The Q1 CPI report is due tomorrow and is likely to influence when the RBA will start hiking the cash rate. The Q1 CPI report is expected to show that annual inflation however measured continues to languish at 2% y-o-y or less. If the report is as widely expected, it means that inflation is still sitting at the bottom of the RBA’s 2-3% inflation target band placing almost no pressure on the RBA to consider a cash rate hike in the near term. However, there may be clues in the Q1 CPI report that annual inflation will not sit at 2% for much longer implying annual inflation moving upwards inside the RBA’s 2-3% target band later this year.
Going back to Q4 2017 there were signs that low annual inflation (2% or lower) was mostly a function of price deflation in four of the eleven major sub categories of the CPI helping to offset quite high inflation (3% or higher) in five other major sub categories. Annual deflation is likely to be less pronounced in two of the four deflating categories of the CPI, namely the food and non-alcoholic beverages category (-0.2% y-o-y in Q4 2017) and the clothing and footwear category (-3.0% y-o-y in Q4 2017).
The food category that includes not just food groceries but also restaurant and takeaway food costs is not only starting to show some seasonal upward price pressure but also some cost pressure too. There are also the first indications that the longstanding price war between the major supermarket chains is ending. Within the Q1 CPI the food category could move out of annual price deflation to slight inflation. The chances are that food price escalation will become more pronounced beyond Q1.
The clothing and footwear category is also starting to come under upward wholesale price pressure from rising producer prices overseas and the impact of a mildly weaker Australian dollar. Annual deflation in clothing and footwear prices is still likely to be evident in the Q1 CPI but the extent of deflation is likely to fade in Q2 and beyond.
Annual price deflation may continue in two remaining deflating categories – furnishings and household equipment (-0.8% y-o-y in Q4 2017) and communication (-3.4% y-o-y). In both categories price competition is intense and is unlikely to diminish.
Nevertheless, the story of the deflating categories is that four may turn to two beyond Q1 2018, reducing the downward pull on general annual inflation.
Turning to the five high inflation categories, three of the five seem set to maintain or increase the pace of annual inflation exhibited in Q4 2017.
The alcohol and tobacco category showed 7.3% y-o-y inflation in Q4 2017 and current government policies (one of the few policy areas that has whole-hearted support from all opposition parties too) is to continue using higher taxes to increase the price of tobacco and alcohol at least at the current annual price to try and reduce demand over time thereby improving national health outcomes and limiting growth in government spending on health.
Housing annual price inflation (3.4% y-o-y) is subject to mixed forces. The price of homes is flattening out and rents are falling in some areas. Set against this the cost of home loans is starting to increase. Funding pressures are starting a round of home loan interest rate increases even before the RBA starts lifting the cash rate. Utility charges for gas and electricity also included in the housing category continue to rise sharply. All told, if annual housing inflation diminishes the extent is likely to be modest and short-term ahead of bigger increases down the track.
Health is the last of the three comparatively stable high inflation categories (4.0% y-o-y in Q4 2017). There are opposing price pressure forces in this category too. Annual private health insurance premiums rose more modestly this year, although still close to 4%. Changes to government pharmaceutical benefits are mostly holding down prices in the sector, but medical professional fees are escalating as are prices for the likes of age care services where growth in demand is especially strong. In the near term, health sector annual inflation may stay close to 4%, but longer term rapidly increasing age-related demand is likely to push sector inflation much higher.
Two high inflation sectors are at risk of inflation pushing higher in the near term, transport (3.3% y-o-y in Q4 2017) and education (3.2% y-o-y). In the transport sector higher fuel prices loom large. While petrol prices are volatile the trend is upwards as international crude oil prices push higher. Higher crude oil prices are a natural consequence of stronger global economic growth but supply manipulation by key oil producers is playing a part in driving up oil prices even more. Annual inflation in transport could lift much more as the year progresses.
Education is always a high inflation sector and 3.2% y-o-y in Q4 was comparatively modest by the standards of recent years. Cost pressures are, however, threatening to rise sharply in the sector, especially in pre-school education. Our estimate is that annual education inflation will lift to nearer 5% by this time next year.
Taking what is happening to inflation (and deflation) in the major sectors of the CPI even if the Q1 CPI result tomorrow is relatively benign there are many signs that annual inflation will lift down the track. We suspect that the RBA sees these pressures building too, a key reason why they will not delay far beyond mid-year before delivering a cash rate hike.