing pay rises and implementing wage freezes. Overall, the wage setting environment may be more responsive to economic conditions than in past downturns, which should help to moderate the fall in employment over the coming year or so.

Upstream price pressures eased considerably in the March quarter, driven by a fall in construction prices and a sharp decline in prices for commodities and related items (Graph 78). At the preliminary stage, producer prices fell by 4.6 per cent in the quarter, driven by large falls in the prices of a range of resources (oil & gas, non-ferrous metals and iron & steel). At the final stage (excluding oil), producer prices fell by 0.2 per cent, to be 5.2 per cent higher over the year. Final-stage domestic prices fell by 0.8 per cent in the quarter, which is the first fall in domestic prices since September 2000 and largely reflects substantial declines in building prices. In contrast, final-stage import prices rose by 4 per cent due to the ongoing effects of the currency depreciation in the second half of 2008, which more than offset any weakness in world prices flowing from the global economic downturn. Manufacturing prices fell due to declines in petroleum and basic metals prices, as well as for some foodstuffs, with a partial offset from higher prices for industrial machinery & equipment. In the construction industry, the decline in prices was broad-based across both residential and non-residential sectors, and came despite persistent inflation in input costs. Property services and transport & storage prices both fell by around 2–2½ per cent, while business services prices rose.

Data on business margins, based on ABS profits data, suggest that margins in both the broader economy and the goods distribution sector – which includes retail & wholesale trade and transport – narrowed in late 2008, to be slightly below the average level of recent years (Graph 79). The NAB survey suggests that margins remained at below-average levels in the March quarter, consistent with the Bank's liaison with firms, which points to considerable pressure on margins across a range of industries. Distributors and retailers continue to report that soft consumer demand and ongoing competitive pressures are making it difficult to fully pass on the higher cost of imports.

Inflation expectations

Inflation expectations are currently below the average of the past decade or so, after they were well above average in late 2007 and the first half of 2008 (Graph 80). Consumer inflation expectations, as measured by the Melbourne Institute survey, have been between 2 and 2½ per cent in recent months after peaking at around 6 per cent in mid 2008. Measures of inflation expectations derived from financial markets have been around 2–2½ per cent in recent months.

Market economists surveyed by the Bank following the release of the March quarter CPI expect inflation to moderate further in the near term. The median expectation for headline inflation over the year to the December quarter 2009 is now 2.1 per cent, compared with 2.5 per cent in February (Table 15). Over the year to the December quarter 2010, the median inflation expectation is 2.4 per cent, unchanged from February. Surveys of both businesses and union officials also generally suggest that inflation expectations have fallen noticeably in recent months.