Statement on Monetary Policy – November 2006
Inflation Trends and Prospects
Recent developments in inflation
The Consumer Price Index (CPI) rose by 0.9 per cent in the September quarter and by 3.9 per cent over the year (Graph 63, Table 14). While headline inflation was boosted by further increases in banana and other fruit prices due to the impact of Cyclone Larry, there were also significant increases in property rates & charges and water & sewerage prices. Although prices fell for some items, such as vegetables, petrol and pharmaceuticals, the proportion of items growing above an annual rate of 2.5 per cent stood at over 60 per cent (Graph 64). Based on a range of measures, the Bank’s assessment is that underlying inflation was around ¾ of a per cent in the September quarter and 3 per cent over the year to the September quarter, up from a rate of around 2½ per cent through 2005.
Non-tradables inflation has remained above its medium-term average rate, running at around 3½ per cent over the year to the September quarter (Graph 65). This is somewhat lower than the peak reached in 2003 when house-building costs were growing rapidly, but in recent quarters non-tradables inflation appears to have stopped falling. Excluding the effects of food and petrol, tradables inflation was 0.4 per cent in the year to the September quarter. It has gradually increased over the past two years, and is no longer being held down by the appreciation of the exchange rate over 2002 and 2003. It is possible that the pick-up also reflects some waning in global disinflationary forces.
Producer price data suggest that upstream inflation pressures remain strong. Final-stage prices rose by 1.0 per cent in the quarter, to be 4.0 per cent higher over the year. Year-ended manufacturing price inflation (excluding oil) remained high (Graph 66). Output prices were also firm for the construction and transport sectors, and picked up in the property & business services sector.
Recent indicators show that wage growth remains above its average of recent years, though it has not accelerated further in the latest year despite high labour demand. The wage price index (WPI) grew by 1.1 per cent in the June quarter, and by 4.1 per cent over the year, similar to the growth observed over the previous year (Graph 67). In addition, weighting new agreements by each industry’s share of overall employment, the average annualised wage increase for federal enterprise bargaining agreements (EBAs) certified in the June quarter was little changed from recent quarters. In the private sector, wages growth in the mining, construction and utilities industries has picked up of late, consistent with robust activity in those areas of the economy.
The Australian Fair Pay Commission announced its first wages decision on 26 October. It awarded an increase of around $27 a week to the federal minimum wage and award wage workers earning less than $700 per week, and $22 for award workers earning over that amount, starting from December 2006. This is equivalent to an annualised increase of around 3¾ per cent for minimum wage earners, and around 2¾ per cent for all award workers, once the 18-month period since the last wage increase is taken into account.
Business surveys and the Bank’s liaison program continue to point to high labour demand and shortages of skilled labour. According to the NAB survey, concerns about the availability of suitable labour intensified further in the September quarter and this remains a greater constraint on firm activity than the more traditional concern of lack of demand (Graph 68). These conditions are prompting firms to offer a range of non-wage incentives to attract and retain staff.
Recent business surveys suggest that the proportion of businesses expecting to increase their prices is significantly above the long-run average. While it is difficult to draw strong conclusions about inflation expectations from these data given their high volatility, they suggest price pressures are firm.
Market economists surveyed by the Bank following the release of the September quarter CPI mostly left their forecasts unchanged for the year to the June quarter of 2007, with a median forecast of 2.7 per cent (Table 15). They also continue to expect headline inflation to be in the middle of the target band in June 2008. Union officials have reduced their expectations somewhat, but expectations still remain above their longer-term average.
According to the Melbourne Institute survey of households, the median expectation for consumer price inflation over the coming year fell back to 3.4 per cent in October. Although this is slightly higher than the average over the inflation-targeting period, it is lower than its June quarter high, in line with the recent easing in fuel prices. The implied medium-term inflation expectations of financial market participants, as measured by the difference between nominal and indexed bond yields was around 3¼ per cent in early November. However, as noted in previous Statements, this measure can be affected by factors unrelated to expectations about inflation, such as changes in institutional demand for indexed securities.
The effect of the drought
Wheat prices have risen recently due to forecasts of reduced crop sizes in Australia and elsewhere. Reports have suggested that the prices of a range of foods will be driven up by the drought, including products that rely on wheat as an input, and fruit and vegetables that rely on irrigation. However, historically, the net effect of droughts on the CPI has been relatively small. Over the four previous droughts, average food prices did not rise by more than the prevailing rate of inflation (Graph 69).
There are several reasons why droughts have historically had relatively small effects on consumer price inflation. First, many food items can be imported in the event of shortfalls in domestic production, limiting the effect on domestic prices. Second, the contribution of commodity prices to final retail food prices is often small. For example, in the 2002/03 drought there was a significant run-up then a significant fall in wheat prices but the movements in bread prices were much smaller. Finally, while cereal prices generally rise during a drought, meat prices tend to fall initially as slaughter rates rise in response to the dry conditions; the latter effect could, however, diminish as a drought persists. At this stage, the net effect on the CPI from the current drought is expected to be fairly small in coming quarters.
While headline inflation remained close to 4 per cent over the year to the September quarter, this rate was significantly boosted by earlier sharp increases in petrol and fruit prices. Nonetheless, looking through the volatility in these prices, underlying quarterly inflation outcomes in 2006 have been above the levels seen in 2005. The proportion of CPI items rising by more than the mid-point of the target band has remained high and business surveys indicate that a larger-than-average share of firms are reporting increasing prices.
The Bank’s forecasts assume that oil prices and the exchange rate remain around current levels through to the end of the forecast period (December quarter 2008), and that global growth remains above trend but slows in line with the path implied by Consensus forecasts. The terms of trade are expected to gradually decline by around 10 per cent over the forecast period. The forecasts envisage GDP growth will be held down somewhat by the drought over the next year, with a modest pick-up to around 3¼ per cent thereafter. While exports of raw materials should grow strongly, and the house-building sector is expected to recover gradually, growth in consumer demand is expected to remain moderate and growth in investment is expected to slow from recent very high rates.
With only a modest easing in capacity constraints expected over the forecast period, the generalised price pressures currently evident in the economy are likely to continue in the near term. The central forecast is that underlying inflation will remain at around 3 per cent over the next year. Thereafter, it may decline slightly but is likely to remain near the top of the target band. This forecast takes into account the November cash rate increase and assumes some easing in world inflationary pressures reflecting the recent decline in oil prices and the modest slowing in global growth. On the domestic side, wage growth is expected to remain around current rates. However, the recent interest rate increases should contribute to containing demand and inflation pressures, and a pick-up in productivity growth should help to expand capacity and contain unit labour costs. Headline inflation will be significantly reduced by movements in petrol and fruit prices over the next year, with petrol prices having fallen markedly in the December quarter to date and fruit prices expected to fall significantly with the return to more normal banana supply from around the end of the year. It should then rise again to be the same as underlying inflation by the middle of 2008.
The risks to the inflation outlook on the external side include the possibility of a larger-than-expected slowing in the global economy. On the other hand, there is some upside risk to domestic price pressures as the economy continues to operate at close to capacity. In addition, there is some risk that the current high level of headline inflation will result in a sustained higher level of inflation expectations, although the recent increases in the cash rate and the projected decline in headline inflation in coming quarters should mitigate this risk.