More CPI previews

UBS was dovish. Damien Boey at Credit Suisse is hawkish:

Ahead of next week’s much anticipated CPI release, we thought it would be interesting to see what the RBA’s core inflation models are saying right now.

As background, the RBA models core inflation using the following variables:

  • The size of the output gap.
  • Unit labour cost inflation (ie wage inflation net of productivity growth).
  • Import price inflation.
  • Bond market inflation expectations.
  • Historical core CPI inflation.

In other words, the output gap drives growth in real unit labour costs, or the labour share of GDP. More (less) slack means less (more) wage bargaining power. Wage bargaining power combines with what people have come to expect about inflation, to drive actual wage claims. And supply-side factors, such as imported cost inflation, and profit margin growth, make up the difference between labour cost inflation and CPI inflation.

We use our proprietary, real-time output gap measure in place of the RBA’s modelled output gap. For reference, our real-time output gap measure is based upon male full-time equivalent employment as a share of the “active” labour force, and NAB survey capacity utilization. We prefer our measure, because it is readily observable, and is not subject to estimation errors associated with trend GDP growth. Apart from the choice of output gap measure, our model inputs are virtually identical to those of the Bank.

At present, our version of the RBA’s inflation model points to quarterly core inflation of around 0.6% in 3Q, or 2.4% annualized. This is a mean estimate. There are of course wide uncertainty bands surrounding this forecast. However, even after accounting for an undershoot of one standard deviation, we still arrive at an 0.4% quarterly figure, or 1.6% annualized (coincidentally, the current trend pace of core inflation). In other words, there is upside risk to the 3Q CPI number. The recent spike in unit labour costs, and surprisingly thin output gap, are driving the upside. In our view, both are functions of declining productivity. It is also worth noting that weaker currency has boosted imported goods inflation.

For what it is worth, we can explain and predict cumulative under and overshoots in core CPI relative to the model, using the relative strength of emerging markets relative to developed markets. This makes intuitive sense – most of the variables we have used to model CPI are based on developed world, or local factors. Yet Australia sits within the emerging market complex from a trade perspective, and therefore swings in emerging market growth and sentiment should have an impact on inflation. Our proprietary emerging market leading indicator, based on relative growth and capital flows has been pointing much higher in recent times, also suggesting that there is upside risk to core CPI inflation.

3Q NZ CPI surprised to the upside in 3Q. Inflation is everywhere and anywhere a global phenomenon. We think that an upside surprise in Australian 3Q CPI is very plausible in the circumstances. And should inflation come in hotter than 1.6% annualized, the risk is that bonds sell off even more, undermining related exposures within the equity market.

Westpac is in the middle:

Westpac is forecasting a 0.6% rise in the September quarter CPI lifting the annual pace to 1.8%yr from 1.6%yr.

The September quarter tends to be a seasonally strong quarter with the ABS projecting a seasonal factor of –0.1ppt. The seasonally adjusted CPI is forecast to rise 0.5%. The trimmed mean is forecast to rise 0.32%qtr/1.5%yr and the weighted median is forecast to rise 0.27%qtr/1.2%yr. The average of the core inflation measures is forecast to print 0.29%qtr with the annual pace easing back to 1.3%yr from 1.4%yr.

Boosting the CPI in the September quarter is food (drought offsetting normal seasonal softness), alcohol & tobacco (mostly the annual re-indexing of the tobacco excise) and holiday travel & accommodation (with domestic lifting 6% and international rising 3% in the quarter).

Housing costs to rise 0.2% as the solid 3% seasonal rise in property rates & charges is offset rents, dwelling purchases and utilities prices.

Auto fuel set to be a drag in the quarter (–2.0%) as the Saudi strike led spike in crude prices occurred late in the quarter. Traded prices are forecast to rise 0.8%qtr while non-traded prices are forecast to rise 0.4%qtr.

We have allowed some modest AUD pass though boosting our estimates of clothing & footwear, household furnishings and audio visual & computing.

Core inflation remains well below the bottom of the RBA target band as moderating housing costs offset modest inflationary pressure elsewhere. Competitive disinflationary pressure in consumer goods is limiting the pass through of the weaker AUD though it is having some impact. Given this we find it hard to envisage core inflation breaking higher any time soon let alone returning to the mid-point of the 2%yr to 3%yr target band.

Monthly inflation has been weak:

I’ll take the under but if wrong might buy any bond weakness!

David Llewellyn-Smith
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