Inflation is slowly deflating and the RBA should be worried

Wed, 22 Oct 2014  |  

Australia's inflation rate is heading lower. What is interesting is the deceleration in inflation is starting from a position where inflation was within the RBA's target band of 2 to 3 per cent.

In the September quarter, the CPI rose by 0.5 per cent, to be up 2.3 per cent for the year. Taking out the large prices swings and using the RBA underlying measures, inflation was 0.5 per cent for the quarter for an annual rise of just 2.5 per cent. In the first half of 2014, headline inflation was near 3 per cent with underlying inflation around 2.75 per cent.

Inflation is well contained, which ever way you cut it. Indeed, it looks like the quarterly momentum on prices is slowing which will filter into the year on year inflation run rate over the next few quarters. If, for example, underlying inflation is 0.6 per cent in the December quarter, annual underlying inflation, all of a sudden, is down at 2.25 per cent.

What is interesting is to use the latest inflation data to recast inflation forecasts into 2015 and 2016. With the unemployment rate on the rise, with wages growth falling to levels not seen since before the Whitlam government was in power, it is easy to frame a forecast scenario where inflation will be lower over the next 18 months, rather than higher.

Throw into that mix the free fall in the terms of trade, deflationary pressures from Europe, sharp falls in inflation in China and the world more generally, and the scenario for the RBA missing its inflation target on the down side loom large. This time next year, underlying inflation could be testing record lows around 1.75 per cent.

Which is why the RBA needs to be cutting interest rates. While its rhetoric and constant briefing of market economists has them all singing from the same song sheet, the next move in interest rates is up, another few months of soggy local economic data, a further uptick in unemployment, downtick in wages growth and further confirmation that inflation is falling, should see it change its mind early in 2015. That's when the next interest rate move – down – it likely to occur.

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