THE WEEK AHEAD: All eyes on inflation

It would be a far less complicated world if there was just one measure of inflation. But unfortunately there isn’t. While the general public focuses on the consumer price index to get a handle on inflation, policymakers and other boffins closely track a myriad of other measures to try and understand what the ‘true’ rate of inflation really is.

It is understandable that the Reserve Bank wants to dig much further beneath the surface on the inflation issue. Prices tend to be volatile, especially for petrol and fresh food. The central bank must be sure that it is changing interest rates in response to true shifts in inflation.

Currently the published or ‘headline’ rate of inflation stands at 1.5%, and it probably fell even further to decade lows of 1.2% in the September quarter. Inflation is super-low because petrol and food prices have been falling while lower interest rates have reduced the cost of financial services.

Still, if you strip out ‘volatile’ items like petrol and food, then inflation stands at 2.5% – in the middle of the 2-3% target band. The same measure for ‘market goods and services’ (MGSX) stands at 2%.

There is yet another measure of inflation that excludes housing and financial services. That inflation measure stands at 1.4%. And still yet another inflation measure focuses on non-tradables, that is prices of goods and services that depend on Australian-specific factors. That inflation measure stands at 2%.

All these measures suggest no inflation problem. But then there are two ‘statistical’ measures that the Reserve Bank watches closely. The ‘weighted median’ measure of inflation stands at 4.2% with ‘trimmed mean’ at 3.6%. These inflation measures have been above 3% for the past two years as opposed to the MGSX measure that only strayed outside the inflation target during 2008.

Has the Reserve Bank got it wrong by focusing on these ‘statistical’ measures? Perhaps. But while these measures aren’t targeted by central banks across the globe, Reserve Bank boffins vigorously defend the use of these measures in Australia. So if they’re wrongly focused on the measures, they will be loathe to admit it.

High housing costs (especially rents) have introduced an upward bias into the statistical measures in recent years, driven by a shortage of housing stock. Fortunately that imbalance is slowly being addressed. And the other key issue is a reduction in business competition in Australia, keeping prices high.

The Reserve Bank will rightly lift interest rates to more normal levels over the coming year. But if inflation remains ‘stubbornly high’ it will need to address structural factors rather than just keep on lifting rates.

The week ahead

If there was a word for the coming week it would be ‘inflation’. Figures on business inflation (producer prices) are released on Monday while the main measure of economy-wide inflation – the consumer price index (CPI) – is issued on Wednesday.

The key influences on inflation in the September quarter were slightly higher commodity prices (petrol up 4%), a firmer Aussie dollar, lower food prices and the annual increase in utility rates and government charges from July 1. Discounting by retailers also would have restrained consumer prices over the quarter.

Overall we expect that producer prices rose by around 0.5% in the September quarter, cutting the annual rate of business inflation from 2.1% to 0.7%. A 7% average lift in the Aussie dollar against the greenback over the quarter would have acted to restrain imported prices, offset by a 12% lift in the Singapore gasoline price.

In terms of the CPI, we expect that prices grew by around 0.9% in the September quarter. While up from the June quarter result, the annual rate of inflation would still fall given that it is a smaller quarterly rise than in the same quarter a year ago. The annual headline rate of inflation is expected to fall to a decade low of 1.2%, down from 1.5% in the June quarter.

While the ‘headline’ or published rate of inflation is below the Reserve Bank’s 2-3% target band, policymakers also worry about ‘underlying’ measures. Underlying inflation measures may have risen by 0.8% in the September quarter with the annual ‘trimmed mean’ measure falling from 3.6% to 3.2% and ‘weighted median’ down from 4.2% to 3.8%.

If underlying inflation measures continue to rise by 0.8% or more a quarter, then clearly the annual rate won’t fall back into the 2-3% band – and that’s a concern for the Reserve Bank.

Also on the domestic agenda in the coming week is a speech by Reserve Bank assistant governor Malcolm Edey on Wednesday, new home sales data on Thursday, while private sector credit and the RP Data home price series are issued on Friday. We expect that credit grew by 0.2% in September and by 1.9% over the year.

In the US, data on durable goods orders and consumer confidence are released on Tuesday with new home sales on Wednesday, GDP (economic growth) on Thursday and personal income and spending on Friday.

Modest gains are expected in durable goods orders, new home sales and consumer confidence while personal spending probably eased 0.5% with the ending of the ‘cash for clunkers’ program. But the main focus will be on GDP. Analysts expect that the US economy grew at a 3.2% annual rate in the September quarter, a result that will be heralded as signalling the end of the recession.

Sharemarket

There is still a host of US companies to report earnings over the coming week, but less of the ‘Who’s Who’ of Corporate America. Among companies reporting on Tuesday are US Steel and E*TRADE. ConocoPhillips releases earnings on Wednesday with Exxon Mobil, Motorola, Office Depot and Sun Microsystems with results on Thursday. And on Friday Chevon is expected to report.

In Australia, the focus is the bank reporting season. NAB reports on Wednesday, ANZ on Thursday and Macquarie Bank on Friday. Westpac reports its full year earnings on November 4.

Our new team of resource analysts believe the medium-term outlook for the resource giants, BHP Billiton and Rio Tinto, is extremely positive: “In the long-term, the continued economic development of China coupled with a broader global economic recovery from the GFC will see strong demand growth for commodities.” But the analysts are more wary about prospects in coming months: “In the short-term however there is a significant chance of a correction in over-exuberant commodity markets that have been driven by restocking activity in China. A correction in base metal prices is likely to flow through to equities.”

Interest rates

Economists are generally convinced that the Reserve Bank has embarked on a journey to “normalise” the cash rate – that is, lift the cash rate to around 5%. The $64 million question is what path that normalisation takes. CommSec currently expects the cash rate to rise by 25 basis points (quarter of a percent) in both November and December. But the move in November could actually be 50 basis points if inflation figures in the coming week are at the high end of market expectations.

Currencies & commodities

A key driver of higher commodity prices over recent months – especially the past month – has been the weaker US dollar. Given that commodities are priced in US dollars, a cheaper greenback improves the purchasing power for raw material buyers in Europe and the US. Interestingly the US dollar index has fallen around 7% over the past four months while the CRB futures commodity index has lifted 9% over the same period.

Investors need to keep a weather eye on the relationship between the greenback and commodity prices. If the greenback starts to rebound, commodity prices would come under pressure, especially given that demand is still fragile.

Craig James is chief economist at CommSec.