THE BIG PICTURE: Inflation data will determine how the RBA moves on rates

On the first Tuesday in August the Reserve Bank Board sat down as usual to consider interest rate settings. While rates were left unchanged, the main surprise was in the wording of the statement and the fact that the Board had considered lifting interest rates – “the Board considered whether the recent information warranted further policy tightening.”

Certainly the inflation figures released at the end of July were at the upper end of market expectations. Both the trimmed mean and weighted median measures rose by 0.9% in the quarter to stand 2.7% higher over the year. As a result the Reserve Bank openly worried about whether inflation could remain within its preferred 2-3% target band.

Fortunately the Reserve Bank didn’t go ahead with the decision to lift interest rates. The European debt crisis worsened over August and September while the domestic economy also continued to soften. And importantly, revised data suggested that inflation wasn’t the problem that many economists assumed, including the Reserve Bank.

Rather than rising by 0.9%, the seasonally adjusted measure of the weighted median prices measure is now estimated to have lifted only 0.5% in the June quarter with the new weights for the Consumer Price Index. The trimmed mean measure was also estimated to have lifted 0.7%, rather than 0.9%.

Fast forward to the more recent October Reserve Bank Board meeting and the view from Martin Place was decidedly different. The Board highlighted the new estimates on inflation, saying that “the path for inflation may now be more consistent with the 2–3% target in 2012 and 2013.” And the Board went further, noting that if the next batch of inflation figures were favourable, that it would give thought to actually cutting rates: “An improved inflation outlook would increase the scope for monetary policy to provide some support to demand, should that prove necessary.”

From rate hikes to rate cuts in the space of two months! Based on the new weights and seasonal factors for the Consumer Price Index, the Reserve Bank now estimates “that underlying inflation over the year to the June quarter would have been 2.25–2.5%, rather than 2.5 –2.75.”

If Aussie consumers continued their shift to lower priced imported goods in the September quarter, then another low inflation result will be on the cards, thus raising the possibility of a rate cut on Melbourne Cup day.

The week ahead

In Australia the “inflation reporting season” continues with producer prices on Monday and consumer prices on Wednesday. Meanwhile in the US a raft of economic data releases are scheduled with the first look at the September quarter economic growth figures on Thursday.

In Australia, the producer price index (PPI) – the main measure of business inflation – is released on Monday. Each quarter the PPI plays second fiddle to the consumer price index (CPI) and it will be no different this quarter. In the June quarter prices rose 0.8% to stand 3.4% higher than a year ago. But in the September quarter we expect that prices were largely unchanged to leave the PPI up 2.0% on a year ago. The high Aussie dollar is expected to have capped prices of imported goods while energy prices were largely flat in Aussie dollar terms.

The CPI is released on Wednesday and it will be the first time that the new weights will apply to the inflation data. Currently the headline rate of inflation stands at 3.6%, a figure boosted by one-off influences such as the flood/cyclone impact on fruit and vegetable prices and higher global oil prices. In the June quarter we expect that the CPI lifted by around 0.4%, dragging the annual rate back to 3.3%. One key influence on the result is the lower cost of petrol with pump prices down 0.9% in the quarter.

But as always the Reserve Bank is more interested in “underlying inflation” – the concept that excludes volatile prices like fruit & vegetables and petrol. The Reserve Bank has estimated that underlying inflation is between 2.25-2.50%. If underlying inflation rises by around 0.8% as we suspect, then the annual growth rate will probably lift into the 2.50-2.75% band. The Reserve Bank has said recently that it expects underlying inflation to remain in the 2-3% target band over the “medium term”.

A rate cut would be solidly on the table if underlying prices lift 0.6% or less in the June quarter, but a 0.8% increase would make a rate cut more of a 50:50 proposition. And a lift in underlying prices of 0.9% or higher would make it fairly difficult for the Reserve Bank to deliver a rate cut.

Apart from the inflation data, Reserve Bank Deputy Governor Ric Battellino delivers a speech on Tuesday. On Wednesday the Australian Bureau of Statistics (ABS) issues the latest “Modellers’ Database” – a release that includes the latest estimates on wealth. However, with both share and home prices softer, wealth levels probably eased in the June quarter.

In the US, the week kicks off with the Chicago Fed index on Monday while data on home prices and consumer confidence follows on Tuesday, alongside the influential Richmond Fed manufacturing index. Home prices show signs of stabilising with the Case Shiller 20-city measure unchanged in seasonally adjusted terms in August and the unadjusted measure showing a solid 0.9% lift in the month. But consumer confidence was most likely little changed in October.

On Wednesday new home sales may have edged slightly higher in September – a further sign that the housing sector is stabilising. And durable goods orders may have lifted modestly in September after easing 0.1% in August. On Thursday investors get their first look at September quarter economic growth figures while pending home sales, weekly jobless claims and a number of regional gauges are also released. Economists tip 2% annualised growth for the US economy – well above recession territory.

And on Friday, personal income, consumer sentiment and the employment cost index are issued. Economists tip healthy gains of 0.3% for income and 0.5% for spending in September.

Elsewhere investors will respond on Monday to this weekend’s (October 22-23) summit of European leaders to consider solutions to the region’s debt crisis. Bank of Canada releases its rates decision on Tuesday while central banks of Japan and New Zealand have monetary policy announcements on Thursday.

Sharemarket

The US profit-reporting season continues in the coming week. There are certainly far less household names on the earnings list but the actual number of firms reporting certainly has ramped up compared with last week. Amongst those reporting on Monday are Caterpillar, Kimberly Clark, ResMed, Netflix, Unisys and Texas Instruments. On Tuesday profit results are expected from 3M, BP, Deutsche Bank, Ford, UBS, Amazon and US Steel. Boeing is amongst those to report on Wednesday alongside ConocoPhillips and Visa. On Thursday Colgate-Palmolive, Exxon Mobil, US Airways and Advanced Micro Devices issue earnings results. And on Friday Arch Coal, Chevron, Newmont Mining and Merck are amongst those to issue results.

Interest rates, currencies & commodities

The spot iron ore price soared from just under US$68 a tonne in June 2009 to a record high of US$191.90 a tonne in February this year. We had always expected that prices would eventually come down to earth as supply and demand moved closer together, and that adjustment is clearly in progress. Since early September iron ore prices have been in retreat, easing from US$181 a tonne to a near 12-month low of US$150.30 a tonne. And while that seems a sharp drop in price, it’s important to note that cash costs for many producers are currently closer to $50 a tonne.

Craig James is chief economist at CommSec