Statement on Monetary Policy – May 2008 Price and Wage Developments

Recent developments in inflation

The CPI outcome for the March quarter showed a continuation of the high inflation observed in the second half of 2007. The CPI increased by 1.3 per cent in the quarter and by 4.2 per cent over the year. The largest contributors in the quarter were increases in automotive fuel, housing costs, food, financial & insurance services, and seasonal increases in electricity, health and education costs, offset partly by falls in the prices of clothing and household goods. A range of measures suggest that underlying inflation increased to around 1.2 per cent in the quarter, and to more than 4 per cent over the year (Table 11, Graph 68).

The strong inflation outcome over the quarter and the rising trend over the past year have reflected broad-based price pressures. At the geographic level, all capital cities have recorded inflation outcomes of 3½ per cent or more over the past year, for both CPI and trimmed mean inflation (Graph 69).

Inflation has also been broad-based when looking across the different items in the CPI. There are a number of factors that help to explain the recent price increases for some groups. For example, the 19 per cent annual increase in petrol prices reflects the pick-up in world oil prices, partly dampened by the appreciation of the exchange rate; the increase of nearly 6 per cent in food prices partly reflects the impact of the drought and global food price rises; the 7 per cent increase in rents reflects the current low vacancy rates; and the 7 per cent increase in financial services prices reflects that rising house prices have boosted real estate fees and that mortgage rates have risen by more than household deposit rates. Nevertheless, looking across the broad expenditure groups in the CPI, seven of the eleven groups (representing three-quarters of the CPI by weight) have grown by significantly more than 2½ per cent per annum over the past two years, with the groups that have grown more slowly being ones where prices have been held down by global trends, including the effect of China and other emerging economies on the prices of manufactured goods (Graph 70).

Dividing the CPI into ‘tradables’ and ‘nontradables’ items shows that a large number of non-tradable items have recorded significant price increases. Overall non-tradables prices (which are primarily services) increased by 1.7 per cent in the quarter and by 5.3 per cent over the year (adjusted for the changes to the treatment of the child care rebate in mid 2007), its fastest year-ended pace since September 1991 (Graph 71). Nearly 90 per cent of non-tradables prices (by expenditure weight) have grown by more than 2.5 per cent over the past year (Graph 72). While tradables prices increased by 3.3 per cent over the year, much of this reflected higher fuel and food costs; excluding these volatile items, year-ended tradables inflation was 0.6 per cent. Inflation for this group of tradables (representing around one-quarter of the CPI) has been below 1 per cent for more than five years, reflecting the trend appreciation of the exchange rate and global developments in the prices of manufactured goods.

Costs and margins

The broad-based nature of the current price pressures reflects the high level of capacity utilisation in the economy, strong growth in labour costs and other input prices, and the increase in inflation expectations over the past year.

Labour costs have continued to increase solidly, due to the tight labour market and shortage of suitable labour. The wage price index (WPI) rose by 1.1 per cent in the December quarter, with year-ended growth at 4.2 per cent, which is around the highest rate seen over the ten-year history of this series (Graph 73). Within the overall WPI, year-ended growth for the private sector picked up to reach 4.3 per cent, its fastest pace of growth in the series' history (Graph 74). Private sector WPI growth has steadily increased over the past three years, consistent with business surveys and the Bank's liaison. Average earnings as indicated by the national accounts – a broader measure of labour costs than the WPI – were unchanged in the December quarter but were up by 4.6 per cent in year-ended terms. In trend terms, which abstracts from the volatility in this series, annual growth in average earnings remained around 5 per cent.

Upstream cost pressures intensified in the March quarter, according to the producer price index. Final-stage prices increased by 1.9 per cent in the quarter, to be 4.8 per cent higher over the year; this is the largest quarterly increase since the series began in 1998. The sharp increase in the quarter partly reflected increases in oil prices, which intensified in the early part of the June quarter; the price of Tapis recently reached a record high of US$126 per barrel, following a number of supply disruptions. However, prices of non-oil, final-stage producer goods and services also increased significantly. The strength was broad-based across different sectors, with the largest contribution coming from the construction sector, which includes both housing and non-residential construction costs (Graph 75). Prices of manufactured goods and transport & storage services picked up markedly, while growth in property and business services costs remained high.

Notwithstanding the strong growth in input costs, business margins appear to have remained strong, consistent with the strength of demand. Estimates based on ABS profits data suggest that margins in both the broader economy and goods distribution sector – which includes retail and wholesale trade and transport – were at comparatively high levels in the December quarter (Graph 76). The NAB survey reports that the net balance of respondents increasing margins has been somewhat above average in recent quarters, although this has been a volatile indicator. The Bank's liaison also suggests margins have expanded over recent quarters.

Inflation expectations

Inflation expectations remain relatively high. Business surveys report that the proportion of businesses expecting to increase prices in the near term remains above long-run average levels (Graph 77).

The median expectation for consumer price inflation for the year ahead, as measured by the Melbourne Institute survey of households, was high in April at 4.3 per cent. This measure has exceeded 4 per cent for seven consecutive months, well above the average expectation of around 3 per cent over the inflation-targeting period. Market economists surveyed by the Bank following the release of the March quarter CPI have also increased their inflation forecasts. The median expectation for headline inflation over the year to the June quarter 2009 is now 3.0 per cent, up from 2.8 per cent in February (Table 12). Over the year to the June quarter 2010, the median inflation expectation is 2.8 per cent. In addition, union officials have increased their inflation expectations.