I was quite surprised by the RBA’s statement today. What surprised me was that they totally re-wrote the inflation section, and left out the inflation forecast – which was their argument for higher rates. It’s not often that the RBA gives up an option to tighten … so what happened?
I think a larger than expected drop in production in Q1 made them re-assess the split between supply shock and demand driven inflation in Q1.
Let me explain …
So, we had the following (from their June Statement) —
CPI inflation has risen over the past year, reflecting the effects of extreme weather and rises in utilities prices, with lower prices for traded goods providing some offset. The weather-affected prices should fall back later in the year, though substantial rises in utilities prices are still occurring. The Bank expects that, as the temporary price shocks dissipate over the coming quarters, CPI inflation will be close to target over the next 12 months.
replace (from their May Statement) —
Recent data on inflation show the effects of production losses due to the floods and Cyclone Yasi. The affected prices should fall back later in the year, though substantial rises in utilities prices are still occurring. The Bank expects that, as the temporary price shocks dissipate over the coming quarters, CPI inflation will be close to target over the year ahead.
Looking through these short-term movements, however, the recent information suggests that the marked decline in underlying inflation from the peak in 2008 has now run its course. While the rising exchange rate will be helping to hold down prices for some consumer products over the coming few quarters, over the longer term inflation can be expected to increase somewhat if economic conditions evolve broadly as expected.
What I see is that they edited their inflation forecast out of the June Statement. I interpret this to mean that the Bank has less confidence in their prior forecast.
Why might this have happened?
I have spent a bit of time modelling inflation, and I can report that inflation forecasts don’t change very quickly. Both Aussie and global data has been a bit soft, but not terribly so. Also, the Bank retained their view that Aussie growth would be above trend. Thus, the main inputs into their inflation forecast have not changed — so why the drop in confidence?
I was puzzled initially, but my trip home from work afforded me the following insight — the Q1 national accounts may have materially changed the identification of the inflation pulse. This is a bit technical sounding but it really boils down to how they apportion the increase in inflation between supply and demand.
The weakness in Q1 production side numbers may have motivated a change in the Bank’s identification of the underlying inflation pulse, and hence a decrease in the confidence around their assessment that underlying inflation was picking up and likely to push up above their 3% threshold in 2013.
A little theory may clear things up – the prices the ABS measures in their CPI survey represent contract points (the prices at which goods traded). These are the intersection of supply and demand curves.
In normal periods, supply moves only slowly, so identification is relatively simple. In Q4 / Q1, we had a severe supply shock — so our problem is to separate the change in the price level between the (probably temporary) supply impairment and demand.
Doing this properly is difficult; however a quick and simple way to get an impression of what’s going on is rotate the CPI-GDP space by 45 degrees. The sketch above gives the idea. An increase in demand makes both inflation and GDP rise together; an increase in supply makes inflation fall and GDP rise (so a supply shock, such as we had will tend to make prices rise and GDP fall).
A quick implementation of this process (rotating 2q AR real non-farm GDP less 3.25% & the average of 2q AR WM and TM CPI less 2.5%) suggests that the recent increase in inflation may have been due to a supply shock. As can be seen from the above chart, Q1 was characterised by a sharp drop in supply, and a modest drop in demand.
I distrust quarterly data, however I thought this QoQ GDP / core CPI chart was worth including as it clearly demonstrates my contention – Q1 was characterised by a large drop in supply, and a small drop in demand.
This idea needs a lot more work – for example, it’s not clear we should rotate by 45’. I like the story that the drop on the production side means that there was more inflation due to lower supply. A potential source of bias in the above method is that there has not been an adjustment for the drop in supply potential due to the floods. That would, of couse, mean the even more of the inflation pulse was due to supply factors.
I think this thematic at least gives some insight into why the RBA might have tuned down their CPI forecast.
My guess is that the Bank now awaits Q2 CPI to update its CPI forecasts – and that it will then respond on the basis of these new forecasts.
So — what’s the RBA going to do next? I don’t know – but I think inflation is probably picking up, so my guess is that they hike at their August meeting … however I will be wrong about this if Q2 CPI is low (say +0.5%q/q).