Q3 CPI has printed, but it is the same old story — the RBA is wrong on inflation. They are in good company. Pretty much every central bank has chronically over-estimated inflation over the past few years. If it were any other forecaster we’d be accustomed to adjusting down their estimates, but the market hasn’t been doing that to the RBA. Instead there are hikes priced for 2018 despite the fact that the RBA doesn’t know when inflation will return to their 2.5% target.
As you can see from the above chart, the RBA does not currently predict Trimmed Mean CPI, the RBA’s preferred measure of CPI, to converge to their 2.5%y/y target at any time within their forecasting horizon. Rolling their model forward, my best guess is that Trimmed Mean CPI was expected to hit 2.5% sometime in 2021 or 2022.
I say was because these fan-chart forecasts were made before the disappointing Q3 number. If you squint you’ll see that the RBA expected Trimmed Mean CPI of ~1.95%y/y in Q3. Instead they got 1.83%y/y. We get new forecasts on 10 November.
This isn’t a massive miss, but it’s meaningful. More important is the sequential deceleration of inflation: inflation slowed ~15bps from 52bps in Q2’17 to ~37bps in Q3. The importance of this is that we cannot be sure that the cyclical lows for inflation pressure have been seen. The annual pace of trimmed mean inflation has steady at ~1.8%y/y for three quarters now — and there are some deflationary headwinds coming in 2018.
The first is the re-weighting of the CPI basket. The current series is based on spending patterns from 2010. Over time spending patterns tend to move toward cheaper and more slowly inflating goods, so the current estimates of inflation are almost certainly over-estimates. We cannot say by how much for sure, as we do not yet know the outcome of the 17th series. What we do know, from Deputy Gov Debelle’s speech last week, is that the RBA have not adjusted their inflation forecasts to reflect the level shift down of inflation that that will occur when we move to the 17th series.
The ABS will very shortly update the expenditure weights in the CPI. Because of substitution bias, history suggests that measured CPI inflation has been overstated by an average of ¼ percentage point in the period between expenditure share updates. While we are aware of this bias, we are not able to be precise about its magnitude until the new expenditure shares are published, because past re-weightings are not necessarily a good guide. It is also not straightforward to account for this in forecasts of inflation. (my emphasis)
Finally, Amazon Australia has yet to hit the data — which will set off a chain reaction that i think will subtract about 25bps per year from CPI for three to five years. Sure, pre-emptive re-pricing might account for some of the food price deflation in Q3’17, but i think that is more about Coles fighting back against the European entrants (Aldi &c).
So the state of play with regard to Australian inflation is as follows:
1/ The RBA overestimated Q3 CPI by ~10bps in their August SOMP, and will downgrade slightly in their new forecasts — which are published 10 November;
2/ The RBA’s current inflation forecasts do not take into account the likely 25bps level decline of the estimated pace of inflation when we move to the 17th series; and
3/ The entry of Amazon into the Australian market (and competition from European entrants) is likely to lead to sustained downward pressure on retail prices over the next few years. My best guess is that this will shave 25bps to 50bps per year from CPI over the next three to five years.
So these are all reasons why the RBA will have to keep downgrading core CPI over the next year or two.
When will we see 2.5%y/y (core) inflation? My guess is some time in the mid 2020s.
The market continues to flirt with a rate hike in 2018. I very much doubt it. I think that’s about a year too early.
Once the unemployment rate dips below 5% and trimmed mean CPI is sustainably above 2% the RBA might start nudging rates up … but we’re a long way away from that just yet!