THE BIG PICTURE: Inflation numbers will decide interest rate movements

Inflation is back in the spotlight in the coming week. Given that the price readings are only done once a quarter, not monthly like in most countries, it is understandable that the figures will command attention. (By the way, the RBA is pushing for monthly consumer price figures, but we’ll have to see how that goes).

It’s important to note that the Reserve Bank doesn’t just look at the bottom-line (or headline) CPI measure. No, it actually looks at seven measures each quarter. And that’s because prices tend to be volatile, so the Reserve Bank wants to be sure that it’s the strength of the underlying economy that is causing price pressures to rise (or fall), not just one-off factors like petrol, fruit or vegetables.

There are three measures of underlying inflation that the Reserve Bank focuses on. Two are so-called statistical measures – the weighted median and trimmed mean. These measures are constructed basically by removing more volatile components of the CPI to get a sense of what prices generally are doing.

The third measure is one of the exclusion measures – that is, parts of the CPI are removed from the calculation. It goes by the title of the CPI less volatile items (fruit, vegetables and petrol) and deposit and loan facilities or CPIX.

The headline CPI is currently growing at a 2.9% annual pace while the average of the three underlying measures stands at 3.0%. Courtesy of one-off measures like the hike in tobacco excise, the Reserve Bank expects headline inflation to rise “to a little above 3%” in the June quarter. And the Bank tips the underlying rate “to be below 3% for the first time in three years.”

Economists generally expect headline inflation to have risen by between 0.7-1.1% in the June quarter, meaning annual inflation will lift to between 3.1-3.5%. Overall the RBA would be happy with a result of 0.9-1.0% or below. For underlying inflation to meet its forecast, the Bank would want to see quarterly growth of 0.8% or below – unless of course the statistical measures for previous quarters are revised – it does happen.

A 0.9% result for underlying inflation would mean that the annual rate creeps up from 3.0% to 3.1% – hardly a disaster. So don’t immediately assume rates are going up with a 0.9% lift in underlying inflation – as always the Reserve Bank will be slicing and dicing the figures to makes sure no rogue element has been responsible for underlying inflation remaining just outside the preferred 2-3% target band.

The week ahead

There is no doubt that inflation dominates centre-stage in the coming week. Data on business inflation (producer prices) is released on Monday while the more important consumer price index is slated for Wednesday.

As noted above, currently the headline rate of inflation stands at 2.9% while the Reserve Bank says that underlying inflation is around three%.

The headline rate of inflation in the June quarter would have been boosted by seasonal increases in medical fund premiums, a 25% lift in the excise tax on tobacco and higher costs of home purchase and deposit and loan facilities. The petrol price rose by 1.4% in the quarter, adding just 0.05 percentage points to the CPI growth rate, down from 0.2pp in the March quarter. But factors restraining the inflation rate in the quarter include broad discounting by retailers, cheaper electrical goods (courtesy of a firmer currency), cheaper discount airfares and falls in fruit and vegetable prices.

Overall we expect that headline inflation lifted by around 1% in the quarter, pushing the annual rate up to 3.4%. The underlying rate probably rose by around 0.7% with annual inflation around 2.9%.

The other events to watch over the week include the Housing Industry Association’s trades report (Tuesday), the HIA’s new home sales report (Thursday) and private sector credit and the RP Data /Rismark home price report (both on Friday). Given the focus on population growth by all sides of politics at present, Bureau of Statistics figures on migration to be released on Thursday are also worth a look.

We expect that private sector credit (lending) edged up by 0.4% in June, lifting the annual growth rate from 2.7% to 3.0%. And judging by anecdotal information, home prices probably recorded more orderly growth in the latest month with the annual rate likely easing to the 11.5-12.0% range.

In the US there is a healthy spattering of economic data over the week. On Monday new home sales data is released together with the Chicago Fed index. On Tuesday the Case Shiller home price series is released alongside consumer confidence and the Richmond and Chicago regional manufacturing gauges. On Wednesday orders for durable goods are released together with the Federal Reserve Beige book summary of economic conditions. And on Friday the first estimate of economic growth in the June quarter is issued alongside the employment cost index and Chicago purchasing managers index.

Overall, economists are tipping another uninspiring set of numbers, indicating that the economy is still finding it hard to get some momentum. Home sales may have lifted 6-7% in June from record lows, home prices were probably flat in the month and consumer confidence is tipped to ease in line with the recent fall in the University of Michigan measure. And durable goods may have merely recovered the ground lost in May.

But the GDP (economic growth) report may be reason for some cheer. While Americans remain downbeat, the economy was probably tracking along at a near 3% annual rate in the June quarter, or close to the ‘normal’ pace. This follows data showing GDP growing at a 2.7% annual rate in the March quarter. If Americans chose to put the global financial crisis behind them and get on with business then the world as a whole would be thankful.

Sharemarket

The US corporate earnings season continues in the coming week with more than 730 companies to report. To date companies have been beating consensus earnings forecasts, and generally by a comfortable margin. But where the problems are occurring is the next line of detail – the revenues and expenses. Companies have generally been successful in cutting costs but revenues are a different matter – restrained by budget-constrained consumers and cautious businesses. Still, if companies are making money and balance sheets are improving, then they will have scope to invest, hire and acquire in coming months. And if companies don’t put the pile of cash to work then investors would be justified in seeking to put the money to work elsewhere in the market.

Among the US companies to report on Tuesday are: BP, DuPont, Office Depot, Lockheed Martin and US Steel. Wednesday: Conoco Phillips, Boeing, Visa. Thursday: Colgate-Palmolive. Friday: Merck and Chevron.

Interest rates, currencies & commodities

If you want to know where the Aussie dollar is headed, follow the sharemarket, as the relationship between the two has been very precise since the start of the year. In fact, the correlation (or measure of relationship) between the All Ordinaries and the Aussie dollar (against the US dollar) stands at 0.85, where a ratio of 1.0 would indicate a perfect relationship. And the correlation is actually even stronger at present than that between the Aussie dollar and a key gauge of commodity prices – the Commodity Research Bureau index (ratio of 0.79).

Australian wheat growers – especially in the east – have reason to be positive at present. Seasonal conditions remain favourable, suggesting that the coming crop could be near 22 million tonnes – the best in five years, although down from the record crop in 2003/04 (26.2Mt). But at the same time, wheat prices are lifting, not falling, reflecting the dry conditions in the Northern Hemisphere. The wheat price has risen almost 36% from the early June lows and is up almost 13% on a year earlier. And despite the vagaries of the currency the wheat price is also up 4% on a year ago in Australian dollar terms.

Craig James is chief economist at CommSec.