Inflating inflation surprises

Principal Economist’s View

 

One of the biggest factors driving global markets over the past three years has been inflation, or more importantly the lack of it. It has been a key reason for the continued accommodative monetary policy pursued by global central banks, which has supported economic activity, held down bond yields and helped push equity markets higher.  

We, like most forecasters, have at times been surprised by some of the inflation prints seen in the past year. After all, monthly and quarterly price movements can be notoriously volatile. However, let’s put these forecast misses in context by comparing the 2017 inflation results from predictions formed at the start of the year. By simply reading the press, the impression that you may get is that economists have been well off the mark in predicting inflation over 2017. The evidence tells a different story.    

In the US, headline CPI inflation averaged 2.1% in 2017, compared to our forecast at the start of 2017 for a 2.2% inflation rate (and a Consensus estimate of 2.4%). In the euro area and the UK, our January 2017 forecasts were in-line with the eventual outturns at 1.5% and 2.7% respectively (compared to a Consensus estimate of 1.4% and 2.5% respectively). In Australia, inflation has averaged 2% over the first three quarters of 2017, compared to our full-year forecast of 2.1% formed back in January 2017 (Consensus estimate was also 2.1%).   

Rather, the surprise has really been limited to core inflation in the US, where a few one-off price movements (particularly for mobile phone plans and prescription drugs) led core CPI inflation to average 1.8% in 2017 (vs our estimate from the start of the year of 2.2%). In contrast, the core inflation outturns in the euro area and the UK (1.0% and 2.4% respectively) have been within 10bps from our forecast produced in January 2017, while the core CPI inflation rate in Australia over the first three quarters of 2017 has been in-line with our full-year forecast of 1.8%.

This evidence clearly highlights that inflation outturns in 2017 have not been that far from our expectations, except for core inflation in the US. Next week, we receive the last key inflation print for 2017, Australia’s Q4 consumer price index. We expect the headline CPI will increase 0.7% over the December quarter, pushing the year-ended inflation rate up from 1.8% to 2.0%.

Inflation over the quarter is expected to be boosted by an 8.2% increase in petrol prices and a 7.4% lift in tobacco prices due to higher excise taxes introduced in September. These two components alone will add 40bps to the quarterly inflation rate. A rebound in fruit and vegetable prices (+3.9%), higher domestic travel and accommodation costs (+6.0%) and higher insurance costs (+1.9%) will also push inflation higher. However, ongoing discounting by retailers will see price declines for clothing and footwear, furnishings and household equipment.

With subdued wage growth, an appreciating Australian dollar and heightened competition constraining price increases in many consumer-focussed industries, Australia’s core inflation measures will remain benign. We expect core inflation to rise around 0.4-0.5% over the December quarter, leaving the year-ended core inflation rate unchanged at 1.9%.

If we don’t receive any surprises next week, the Q4 CPI will have little near-term monetary policy implications. Core inflation remains below the RBA’s 2-3% target range and our estimate is roughly in-line with the Bank’s expectations. Nonetheless, such an outturn would provide further evidence that the Australian economy is gradually on the mend. Core inflation would have consistently improved from the 1.5% pace seen in 2016, a period which required the RBA to cut interest rates to a record low of 1.5%. 

With the global economy recovering, oil prices moving higher and conditions in the Australian labour market turning the corner, prospects for a further gradual increase in core inflation remain in place. Based on our recently finalised January 2018 global forecasts, Australian core inflation is expected to edge up to 2.0% by Q3 2018 and 2.1% in Q4 2018. Increased confidence in the global and domestic outlook, signs of improving wage growth and inflation back in the target range should be sufficient for the RBA to contemplate gradually reducing its accommodative monetary policy settings. As such, we retain our long-held view that the RBA will lift rates by 25bps in Q3 2018.  

 Table 1: Financial market movements, 18 - 24 January 2018

Equity index

Level

Change

10-yr government bond

Yield

Change

Foreign exchange

Rate

Change

S&P 500

2,837.5

1.4%

US

2.65%

2.1 bps

US Dollar Index (DXY)

89.21

-1.4%

Nikkei 225

23,940.8

0.7%

Japan

0.08%

0.0 bps

USD-JPY

109.22

-1.7%

FTSE 100

7,643.4

-0.7%

UK

1.41%

7.7 bps

GBP-USD

1.424

2.5%

DAX

13,414.7

1.0%

Germany

0.59%

1.5 bps

EUR-USD

1.241

1.4%

S&P/ASX 200

6,054.7

0.7%

Australia

2.83%

1.7 bps

AUD-USD

0.806

0.8%

Source: Bloomberg

 

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