AUSTRALIAN MARKETS WEEKLY

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1 30 October 2017 AUSTRALIAN MARKETS WEEKLY Inflation what does the latest CPI tell us? In this issue Recent inflation developments 2 Tradable and non-tradable trends 2 Forecasting the CPI 4 Implications for monetary policy 4 Calendar of economic releases 5 Forecasts 6 To contact NAB s market experts, please click on one of the following links: Ask the Economists Ask the FX Strategists Ask the Interest Rate Strategists The Q3 CPI came in a little below expectations, with core rates of inflation of 0.3/0.4% q/q and a headline rate of 0.6% q/q. Economists had expected around 0.4/0.5% and 0.8% q/q rates respectively. These outcomes left y/y inflation rates around the % mark for the various headline and core inflation measures, which was a little below the lower edge of the RBA s 2-3% inflation target. In this Weekly we delve into what is driving the subdued inflation outcomes in Australia. As RBA Deputy Governor Guy Debelle reminded us, it is very important to understand the starting point for the forecast as well as how one arrived at the starting point to successfully forecast the future! We investigate trends within the 87 items of the CPI basket. We find that around 40% of the CPI basket has been falling in price over the past year. This mainly reflects falling prices for food, globally traded manufactured goods such as clothing and furniture, and the long-term price decline in technology products. This leads us to conclude in a general sense that it will be relatively hard for Australian inflation to pick up too much in coming years, barring: (i) an acceleration in the global component of inflation; or (ii) a tightening in the Australian labour market, which sees a decline in unemployment and underemployment lead to some pick-up in wages growth. What does it all mean for the RBA? In the near term, the low Q3 CPI likely rules out a move to increase interest rates early in 2018, not that NAB expected such a move in any case. This does not necessarily mean that the Bank will not adjust monetary policy next year. It however will mean that indicators of labour market spare capacity and wages trends will tend to be more important drivers of monetary policy decisions over the next 6-18 months than CPI outcomes. NAB continues to expect that the RBA will begin to reduce some of the support it is providing to the Australian economy in the form of low interest rates next year and is forecasting a half a percent increase in rates in the second half of For the week ahead, Friday s September Retail Trade Report is the one to watch, NAB s own Cashless Retail Index pointing to a strong 0.5% bounce-back. Other Australian data out this week includes Credit Statistics on Tuesday, followed by Building Approvals and Trade Balance on Thursday. Offshore it s a busy week with the Bank of England expected to hikes rates on Thursday (markets are 80% priced). The US has its key PCE deflators Monday, ISM Manufacturing and FOMC on Wednesday, then Payrolls on Friday. China s manufacturing PMI also gets released on Tuesday. The market is also expecting an announcement from President Trump this week on who the next Fed Chair will be. Key markets over the past week Chart of the week: CPI a touch softer than expected Last % chg week Last bp / % chg week AUD RBA cash AUD/CNY y swap AUD/JPY ASX 200 5, AUD/EUR Iron ore AUD/NZD WTI oil Source: Bloomberg Ivan Colhoun, Chief Economist, Markets Tapas Strickland, Economist National Australia Bank Limited ABN AFSL and Australian Credit Licence

2 Recent inflation developments Charts 2 to 4 look at Australian inflation developments over the past quarter, year and five years. In terms of this quarter s inflation outcome, we d suggest the important takeaways are: the undershoot relative to the forecast for headline inflation mainly reflected the large fall in vegetable prices and a smaller rise in electricity prices than expected, neither of which particularly reflect demand-driven effects (veggie prices returning to more normal levels after the cyclone and electricity prices likely reflecting measurement timing issues); the preponderance of items with declining prices primarily reflects three factors: (i) falling prices for food (largely reflecting heightened supermarket price competition ie. not necessarily reflecting weak demand importantly pricing behaviour that seems likely to broadly persist); (ii) falling prices for globally traded manufactured goods, such as clothing and footwear, furniture, textiles, toys and appliances (which likely reflects both the rise of China as a manufacturing centre and a degree of excess capacity globally); and (iii) technology-related products such as TVs, computers and telecommunications, where quality adjustments related to technological advances and a short product life cycle tend to result in consistent falls in price across time. Again, these pricing trends do not look likely to change any time soon and indeed the forthcoming reweighting of the CPI is expected to see an increase in their weight in the CPI. The long period between CPI re-weightings also tends to lead to some over-statement of inflation as consumers substitute from high priced goods to those falling in price such as technology. RBA Deputy Governor suggested such a bias could be around 0.25 percentage points, though a forthcoming move to annual re-weighting will reduce that problem. Chart 1: 40% of items are declining in price y/y Share of CPI Items Falling in Price Source: National Australia Bank, ABS Share of items, % Looking at price changes over the past year and past five years, the same trends are broadly evident, with the distinction between traded and non-traded goods very clear. The effect of price falls of computing equipment and telecommunications is also particularly noticeable over a five year period (Charts 3 and 4). Chart 2: Falls in veggie prices; power rises undershoot Chart 3: Price declines sharpest in Fruit, Veg & Tech Chart 4: Persistent declines in Food, Clothing & Tech Items with the largest price increases typically have some form of government tax or regulated pricing aspect or are non-traded (eg electricity, gas, education, insurance, tobacco, health, transport fares). Again, it does not seem particularly likely that prices for these items will not continue to rise relatively quickly in the next few years, though of course the government will be hoping its energy market policy will slow price rises and even reduce electricity prices somewhat in due course. Tradable and non-tradable trends Looking at the distinction between tradables and nontradables inflation a little more closely (Chart 4), we can observe a number of important trends, which will help inform our forecast of inflation: Non-tradables inflation (which comprises some 64% of the CPI) used to cycle around a 4% inflation rate, but since around 2013 has moderated to around a 2% annual inflation rate; and NAB Markets Research 2

3 There has been a good deal of cyclicality in tradables inflation (36% of the CPI), albeit about a very low level of price inflation in recent years. Chart 5: Traded and non-traded gods inflation Chart 6 reveals that much of the cyclical nature of tradables inflation reflecting variations in oil/petrol prices in the CPI, though there is also a significant decline in tradables inflation in , which is not due to oil/petrol prices. Interestingly, this is also around the time that non-tradables inflation moderated. Other central banks, the BoC most recently and the RBNZ previously, have noted that in recent years there has been a very significant common global inflation component explaining developments in individual country s CPIs. Replicating this analysis for Australia finds a global inflation component can explain round 53% of headline inflation and 24% of core inflation. slowdown noticeable in the mining regions, which has produced an unusual divergence in inflation rates between the states (see table above). The very significant influence of rents on Australian inflation and on core inflation likely continues to be under-appreciated. Rents have around a 6.7% weight in the headline CPI and a 9.6% weight in the core CPI. Chart 8 shows the very significant decline in rents that has occurred in Perth and Darwin in the wake of the mining slowdown/recession. This downturn and the broader flow-on effects in these states/territories has produced significantly lower annual rates of inflation in these two cities which make up around 15% of the national CPI. The falls of around 7-8% y/y reduce headline inflation by nearly half a percent in these regions and core inflation by percentage points, and individually reduce the national CPI by around 0.1% points. Chart 7: Core CPI heavily influeced by rents Chart 6: Tradables inflation linked to oil prices Chart 8: Rents falling in Darwin and Perth Our previous work has looked at the moderation in non-tradables inflation and found that this moderation has been explained by two major developments a slowdown in both rents and wages with the biggest Table 1: Capital City Inflation Per cent change September quarter 2017 Qtry % Annual All groups CPI Sydney Melbourne Brisbane Adelaide Perth Hobart Darwin Canberra Source: National Australia Bank, ABS Rents however have also moderated in all other capital cities over this time period, likely reflecting a combination of lower interest rates and lower headline CPI rates. More recently rents have begun to decline in Brisbane, reflecting increasing vacancy rates, which in turn reflect the large (and likely somewhat excessive) supply of apartments being completed in that city over the next months. Thankfully, both overseas and interstate migration to Queensland has begun to pick up in recent quarters, which should provide some offset to this oversupply and residential building approvals have also moderated in BNE over much of the past 15 or so months. That said, the course of Brisbane rents and vacancy rates will be a very important component to monitor over coming quarters in relation to the overall NAB Markets Research 3

4 Australian CPI as Brisbane has a weight in the CPI similar to Perth and Darwin combined and some further declines in rent seem likely. This particular influence and the likely track of rents more generally will likely remain a headwind for the RBA s reachieval of its 2-3% inflation target in the immediate future, however, it s worth distinguishing between the mining-related demand-driven weakness in rents witnessed in Perth and Darwin and the excesssupply related rental weakness evident in Brisbane. As Chart 9 below shows, wages developments have also had an important mining cycle element to them, the negative influence of which should be beginning to moderate as mining business conditions improve. Internationally, producer prices are increasing in line with the recent tick up in commodity prices (Chart 10) and this should feed into domestic inflation in time (Chart 11). Chart 10: Global prices are on the rise Chart 9: Compensation very weak in QLD and WA Chart 11: Labour costs need to rise to get inflation up Forecasting the CPI Having spent some time establishing the reasons for current sub-target inflation, it s worth considering how these factors might play out in the next months, which is the timeframe that the RBA can reasonably hope to forecast. Some general observations and conclusions can be made: Grocery price deflation/supermarket price wars and IT and communications price falls seem likely to generally persist; Rents in Brisbane are likely to be a drag on the CPI in coming quarters offsetting any improvement in rental conditions in Perth and Darwin; Cycles in petrol prices are important for tradables inflation this quarter, it s more likely that petrol prices will rise, but a more protracted period of oil price rises is not generally expected. This leads us to conclude in a general sense that it will be relatively hard for Australian inflation to pick up too much in coming years, barring: (i) an acceleration in the global component of inflation; or (ii) a tightening in the Australian labour market, which sees a decline in unemployment and underemployment lead to some pick-up in wages growth. Again, thankfully, there are some encouraging signs on both of these fronts with measures of job advertising and on the difficulty finding suitable labour, both beginning to suggest some improvement in Australian labour market conditions. The degree to which the mining regions of Australia bounce back, will also be important to monitor. Implications for monetary policy The low Q3 CPI outcome and more importantly the likelihood that many of the reasons for the low outcome will likely persist on a month outlook suggests that significantly strengthening inflation is not likely to be a concern for the RBA in the next 6-12 months. In the near term, the low Q3 CPI likely rules out a move to increase interest rates early in 2018, not that NAB expected such a move in any case. This does not necessarily mean that the Bank will not adjust monetary policy next year. It however will mean that indicators of labour market spare capacity and wages trends will tend to be more important drivers of monetary policy decisions over the next 6-18 months than CPI outcomes. NAB continues to expect that the RBA will begin to reduce some of the support it is providing to the Australian economy in the form of low interest rates next year and is forecasting a half a percent increase in rates in the second half of Ivan.Colhoun@nab.com.au Tapas.Strickland@nab.com.au NAB Markets Research 4

5 CALENDAR OF ECONOMIC RELEASES Country Economic Indicator Period Forecast Consensus Actual Previous GMT AEDT Monday, 30 October 2017 JN Retail Sales MoM/YoY Sep 0.8/ / UK Net Consumer Credit/Mortgage approvals Sep 1.5/66 1.6/ EC Business Climate Indicator Oct US Personal Income/Spending Sep 0.4/ / US PCE Deflator MoM/YoY Sep 0.4/ / US PCE Core MoM/YoY Sep 0.1/ / GE CPI EU Harmonized MoM/YoY Oct P 0.1/ / CA Bloomberg Nanos Confidence Oct US Dallas Fed Manf. Activity Oct Tuesday, 31 October 2017 NZ Building Permits MoM Sep AU ANZ Roy Morgan Weekly Consumer Confidence Index Oct JN Jobless Rate/Job-ro-Applicant Ratio Sep 2.8/ / JN Overall Household Spending YoY Sep JN Industrial Production MoM/YoY Sep P -1.6/2 2.0/ NZ ANZ Activity Outlook/Business Confidence Oct / 29.6/ AU HIA New Home Sales MoM Sep UK GfK Consumer Confidence Oct UK Lloyds Business Barometer Oct AU Private Sector Credit MoM/YoY Sep 0.5/ / / CH Manufacturing/Non-manufacturing PMI Oct 52/ 52.4/ NZ Credit Aggregates, Household YoY Sep JN BOJ Policy Balance Rate Oct JN Vehicle Production YoY Sep JN Small Business Confidence #N/A Field Not Applicable 49.4 #VALUE! #VALUE! JN BOJ Kuroda speaks at press conference after MPM EC ECB's Visco, Finance Minister Padoan at World Saving Day Event EC GDP SA QoQ/YoY 3Q A 0.5/ / EC CPI Estimate YoY/Core CPI Oct 1.5/ / EC Unemployment Rate Sep CA GDP MoM/YoY Aug 0.1/ / CA Industrial Product Price/Raw Materials Price MoM Sep 0.5/ / US Employment Cost Index 3Q US S&P CoreLogic CS 20-City MoM SA/YoY Aug 0.4/ / US Chicago Purchasing Manager Oct US Conf. Board Consumer Confidence Oct Wednesday, 1 November 2017 NZ Employment Change QoQ/YoY 3Q / / NZ Unemployment Rate 3Q NZ Pvt Wages Ex/Incl Overtime QoQ 3Q / / AU CBA Australia PMI Mfg Oct AU AiG Perf of Mfg Index Oct AU CoreLogic House Px MoM Oct UK BRC Shop Price Index YoY Oct JN Nikkei Japan PMI Mfg Oct F CH Caixin China PMI Mfg Oct JN BOJ Nakaso speaks at FinTech Forum AU Commodity Index AUD/SDR YoY Oct / 120.8/ UK Markit UK PMI Manufacturing SA Oct CA MLI Leading Indicator MoM Sep US ADP Employment Change Oct CA Markit Canada Manufacturing PMI Oct US Markit US Manufacturing PMI Oct F US ISM Manufacturing/Prices Paid Oct 59.4/ / US Construction Spending MoM Sep NZ QV House Prices YoY Oct US FOMC Rate Decision (Lower/Upper Bound) Nov 1 1/ / Thursday, 2 November 2017 NZ ANZ Job Advertisements MoM Oct AU Trade Balance Sep AU Building Approvals MoM/YoY Sep 1.1-1/ / JN Consumer Confidence Index Oct GE Unemployment Change (000's/Rate) Oct -10/ / GE Markit/BME Germany Manufacturing PMI Oct F EC Markit Eurozone Manufacturing PMI Oct F UK Markit/CIPS UK Construction PMI Oct US Challenger Job Cuts YoY Oct UK Bank of England Bank Rate Nov UK BOE Asset Purchase/Corporate Bond Target Nov 435/ / US Initial Jobless Claims Oct US Nonfarm Productivity/Unit Labour Costs 3Q P 2.5/ / US Wards Total Vehicle Sales Oct US Bloomberg Consumer Comfort Oct Friday, 3 November 2017 AU CBA Australia PMI Services/Composite Oct / 53.2/ US Fed's Bostic Speaks in Chicago about Government Statistics AU AiG Perf of Services Index Oct AU Retail Sales MoM/ex inflation QoQ Sep 0.5/ /0-0.6/ CH Caixin China PMI Services/Composite Oct / 50.6/ UK Markit/CIPS UK Services/Composite PMI Oct 53.3/ / US Change in Nonfarm Payrolls/Unemployment Rate Oct 310/ / US Average Hourly Earnings MoM/YoY Oct 0.2/ / US Labor Force Participation Rate/Underemployment Rate Oct 63.1/ 63.1/ US Trade Balance Sep US ISM Non-Manf. Composite Oct US Factory Orders/Ex Trans Sep 1.2/ 1.2/ CA Net Change in Employment/Unemployment Rate Oct CA Participation Rate Oct CA Int'l Merchandise Trade Sep US Markit US Services/Composite PMI Oct F 55.9/ 55.9/ US Fed's Kashkari Speaks on Housing and Finance EC ECB's Coeure Speaks in Washington Upcoming Central Bank Interest Rate Announcements Japan, BoJ 31-Oct -0.1% -0.1% -0.1% US Federal Reserve 2-Nov % % % UK BOE 2-Nov 0.25% Australia, RBA 7-Nov 1.50% 1.50% 1.50% New Zeraland, RBNZ 9-Nov 1.75% 1.75% 1.75% Canada, BoC 7-Dec 1.00% Europe ECB 14-Dec -0.4% -0.4% -0.4% GMT: Greenwich Mean Time; AEDT: Australian Eastern Daylight Savings Time NAB Markets Research 5

6 FORECASTS Economic Forecasts Annual % change Quarterly % change Australia Forecasts Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Household Consumption Underlying Business Investment Residential Construction Underlying Public Spending Exports Imports Net Exports (a) Inventories (a) Domestic Demand - qtr% Dom Demand - ann % Real GDP - qtr % Real GDP - ann % CPI headline - qtr % CPI headline - ann % CPI underlying - qtr % CPI underlying - ann % Wages (Pvte WPI - qtr % Wages (Pvte WPI - ann %) Unemployment Rate (%) Terms of trade G&S trade balance, $Abn % of GDP Current Account (% GDP) Source: NAB Group Economics; (a) Contributions to GDP growth Exchange Rate Forecasts Global GDP 30-Oct Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 Dec year Majors Australia AUD/USD US NZD/USD Eurozone USD/JPY UK EUR/USD Japan GBP/USD China USD/CNY India USD/CAD New Zealand USD/CHF World MTP Top Australian Cross Rates AUD/NZD Commodity prices ($US) AUD/JPY Oct Dec-17 Mar-18 Jun-18 Dec-18 Dec-19 AUD/EUR WTI oil AUD/GBP Gold AUD/CNY Iron ore AUD/CAD Hard coking coal AUD/CHF Thermal coal Copper Interest Rate Forecasts Aust LNG (*) Australia Rates 30-Oct Dec-17 Mar-18 Jun-18 Sep-18 Dec-18 (*) Implied Australian LNG export prices. RBA Cash rate month bill rate Year Swap Rate Year Swap Rate Offshore Policy Rates US Fed funds ECB deposit rate BoE repo rate BoJ excess reserves rate RBNZ OCR China 1yr lending rate China Reserve Ratio year Benchmark Bond Yields Australia United States New Zealand Sources: NAB Global Markets Research; Bloomberg; ABS 20 Yr Avge NAB Markets Research 6

7 CONTACT DETAILS Market Economics Ivan Colhoun Chief Economist, Markets ivan.colhoun@nab.com.au David de Garis Director, Economics david.degaris@nab.com.au Tapas Strickland Economist tapas.strickland@nab.com.au Markets Research Peter Jolly Global Head of Research peter.jolly@nab.com.au Group Economics Alan Oster Chief Economist alan_oster@national.com.au Riki Polygenis Head of Australian Economics riki.polygenis@nab.com.au Important Notice This document has been prepared by National Australia Bank Limited ABN AFSL ("NAB"). Any advice contained in this document has been prepared without taking into account your objectives, financial situation or needs. Before acting on any advice in this document, NAB recommends that you consider whether the advice is appropriate for your circumstances. NAB recommends that you obtain and consider the relevant Product Disclosure Statement or other disclosure document, before making any decision about a product including whether to acquire or to continue to hold it. Please click here to view our disclaimer and terms of use. NAB Markets Research 7