Statement on Monetary Policy – November 2007 Inflation Trends and Prospects

Recent developments in inflation

The headline rate of CPI inflation has been highly volatile over the recent period. After peaking at 4 per cent in mid 2006, CPI inflation fell to 1.9 per cent in the year to the September quarter, and it is likely to pick up markedly over the next two quarters. These large movements mostly reflect changes in the prices of just a few items during the past year, notably fruit and petrol prices. Given this volatility, it is important to look at measures of underlying inflation to get a better sense of the trend in inflation. Based on a range of measures, underlying inflation appears to have been around 0.9 per cent in the September quarter, similar to the outcome in the June quarter, and to have been running close to 3 per cent over the past year (Table 14, Graph 72).

Headline inflation was 0.7 per cent in the September quarter. The largest positive contributions came from fruit & vegetable prices, housing costs, financial service costs, and holiday travel & accommodation prices. Retail petrol prices declined in the quarter; the increase in world crude oil prices was more than offset by the appreciation of the Australian dollar and a fall in refinery margins. In addition, child care costs made a significant negative contribution in the quarter due to a change in the treatment by the ABS of the government's child care rebate. Overall, there was broad-based strength in inflation; measured by expenditure weights, the share of items in the CPI that grew at an annualised rate of more than 2.5 per cent remained above 60 per cent in the September quarter (Graph 73).

Non-tradables inflation increased to 1.1 per cent in the quarter, driven in part by higher rents and house purchase costs. In year-ended terms, non-tradables inflation rose slightly, to 3.5 per cent; these outcomes would have been around 0.3 percentage points higher in the absence of the change in the treatment of the child care rebate. Excluding petrol and food, tradables prices were broadly flat in the quarter, to be 0.6 per cent higher over the year (Graph 74). It is likely that tradables inflation is being held down somewhat by the appreciation of the exchange rate over recent years, especially the appreciation that has taken place since early 2007.

Producer prices increased at a solid pace in the September quarter. Final-stage prices increased by 1.1 per cent in the September quarter, although the year-ended rate remained broadly steady at 2.4 per cent. Excluding oil, domestic producer price inflation remained high at 4.0 per cent over the year, driven by strong price increases in the construction sector and in property services (Graph 75). In contrast, import prices fell in both the quarter and over the year, partly reflecting the appreciation of the exchange rate.

Labour costs

Consistent with the strong labour market conditions, the pace of growth in wages has been firm. The wage price index (WPI) grew by 1.1 per cent in the June quarter, to be 4.0 per cent higher over the year, around the same year-ended pace that has prevailed during the past two years (Graph 76). Broader indicators of wages growth, as measured by the national accounts, have been somewhat stronger – and in the upper range of recent experience – although these measures have historically been volatile. Average earnings from the national accounts – which include both wage and non-wage labour costs – rose by a strong 2.2 per cent in the June quarter, to be 5.5 per cent higher over the year. Private-sector surveys of firms also suggest the pace of labour cost growth has gradually increased over recent years (Graph 77). However, with the national accounts suggesting a pick-up in productivity growth in recent quarters, it is likely that the growth in unit labour costs is less than indicated by the pick-up in the broader measures of labour costs.

Inflation expectations

Based on a number of measures, inflation expectations in the economy remain relatively high. According to private-sector surveys, the proportion of businesses expecting to increase prices in the near term has picked up, to be above long-run average levels. The Melbourne Institute survey of households reports that the median expectation for consumer price inflation over the year ahead averaged 3.8 per cent over the three months to October, well above the average expectation over the inflation-targeting period. Market economists surveyed by the Bank following the release of the September quarter CPI have also increased their near-term inflation forecasts. The median expectation for headline inflation over the year to the June quarter 2008 is now 2.9 per cent, up from 2.7 per cent in August (Table 15). Union officials' inflation expectations have remained stable at 3 per cent.

Inflation outlook

The outlook for growth in demand and output is broadly similar to that presented in the previous Statement. The most recent data indicate that the economy had more momentum than expected through the middle of 2007. On its own, this pushes up forecasts for near-term growth. But forecasts for global growth have been revised down, and some market-driven tightening of credit conditions in addition to the rise in the cash rate has occurred. Over time, these will act in an offsetting direction.

Growth in domestic demand should slow from its recent above-trend pace over the next couple of years, with tighter financial conditions trimming private spending, and public spending growth moderating if the assumptions in the MYEFO projections for federal and state spending are borne out. Export growth should pick up as increased capacity in the resource sector comes on stream, and as the contractionary effect of the drought on rural exports eventually abates. With the forecast recovery in the farm sector now delayed and more gradual, overall GDP growth could be 3¾ per cent over 2007/08 and 3½ per cent over 2008/09. Non-farm GDP should expand at an annual rate of about 3½ per cent over the forecast period. Given that this includes a significant contribution from the resources sector, this rate of non-farm output growth would allow pressures on capacity in the non-resource sectors of the economy to begin to ease, though only quite slowly.

Recent quarterly inflation outcomes have been a little higher than forecast, after a period in late 2006 and early 2007 when they were surprisingly low. In the near term, given tight capacity conditions in many sectors, the recent inflation pressures are likely to persist. Given the recent pattern of quarterly outcomes, both CPI inflation and underlying measures are likely to rise above 3 per cent on a year-ended basis over the next two quarters.

Over the medium term, upward pressure on the inflation rate should diminish, helped in part by the rise in the exchange rate, assuming it is sustained, and some moderation in the pace of demand growth. But with demand growth still close to trend, and pressure on capacity only diminishing gradually, inflation is unlikely to decline far. Underlying and CPI inflation are accordingly both forecast to be close to 3 per cent during 2008 and 2009 (Table 16).

Risks to this forecast can be identified in both directions. Global growth could slow by more than assumed, if the US economy weakens significantly further, and/or global credit markets take a significant turn for the worse. The impact on Australia would probably be more serious if China's economy slowed abruptly as well, though in that case, the exchange rate could well decline significantly, which would lessen the impact both on growth and prices.

On the other hand, inflation could prove more difficult to contain and reduce than forecast here, especially if demand in Australia did not moderate as much as expected, if higher headline inflation added to wage and price expectations, or if firms' price setting was more responsive to tight capacity conditions than it has been to date.