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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).


  1. What happened? Maybe the financial markets fraternity in Sydney over-interpreted the last quarterly Statement on Monetary Policy? That to me seems an entirely reasonable possibility. I failed to see any real signal that a rate hike was imminent from the Reserve Bank, even taking account of the change to their inflation forecast – certainly it means tighter policy at some point but is there any reason to think that should mean June precisely, or even July? Then we saw a suite of soft monthly data figures rolling in after the May meeting.

    Treasury estimated the impact of the natural disasters at -1.7ppts off Q1 GDP after the National Accounts were released. So -1.2 per cent minus -1.7ppts yields a solid +0.5 per cent expansion in the March quarter ex-force majeure. But on the Sunday ahead of the release they had the floods, et al, impact at -1.0ppt implying the economy was contracting marginally in the quarter. Politically, I understand why they revised their estimate of the impact of the natural disasters from -1.0ppts to -1.7ppts and I also see the analytical reasons for having done so in light of the new information from the Balance of Payment figures.

    However, Treasury and the Reserve Bank can’t be too confident of their read on the underlying strength of the economy at the current point in time. Sure they can be more confident now after the release of the Q1 GDP figures but it’s only after they see the scale of the rebound in Q2, and a lesser extent Q3, that they will really be confident they have the full measure of the natural disasters. [Sure, they’re probably not going to wait until September (Q2 partials) or October (Q2 actuals) to make a decision, but they could certainly wait out the next set of CPI figures.]

    I’m not sure if I were a central banker in that position I would be confident enough to hike rates when you’re feeling in the dark in terms of getting a decent read on the underlying momentum in the economy. The cross check from the labour market suggests weakness as well, average monthly employment gains at around +5k over the past five months versus in excess of +35k in the preceding five months. The only reason the unemployment rate hasn’t risen is because the participation rate has come off its recent high.

    The Reserve Bank hasn’t deployed its “it is likely that higher interest rates will be required, at some point” language, as they did before the November hike, so the markets have justifiably wound back on expectations of a July hike. I suspect you’re right, it’s back to CPI-dependent business as usual with August the next viable window for a hike. The temptation is to over-think what the Reserve Bank is cogitating, chances are its a lot less complicated than a fiercely intelligent and creative mind might project onto a mere central bank.

  2. Remember what Martin Parkinson said to the ABE.

    Thus this decision is not all that surprising

  3. The other plausible explanation is that the RBA presumes everyone read the semi-annual statement and thus knows their inflation forecast, so they didn’t feel the need to repeat it. The RBA does not write these monthly statements like the Fed does, with last month’s words as a template to be edited. Too many analysts are far too exegetical in their approach to the RBA.
    They are really quite simple. If they have lifted rates it’s because they believe inflation pressures are pressing enough that they have to do something to head them off. If they have cut rates it’s because they see inflation falling from a low enough base that they can be more accommodative or less restrictive. And if they have left rates unchanged it’s because they think inflation pressures are not pressing enough to require an urgent change to the cash rate. Whatever words they put around that, this is about all there is to ex-post RBA interpretation.

  4. In my opinion it’s more about housing and lackluster credit growth. These are forward indicators of inflation. Add to that that sometimes it’s better to hold on your bullets if you know you have only a couple more that you can use.

  5. I endorse these comments.

    The RBA have always been more open the the Fed and even more so.

  6. What happened? The RBA looked at the data and the data was awful.

    They quite sensibly chose to ignore the increasingly shrill demands for a rate hike from the bullhawks, and made their decision on the data.

    BTW, do the RBA get advance notice on Thursday’s employment numbers?

    1. then why didn’t they change their assessment of demand or employment?

      and no, i understand that Pink doesn’t even tell the Treasury before hand.

      1. Employment weak again.

        “Dodgy” NSW number from last month has bounced back a bit over half way (down 43.8K up 25.6K) so not so dodgy after all.

        Employment has flat-lined around 11,430K for seven months now. The wage-price spiral simply hasn’t happened.

        All the data since Q1 CPI has been weak; retail, employment, PMI, GDP, car sales, consumer sentiment … all awful, or at least much weaker than expected by the bullhawks.

        I don’t think the RBA is looking at Europe (well maybe a bit) they’re looking at the domestic data.

        1. Agreed, the data has been soft. Q2 looks to be weaker than I (and the RBA) expected, so I expect the hurdle is now higher and that it will take a solid CPI to push em over it.

          I am now thinking that a 0.6%q/q means steady rates and next window in November.

  7. Not quite true. ABS tells Treasury at 9 am in a lock up before the 11:30 release so that the Treasurer can be ready to answer questions about data. But they tell no one any earlier than that.

    Disagree with The Lorax. The RBA has not issued a statement that says the data since last month is awful. They have become a bit more concerned about the way the European situation might play out, but the statement is only a little less hawkish than last month. The implication is not a significant change of view, but just a conclusion that they are under no pressure to hike right now. The RBA never thinks that timing to the month is all that imperative. A rate change now, in either direction, will only have its impact with long and variable lags over a year to 18 months down the track.
    So if they think around now that a rise is needed, that doesn’ t mean they have to do it today or they’ll have stuffed up. No, they realise that it doesn’t matter if it happens in May or June or July or August. All that happened yesterday was that on balance they concluded that what’s happening in Europe is an uncertainty that buys a bit more time before their inflation concerns need to come to the fore.

    1. i totally agree with all of this this – apart from ABS procedure, about which i can’t say anything for sure. Re the RBA, the global stuff were the obvious changes. i still think we need to account for the disappearing inflation outlook.

  8. The TM-CPI number looks completely messed up, +0.3%q/q in Q4 leaping to +0.9%q/q in Q1, the largest quarterly acceleration in this measure of underlying inflation in the (admittedly short) history of the series. The correlation between TM-CPI and headline CPI on a quarterly basis is roughly +0.6 and it is possible the magnitude of the price spikes in Q1 overwhelmed the usual moderating effect of the trim. The +1.6 per cent spike in Q1 headline CPI was the largest quarterly increase during the history of the TM-CPI measure, we’re in unchartered territory. It seems obvious to me that a sharp spike in headline CPI is capable of dragging up the underlying measures to some extent. Be interesting to see some work done on this in terms of an attempt at quantification and a dissection of the actual trim last quarter.

    GDP all over the shop, TM-CPI looking screwy, employment growth slowing, the weirdest cycle we’ve experienced in a long time and a suite of downside risks to global growth, some of which are quite scary. Perhaps not the best environment for a pre-emptive rate hike, even by a courageous central banker.

  9. sorry Warren is correct but technically given it is a lockup it isn’t released in advance anyway I claim I am right!!!!

    Agree on the RBA. Remember they are looking at what happens over the business cycle so whether they raise/cut this month or nest is problematic.

    Warren is incorrect about the lag though. It is instantaneous. We learn that from all those people who saiud it wasn’t fiscal polcy that helped us avoid the GFC it was monetarty policy.

    Should have said it before but I do like your thoughts on this.

    Quite provoking

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