For a more comprehensive round up of the week, listen to Stephen’s full report here.

Australian headline CPI inflation averaged 2.95% y-o-y in the first half of 2014, just shy of the top of the RBA’s 2-3% target band. The good news is that inflation looks set to fall sharply and, on our forecasts, may average only 2.3% y-o-y in the second half of 2014, below the 2.5% mid-point of the RBA’s target band. Importantly, inflation looks set to remain around 2.5% or lower until at least mid-2015. The benign inflation outlook is a key reason why the RBA is likely to leave the cash rate at 2.50% for many months to come. This interest rate outlook is of course dependent upon inflation coming in along the lines we are forecasting. The first test of our inflation forecast occurs this week with the Q3 2014 CPI report out on Wednesday.

The imminent Q3 2014 CPI report is something of a lynch pin for the medium term inflation forecast. Over recent years, the Q3 CPI reading has tended to be the highest reading of the year and last year the Q3 reading was no exception coming in at 1.2% q-o-q. In recent years, the regular 1st of July price changes to many government charges, electricity and gas tariffs have been unusually high. The Q3 2014 changes to government charges and electricity tariffs in contrast, have been comparatively small. Fresh fruit and vegetable prices also seem to have been unseasonably low in Q3. All told, it is unlikely that the Q3 CPI will be above 0.5% q-o-q, against 1.2% in Q3 2013, which would see the annual inflation rate fall, mostly on a base effect, from 3.0% y-o-y in Q2 2014 to 2.3% in Q3.

While the sharp fall in headline inflation expected in Q3 is welcome, it is also primarily due to one-time changes – in particular, prices – and raises the question of whether there is any lasting moderation in inflation. In order to look through the influence of one-time price changes, the RBA will look closely at underlying inflation measures of which the two key ones are the trimmed mean and the weighted median. Both are expected to come in around 0.5% q-o-q edging down the average annual reading for the pair to 2.65% y-o-y from 2.8% in Q2. If these forecasts are close to the mark it will indicate that underlying annual inflation has moderated too, but not quite as much as headline inflation.

The RBA will also want some comfort that the moderation in inflation will persist. An important factor helping to keep inflation contained is unusually low wage-cost pressure. Annual wages growth is exceptionally low, holding at 2.6% y-o-y in both Q1 and Q2 2014 and unlikely to have been any stronger in Q3. While the monthly labour force data are under a cloud at present, what is relatively certain is that average monthly employment growth has been soft over recent months and the unemployment rate has been drifting up. Even though wages growth is unusually low, the weaker labour market seems to indicate that the risk is on the side of even lower annual wages growth. Low wages growth is pointing strongly towards moderating CPI inflation.

Another factor is imported inflation; the Australian dollar has fallen over the past couple of months and if it continues to fall, it may start to lift the price of imported goods. There is, however, a long lag between a change in the currency feeding a change in prices in Australia. It takes time for higher price imports to be landed in Australia depending upon order and shipment schedules and the currency hedging policies of the companies involved. Import companies may also prefer to try and maintain market share and absorb currency changes for a period. In short, it is unlikely that the lower Australian dollar will feed higher import prices in the first 12 months or so after the depreciation.

Another factor to consider with import prices is what inflation is doing in supplier countries. Inflation is very low in the US, China and Japan and is bordering deflation in Europe. Low or falling supplier country prices are also likely to moderate the feed through from a weaker Australian dollar to local prices.

All going well with the Q3 inflation forecast this week, it is highly likely that the RBA will reaffirm its conviction that inflation will stay inside 2-3% target band over the next two years when it produces its latest forecast in its quarterly Monetary Policy Statement on Friday 7th November. That statement is likely to provide considerable comfort to local financial markets that one near-certainty is that the RBA’s cash rate will be no higher than the current 2.50% extending well in to 2015.