A welcome inflation surprise

June CPI data softer than expected by RBA will remain on alert

This week saw the release of the highly anticipated June CPI data in Australia. Leading into the release, concerns were centred around the extent of pass through from the Iran war oil price shock and what it would mean for the RBA. The actual outturn was lower than expected, with quarterly trimmed mean inflation, the measure most closely watched by the RBA, coming in at 0.8%, below both economists' forecasts and the RBA's own expectation. Annual trimmed mean inflation came in at 3.6%. While this is an uncomfortably high rate of annual inflation, the details of the release contained pockets of good news on the inflation front.

Any product that is fuel intensive to make or transport is potentially vulnerable to pass through from higher oil prices. It is not surprising then that over the June quarter we have seen pass through to certain areas of the CPI basket. Groceries have seen a pickup in prices, particularly in areas where farmers have more bargaining power. Dairy product prices lifted sharply over the quarter, largely driven by milk. However, the CPI data and anecdotal evidence from farmers indicate that producers of other areas of fresh food are having a harder time recovering their costs.

Construction companies have also faced sharp increases in the costs of their inputs, leading to a pickup in the price charged for new dwellings. Given its large weight in the CPI basket, this category remains particularly important for the inflation outlook. Monthly momentum had been building over the quarter, with new dwelling prices up 0.9% in the month of May alone. However, growth eased in June to 0.4%, with weakening sentiment in the housing market likely contributing to the slowdown. The June quarter PPI release indicates that housing input costs rose by more than developers were able to pass on to buyers, compressing margins.

Other areas of the basket that might have been expected to show stronger price pressures have shown little evidence of a pickup in inflation. Domestic and international airfares and accommodation prices actually fell over the June quarter on a seasonally adjusted basis, despite jet fuel being a key cost for airlines. Airlines hedge their fuel costs to varying degrees, which has mitigated some of the impact. However, it also appears that carriers have been reluctant to significantly raise prices despite higher costs. 

Retail goods have also shown little sign of pass-through with clothing and footwear, and household goods inflation remaining contained. While it is possible that some firms are delaying price increases until later in the year, the lack of pass through to date suggests businesses remain uncertain about their ability to push higher costs onto consumers.

The key message from the CPI data is that, so far, the Iran war shock has had limited flow-through to underlying inflation. Earlier in the week, RBA Governor Michele Bullock gave a speech outlining her latest thinking on the economy and inflation before the release of the CPI. She noted that 'there's evidence that domestic demand and labour market conditions have been easing as required to bring the economy back towards balance'. This inflation print will give the RBA further assurance that this assessment is correct and higher input costs are not translating into broader inflation pressures. It also gives them some breathing room to wait for more data. Financial markets have reached a similar conclusion, with any chance of an August hike removed and the market pricing around a 50% chance the RBA hikes at all over the next year. 

However, we do not expect the central bank to be content. While the June CPI print was encouraging, it would be premature to assume inflation risks have fully subsided. The oil shock will take time to fully play out, and some businesses will look to recoup the hit to their margins where possible. Indeed, our forecast includes some pass-through from businesses in the September quarter. The recent flare-up between the US and Iran adds uncertainty to the outlook, as a more protracted period of elevated oil prices would see businesses forced to pass on higher costs. All of these factors leave room for upside surprises to inflation going forward.

Ultimately though, we expect the softening in conditions generated by three rate hikes and a housing market in decline will mean inflation pressures do gradually decline. Our forecast is for annual trimmed mean inflation to ease to 3.4% by the end of the year and to return to the target band in the second half of 2027. With policy already in restrictive territory, the RBA should be able to remain on hold over the next year.