what’s inflation?

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The post-Q3 CPI sell-side and (typically well informed) media chatter baffled me.

First of all, it seemed to confuse inflation — a general rise in the price of goods and services — with rising prices. They are not the same thing.

Inflation is not an increase in the cost of living. At least not the sort of inflation that monetary policy might control.

Central banks control the money supply, and the inflation we mean when we talk about policy is a decrease in the value of money due to its excess supply relative to the production of goods and services. Money and credit aggregates are growing very slowly (even more sub-trend than real output) so I cannot see signs of an excess supply of money as a cause of inflation.

For those who want more on this important distinction, i recommend this Fed Lockhart speech.

Looking through the CPI report, I see evidence of tax increases, and a food price spike. They’re all cost of living increases. The RBA doesn’t control taxes, or means testing of benefits, nor does it grow food — so nothing they do with rates will change that.

If they thought the labour market was tight and that workers might negotiate compensation for cost of living increases, they might tighten (or not ease) to prevent these second round spirals from getting started — but we know that the labour market is both slack and weakening, so they are unlikely to be worried about that!

The most obvious thing to ignore is the 10.2%qoq increase in fruit and vegetable prices. This has nothing to do with policy. In addition to this, there is a further 10bps contribution to headline CPI from changes to eligibility for health rebates (medical was +4.5%qoq). Both of these changes are increases in the cost of living which will lower real demand. Easy policy didn’t make these prices rise — the RBA doesn’t control the weather, and it doesn’t collect taxes.

The indirect carbon tax rise is hard to be sure of, but the direct effect is easy to spot — it’s the 12%qoq rise in utilities prices (+50bps to the qoq increase). While only about half of this is due to the carbon tax, the long-standing gold-plating of investment by state governments to ‘game’ the regulator’s pricing determinations also amounts to an ongoing tax increase — this isn’t investment due to higher demand, it’s investment to game bad regulation.

Utilities is the largest part of the ongoing ‘sticky’ non-tradable inflation non-puzzle.

We can also see the carbon tax’s shadow in the 6.6%qoq increase in air travel prices (adding 15bps to headline CPI).

We cannot be sure about the carbon tax, and the second round impacts, so perhaps there is a case for waiting for more information before easing further — but ‘accelerating’ core inflation is not a good argument.

The main reason it’s a BAD argument is that inflation is NOT accelerating.

The RBA judged that the carbon tax by itself would add 25bps to core CPI, and that it would be added in H2’12. Let’s assume that the inflation bias is split 20bps in Q3 and 5bps in Q4.

So right away, that 0.7%qq for the trimmed mean is 0.5%q/q — which happens to be slower than the revised Q2’12 estimate, and at the same level as the first Q2’12 estimate.

Now we should also take some off this number, to account for the bias from the other policy changes and the fresh food price shock.

If you walk with me this far, you ought to be able to see that underlying inflation was 0.4%qoq to 0.5%qoq in Q3. That’s below target for the RBA.

And that’s what we should expect given the the terms of trade are falling and that the unemployment rate is rising …


  1. Great post Ricardo. Incidentally, the ambiguity about the meaning of inflation is one of the things that has motivated NGDP targeting. The basic idea is that it makes no sense to tighten policy due to supply-side shocks.

  2. agree with your take on interpreting the result, although there seems a tendency for the ABS trimmed mean/weighted median CPIs to be revised slightly higher over time – but what do you make of the journalist commentary re: shifting the timing of a cut to december?

    1. i think that if there is a case for a cut that it should be done right away — but some of these guys talk to the RBA, so i guess they might ‘know’. i do not see it myself. inflation is low, demand is weak, the terms of trade are falling, and unemployment is rising.

  3. Ricardo – good post – your trimmed mean calcs assume that the price effects are equally spread across all CPI sub groups. I suspect they are fat-tail distributed and then partially removed by the ABS in its timming before meaning.

    1. sort of, my main adjustment is the 20bps adjustment down from the RBA’s assumption that the broad based increase in prices would bias the core up by 25bps. so, i don’t think that the main part of my adjustment is dependent on your claim. it’s biased up, and we know this. the food and other stuff is more tenuous.

      1. I think that is the key point here. Carbon price has biased up all prices and as a result the core measures don’t fully strip away the effects.

        Rate cut in Nov remains live, despite the fact many economists are now dropping their rate cut calls.

  4. Can I join in this love fest as well?

    I expected to read commonsense and someone who understood how to read CPI statistics.

    I am therefore not surprised to have read this.

    I might just add Treasury over-estimated the ETS contribution.

    Can you write something about Cochrane so I can disagree!!!

  5. A little comment on the RBA.

    They will meet with almost anyone given their time constraint.

    They do not tell anyone what they may or may not do since Glenn Stevens took over.
    In fact you do not have to even meet with them these days.

    There are so many Speeches, Minutes , Statements etc you would get a headache reading them

  6. Disagree on your “one-off” view…. it’s always a “one-off” isn’t it! Since 2007…

    We had underlying inflation running above 3% for a number of months in 2007-2010, so it’s fine to have underlying inflation at 2% for a year now. Also consider that with the higher AU$, rates will be structurally lower, but inflation will be too. The RBA should consider to shift its target from 2-3% to just 2% like most developed nations in the world. RBA has to play this one and the carbon tax very carefully….

    1. i would like to see us more to a 2% fixed target, but that’s another story / debate.

      as for where inflation is, it’s tricky to be sure — but i really think that in this case we have a lot of information. i am not concerned.

      finally, check out AUD inflation overlaid on GER, NZD and USD inflation (all scaled — so subtract the mean and divide by the std dev). they have all traced the same path for 10yrs … which means that the inflation shocks are largely been global and therefore exogenous to domestic policy.

      1. I bet if you overlay AUD inflation over the rest, we are the ones that are “generally” a bit higher…. and we are the ones with unemployment at 5.4%. It’s probably worth to wait to check what unemployment does first by end of year. Anyway, let’s see if you can call the next decision right too! :)

  7. One more thing… what’s up with non-tradable inflation averaging 4% y/y …. since 2007 ?

    1. utilities, for the most part — plus education, health, and some other stuff.

      In a tot shock, most models give high NT-inflation, and low T inflation, as the income means that FX goes high and the domestic firms have pricing power — and the opposite happens on the way down.

      if the AUD doesn’t drop, and NT-inflation works symmetrically with the tot-decline, we will have very low inflation.

      1. “if the AUD doesn’t drop, and NT-inflation works symmetrically with the tot-decline, we will have very low inflation.”

        Which does not mean we still have to target 2-3% necessarily? Is 2% the new inflation normal with a high AUD?

  8. Have a look at this from Paul Bloxham :


    On Page 3, there’s a nice “Components of Inflation” graph.

    The graph makes it clear that we can only have inflation in the target band when we do not import higher inflation.

    Just right after the GFC it’s the only time when non-tradable dropped into the target band. It seems that having non-tradable above 3% and around 4% is the accepted norm… since salaries are growing at 4% too, you would say all is fine… but this split in inflation does not look balanced to me.

  9. Utilities inflation is going to slow over the next few years. We had a once-in-a-generation boost to distribution network capex over the last 5 years (and the next couple), some of it due to gold-plating but most due to rising peak demand and boosted reliability standards in the wake of high-profile outages in Brisbane and Sydney. Air-con penetration in most states is nearing saturation levels, so I doubt we will see an ongoing need for further capex. Wholesale electricity spot prices are in the toilet so it’s quite easy to get discounts of 10-15% off the headline gazetted tariffs, at least in Victoria. I wonder how much of that gets reflected in the CPI.

  10. For the record: RBA could humiliate you in November and the many other economists forecasting a cut. Stephen Koukoulas has been calling it a certainty even after the surprisingly high CPI. Few economists picked October until the journos started singing and few economists get that November is unlikely. I expect more will start wavering/hedging before the meeting.

    1. The RBA humiliate economists and journalists all the time — and i am very aware that i am overdue to get one wrong. if you look back over the blog, you’ll see that i felt the RBA may respond to the decline in the terms of trade prior to the Sep meeting, but for sure the journalists all saying the same thing following the September meeting was a key sign that they were about to act in October.

      I am not sure that we have had quite the same degree of consensus from media, but if we do, it will be a sign that they will wait and see about inflation.

      It’s difficult to know what the trend is at any time — you really need to see the next data point. A cautious bank might wait and see. But waiting to see is different from not moving because inflation has turned and is picking up.

  11. ricardo, i have read this blog. on 4 september, after the RBA ‘s meeting, you wrote:

    “It is possible to see an November cut if everything goes right (or more accurately wrong!). Right now, I have no beef with market pricing for December, though pricing for Oct looks wrong to me.”

    you directly said you did not agree with an Oct cut and a cut would only come in Nov “if everything goes right (or more accurately wrong!)”

    this looks to me like you had no idea an oct cut was coming

    1. you’re right — for October i was most certainly persuaded by the consistent tones coming from the RBA’s media song-birds. The developments in local and global data were secondary to my October rate cut call — important, in that they informed a medium term view i had been developing, but the media was the key part of that judgement.

      I had expected / seen that the decline in the terms of trade was a problem for RBA forecasts — see https://ricardianambivalence.com/2012/09/03/sep-rba-the-100-iron-ore-trapdoor/ — but had not expected such a swift reaction from the Bank.

      The below is from the 3 Sep pre-RBA note:

      “It’s fairly clear just from comparing these two charts that the terms of trade are falling more quickly than the RBA expected. That constitutes a real tightening of monetary conditions, and it is something that the RBA will want to respond to if it is sustained.”

      and you’ll note from the 4 Sep note you quoted from that i thought the market had the RBA’s Sep communique wrong — but you are right that without the media warning i would not have guessed that a cut was coming in October.

      Do you have the sense that the RBA is running the same sort of media campaign against a cut this time around?

  12. i would say a very soft, reversible campaign. Nov is still on the table. smart money might put a 35 to 40 per cent probability.

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