Statement on Monetary Policy – February 2007 Inflation Trends and Prospects

Recent developments in inflation

The consumer price index (CPI) fell by 0.1 per cent in the December quarter, and increased by 3.3 per cent over the year (Graph 70, Table 14). The fall in the headline CPI largely reflected falls in petrol prices (due to lower world oil prices) and the partial unwinding of the mid-2006 increase in banana prices. Significant increases in prices were seen only in a few categories, such as domestic travel & accommodation, vegetables and rents. Abstracting from large price changes in individual components, a range of measures suggest that the pace of underlying inflation slowed to around ½ per cent in the December quarter, with underlying inflation remaining around 3 per cent over the year to the December quarter (Graph 71).

Excluding the effects of food and petrol, tradables inflation remains relatively low, at 0.8 per cent over the year to the December quarter. This reflects falls in the prices of a range of manufactured goods such as clothing & footwear; household appliances; and audio, visual & computing equipment. Nonetheless, tradables inflation has picked up over the past two to three years as the effects of the earlier exchange rate appreciation have faded. Non-tradables inflation has remained relatively high, at 3½ per cent over the year to the December quarter, reflecting significant increases in the prices of a range of services, including rents, childcare, health services and education (Graph 72).

Producer price data for the December quarter suggest that upstream inflation pressures persist, but are not increasing (Graph 73). While final-stage prices increased by a moderate 0.2 per cent in the December quarter and by 3.5 per cent over the year, when oil products are excluded they increased by 0.8 per cent in the quarter and by 3.7 per cent over the year. Manufacturing input and output prices (excluding oil) rose strongly, while lower oil prices contributed to a fall in transport prices, with road, rail and air transport prices all decreasing.

Labour costs

Recent wage data have been somewhat more difficult than usual to interpret, reflecting the delay in the granting of award wage rises last year associated with the introduction of the Australian Fair Pay Commission (AFPC) and the consequent disruption to the earlier seasonal pattern to wage increases. The changed timing of the AFPC decision relative to previous Australian Industrial Relations Commission decisions will continue to affect indicators of wages growth over the coming year.

The wage price index (WPI) grew by 0.8 per cent in the September quarter, and by 3.8 per cent over the year (Graph 74). After accounting for the impact of the timing of the AFPC decision, it appears that the underlying annual rate of wage inflation remained around 4 per cent. Adjusted for industry composition, the average annualised wage increase for federal enterprise bargaining agreements (EBAs) certified in the September quarter fell somewhat to 3.6 per cent. Overall, these and other wages data from the national accounts and average weekly earnings survey continue to indicate that wages growth has remained reasonably stable in the face of sustained strength in the labour market. Nevertheless, the WPI, which is the most reliable indicator, suggests that wages growth is at the upper end of the range that has been observed in the period since the late 1990s.

Business surveys and the Bank's liaison program with firms both indicate that labour market conditions remain tight with firms experiencing shortages of skilled labour. According to the NAB survey in the December quarter, firms report that labour scarcity continues to constrain their activity to a larger extent than lack of demand (Graph 75).

Inflation expectations

The proportion of businesses increasing their prices in the December quarter or expecting to increase their prices in the near term is somewhat above the long-run average according to business surveys. However, on balance the pick-up in pricing pressures apparent in the surveys in late 2005 and early 2006 seems not to have continued (Graph 76).

Market economists, surveyed by the Bank following the release of the December quarter CPI, have reduced their forecasts of CPI inflation slightly. The median expectation for headline inflation over the year to the December quarter 2007 was 2.5 per cent, down from 2.7 per cent in November (Table 15). Over the year to December 2008, the median inflation expectation was also 2.5 per cent. Union officials have reduced their median inflation expectation over the year to the December quarter 2007, by ½ percentage point.

According to the Melbourne Institute survey of households, the median expectation for consumer price inflation over the coming year was 3.5 per cent in January. Although this is slightly higher than the average over the inflation-targeting period, it has fallen from the peaks reached in mid 2006, in line with the easing in fuel prices. The implied medium-term inflation expectations of financial market participants, as measured by the difference between nominal and indexed bond yields, was a little over 3 per cent in early February. Given the institutional factors noted in previous Statements, this figure may overstate actual inflation expectations.

Inflation outlook

Most measures suggest underlying inflation was around ½ per cent in the December quarter. While this may understate the strength of ongoing underlying inflationary pressures, taking the September and December quarters together, it does appear underlying inflation was running at a lower rate in the second half of 2006 than the annualised rate of around 3¼ per cent seen in the first half of the year.

The Bank's forecasts assume that oil prices and the exchange rate remain around current levels through to the end of the forecast period (December quarter 2008), and that global growth evolves in line with Consensus forecasts. The forecasts envisage non-farm GDP growth of around 3¼ per cent over 2007 and 2008, with total GDP growth likely to be a little higher if climatic conditions result in a recovery in rural sector output. These outcomes would be somewhat higher than recent growth outcomes, with the improvement reflecting higher exports of commodities following the substantial investment in new capacity, and a gradual pick-up in the house-building sector. Growth in consumer demand is expected to remain moderate and investment is likely to grow a good deal more slowly than the rapid rates seen in recent years. Overall, growth is forecast to be more balanced than in recent years, with more growth from exports and less from domestic demand.

The central forecast is for year-ended underlying inflation – currently around 3 per cent – to fall to 2¾ per cent in 2007 and 2008 (Table 16). With the recent falls in oil prices and the unwinding of the banana price increases, headline CPI inflation is expected to fall below 2 per cent in mid 2007 before rising to be about the same as underlying inflation later in the forecast period. These forecasts represent a modest downward revision to the inflation forecasts contained in the previous Statement, reflecting both the evidence that underlying inflationary pressures in the second half of 2006 were somewhat weaker than in the first half, and the likelihood that recent falls in world oil prices will result in some dampening effect on cost pressures and inflation expectations. But many of the factors that have pushed up underlying inflation over the past few years persist. Ongoing labour market tightness is likely to keep wage growth at above-average levels. In addition, upstream price pressures appear to remain reasonably strong, and capacity utilisation in the economy has been high and is only expected to ease modestly. Hence the reduction in inflation is likely to be only modest, and outcomes are forecast to be in the upper half of the target band over the next few years. Overall, risks to the forecasts appear to be broadly balanced.