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Last week we pointed out the pivotal role that employment will play in assessing the outlook for both economic growth and inflation. As a result, the relative strength of the labour market is likely to provide an important clue to when the RBA may move the cash rate and in which direction. However, the most important economic variable for RBA rate decision making is still the inflation rate, more accurately the RBA’s own forecast of how inflation will travel over the next two years.

The RBA was one of the earliest central banks to adopt inflation targeting back in the 1990s. The idea behind inflation targeting is that maintaining annual inflation in a low and stable range provides the best contribution a central bank can make towards achieving sustainable economic growth and full employment. Over the past two decades, annual inflation has for the most part been inside the RBA’s 2-3% target band and has averaged 2.6%, more or less the middle of the band. Over the same period, the economy has been recession free and unemployment is low by the standards of most advanced economies.

Importantly, the RBA is flexible in the way it looks at its inflation target. There have been periods when inflation has been well inside target, but the RBA has been lifting interest rates, because in its forecasts it has inflation in the near-to-medium term pushing above 3% with a risk of staying above for some time. Conversely, there have been periods when inflation has been above 3%, but the RBA has held the cash rate steady and it appears that we may be just entering another such period.

The Q2 CPI reading is due this week and the consensus forecast is an increase of 0.6% q-o-q, 3.1% y-o-y up from 0.6% q-o-q, 2.9% y-o-y in Q1. Our forecast is little higher than consensus at 0.7% q-o-q, 3.2% y-o-y. Either way, above 3% annual CPI inflation, if that is what happens, is unlikely to push the RBA to lift the cash rate in the next few months.

The key reason why the RBA is unlikely to turn hawkish on interest rates is that it is reasonably convinced that any blip above 3% annual inflation in the Q2 data is likely to be temporary, ahead of a move back below 3% later in 2014 and in 2015. One reason for the RBA’s conviction that inflation will fall back below 3% is statistical – inflation in the first half of 2014 is annualizing well below 3%, around 2.4% to 2.6% taking a Q1 reading of 0.6% and a Q2 reading of 0.6% or even 0.7%. Inflation is pushing above 3% only because of two high quarterly inflation readings back in Q3 2013 (1.2%) and in Q4 (0.8%). More recently, there is already evidence that inflation is on a lower path.

A more important reason why the RBA is confident annual inflation will come down is that a key factor needed to sustain rising inflation over time, rising wage costs, is just about non-existent. Indeed, annual wages growth is running below the annual inflation rate at 2.6% y-o-y – the lowest annual growth in wages in at least 20 years – and the soft labour market implies the current weak phase in wages growth still has a long way to run.
A third reason why the RBA can be confident that annual inflation will moderate is that some of the big one off price changes that drove quarterly inflation readings higher through the second half of 2013 are moderating sharply. Electricity charges, for example, will not rise at the double digit pace they have over recent years.

There are still pricing pressures in housing and government services in particular, but it is unlikely that these pressures will be sufficient to offset the less inflationary course of many other prices.

Even though the RBA is forecasting lower annual inflation with some confidence, it will not be letting its guard down. It is doubtful that the Q2 CPI report this week can throw enough of a surprise to change materially RBA thinking on the inflation outlook, but the Q3 and Q4 reports could potentially. We are still forecasting that the first RBA cash rate hike will be in Q1 2015, probably in March. The next three CPI readings, including the one due this week, are critical for our forecast – we are looking for 0.7% q-o-q CPI increases each quarter. The risk case has probably migrated to CPI outcomes lower than we are forecasting and the cash rate staying at 2.50% well beyond March next year.