Statement on Monetary Policy – August 2006 Inflation Trends and Prospects

Recent developments in inflation

Based on a range of measures, the Bank's assessment is that underlying consumer inflation edged up to around 0.9 per cent in the June quarter and to a little below 3 per cent over the year to the June quarter. Most measures of underlying inflation were higher than they were six months ago. There has been a similar pick-up in underlying inflation in most industrial countries, reflecting the gradual erosion of spare capacity in the world economy.

The increase in the headline Consumer Price Index (CPI) was larger, at 1.6 per cent in the June quarter and 4.0 per cent over the year (Graph 49, Table 15). The index was substantially boosted by sharp increases in both petrol prices (due to higher world oil prices) and fruit prices (due especially to the effect of Cyclone Larry on banana prices); each of these added around ½ percentage point to inflation in the quarter. The rise in banana prices will be temporary and should be fully reversed by mid 2007. In addition to the increases in petrol and fruit prices in the June quarter, there were significant increases for hospital & medical services, and a number of clothing & footwear categories. At the other end of the distribution, prices fell for audio, visual & computing equipment, domestic travel costs, and motor vehicles. More generally, a larger than usual proportion of items – nearly 70 per cent – grew at an annual rate of above 2.5 per cent (Graph 50).

Non-tradables inflation picked up a little, to be 3.4 per cent over the year to the June quarter, after trending down over the previous two years as house-building costs moderated (Graph 51). Tradables prices rose by 4.8 per cent over the year to the June quarter, but this was concentrated in petrol and food prices; the increase was 0.2 per cent excluding these items. With the exchange rate having been relatively steady for more than two years, the prices of tradables are no longer being affected by the significant exchange rate appreciation of 2002–2003. Instead, the low level of tradables inflation appears to reflect longer-term global factors, including the increasing importance of low-cost goods from China and other emerging markets in Australia's imports.

Producer price data for the June quarter were consistent with continuing upstream inflation pressures (Graph 52, Table 16). Prices at the final stage of production rose by 1.6 per cent in the quarter, compared with an increase of 0.7 per cent in the March quarter, to be 4.5 per cent higher over the year. The pick-up was seen in both the domestically produced and imported components, even after excluding the contribution of higher oil prices. Quarterly price growth was also higher at the preliminary and intermediate stages of production, largely reflecting increases in oil and base metal prices. Liaison has particularly highlighted cost pressures from rising prices of fuel and oil derivatives, such as plastics and packaging, and an increasing share of firms is reporting an intention to pass on these cost increases in an effort to recover margins.

Labour costs

Data for the March quarter suggest that growth in wages remains firm. The wage price index (WPI) rose by 0.9 per cent in the quarter, and by 4.0 per cent over the year, a rate that is somewhat higher than its average over the past few years (Graph 53). Wage increases for new federal enterprise bargaining agreements (EBAs) have been volatile as a result of compositional changes, but the average figure for currently active agreements is also higher than its average in recent years. Both data sources point to some divergence between outcomes in the public and private sectors. According to the WPI, wage growth has eased somewhat in the public sector after a period when measured growth had been fairly high, while growth for the private sector has remained somewhat above average levels, at 4.0 per cent in the year to the March quarter. Overall, the evidence from these data is that wage growth has increased over the past few years, though it has been more stable recently.

Business surveys and the Bank's liaison program continue to suggest that labour shortages are leading firms to use a range of non-wage incentives to attract and retain staff. These include bonus payments, more frequent promotion rates and more attractive work arrangements. One sign of this in the official data is that when bonuses are included, the WPI increased by 1.2 per cent in the March quarter. Total labour cost pressures therefore appear to be stronger than is recorded in those official wage measures which do not capture these forms of compensation. This is especially apparent in resource-related and non-residential construction industries, particularly in Western Australia, but solid labour cost growth is evident in most industries.

Inflation expectations

Business surveys are providing a mixed picture about inflation expectations. The June quarter ACCI-Westpac survey of manufacturing firms and Dun & Bradstreet survey both suggested that the net balance of respondents expecting to raise prices in the near term was below the average level over the inflation-targeting period. However, the AIG survey of manufacturing indicated that businesses were facing increased input cost pressures, with an above-average proportion of firms reporting actual and expected increases in their selling prices.

Market economists surveyed by the Bank following the release of the June quarter CPI increased their forecasts of CPI inflation over the year to the December quarter 2006, with the median expectation rising by 0.7 percentage points to 3.6 per cent (Table 17). This almost entirely reflects a stronger rise in inflation in the June quarter than they had earlier anticipated. The median forecast of the market economists for headline inflation over the year to December 2007 remained at 2.6 per cent. Union officials' inflation expectations are a percentage point higher than six months ago.

The Melbourne Institute survey indicates that the median expectation for consumer price inflation over the coming year was 4.1 per cent in July, which is above the average over the inflation-targeting period. The implied medium-term inflation expectations of financial market participants, as measured by the difference between nominal and indexed bond yields, has continued to drift higher over recent months, to be just under 3½ per cent in early August. However, this measure probably overstates market inflation expectations: yields on indexed securities may have been held down by some specific factors that are unrelated to expectations about inflation. In particular, institutional demand has increased in the face of unchanged tight supply.

Inflation outlook

Although headline inflation rose sharply in the June quarter, much of this increase resulted from large increases in the prices of particular items, notably petrol and fruit. Looking through this volatility, measures of underlying inflation picked up, confirming the upward shift in underlying inflation that was apparent in the March quarter data. The pick-up appears to reflect a number of factors, including higher input cost pressures, ongoing solid growth in total labour costs, and the strengthening in consumer demand that was apparent in the March quarter national accounts and seems to have been maintained in the June quarter.

These factors are likely to continue to result in firm outcomes for underlying inflation for some time. The Bank's forecasts assume that oil prices and the exchange rate remain around current levels through the forecast period to the June 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 remain close to recent highs in the near term, before falling by around 10 per cent by the end of the forecast period. The forecasts envisage that GDP growth over the next year or so will be around 3½ per cent, somewhat higher than previously expected, largely reflecting the strengthening that has been apparent in a range of recent data. Growth is then expected to moderate slightly, a result of both some easing in the impetus from the terms of trade and some dampening impact from the two recent increases in the cash rate.

While underlying inflation has been increasing recently, the central forecast is that it will remain broadly stable over the forecast period, at around 3 per cent, with a number of factors helping to contain inflationary pressures. On the external side, the forecast assumes no further increases in the world prices of oil and other commodities. On the domestic side, the two recent interest rate increases should help to contain demand and inflation pressures. Although the labour market is likely to remain tight, wages growth is expected to remain stable. The annual rate of CPI inflation is likely to remain around 4 per cent in the short term, but should then decline as the effect of recent increases in petrol prices passes. Indeed, the unwinding of the recent pick-up in fruit prices is likely to result in CPI inflation being below underlying inflation in early 2007.

The risks to the inflation forecast appear evenly balanced. On the external side, there is the possibility of a larger than expected slowing in the global economy. On the other hand, there are upside risks associated with the domestic economy operating close to capacity. Most importantly, the current high level of headline inflation may lead to some pick-up in inflation expectations. However, with the two recent increases in the cash rate, monetary policy has been adjusted in response to these risks, and the flow of data over the next few months will give a clearer indication of the extent to which inflationary pressures are likely to remain contained.