Core inflation will ensure the RBA maintains an upward rates trajectory

Headline inflation has fallen more than many had predicted but that will be of little comfort to the RBA due to the persistence of underlying inflation.

A bigger-than-expected fall in inflation suggests the cost of living is easing and interest rates may be near a peak, but the persistence of underlying inflation will be of little comfort to the RBA.

Economists predicted a substantial fall in consumer prices due to the base effects associated with fuel price volatility, as well as the usual fall in holiday travel and accommodation prices after Easter.

But 5.6 per cent in annual inflation recorded by the ABS in its monthly CPI indicator for May undershot a consensus estimate of 6.1 per cent and was at the low end of expectations.

It was the lowest inflation in more than a year and well down from a peak of 8.4 per cent in December.

However, while the share market jumped, the reaction in currency and bond markets was limited. The ASX 200 share index rose 1.1 per cent to 7196.5 points.

UBS Australia chief economist George Tharenou. Picture: Hollie Adams

Sensing downside risk for inflation before the release of the monthly CPI indicator, the interest rate futures market had trimmed its pricing of RBA rate rises to imply less than one increase in the next two meetings. But the monthly CPI is only one inflation indicator and an imperfect and volatile one.

After the CPI data, the market-implied chance of another 25 basis point lift in the cash rate to 4.35 per cent was about 15 per cent for July and about 70 per cent for August. For the RBA’s November meeting, the futures market was pricing in 34 basis points of rate rises – implying a “terminal rate” below the 4.6 per cent consensus estimate of economists surveyed by Bloomberg last week.

The monthly data could lead the RBA board to “skip” an increase at its meeting next Tuesday as it awaits a fuller picture of inflation in quarterly CPI data and updated RBA economic forecasts that will be available at the August meeting, but economists still expect between one and three more rises.

UBS Australia chief economist George Tharenou expects the RBA to lift the cash rate by another 25 basis points to 4.35 per cent in the coming months, most likely in August.

But given the strong jobs data and still-high inflation, he said the RBA could increase the cash rate in July and August.

Mr Tharenou is the only major investment bank economist to correctly predict every interest rate move by the RBA since July 2022. Those included the past four outcomes which were non consensus.

While the monthly CPI data showed a large deceleration in headline inflation, core inflation was less encouraging, according to ANZ senior economist Adelaide Timbrell.

The CPI, excluding volatile items and holiday travel – a focus of the RBA board’s June minutes – showed almost no moderation, rising 6.4 per cent versus 6.5 per cent in April.

Given that the past two decisions were described by the RBA board as “finely balanced”, Ms Timbrell said the RBA could pause in July, before delivering two rate increases in subsequent meetings.

Strong labour market momentum, including employment growth of 143,000 in the three months to May and an unemployment rate of 3.6 per cent, may add to the case for a cash rate increase in July.

Reserve Bank of Australia deputy governor Michele Bullock. Picture: Martin Ollman

In her speech last week, RBA deputy governor Michele Bullock estimated the non-accelerating inflation rate of unemployment was likely to occur at an unemployment rate of about 4.5 per cent.

Other recent data that could offset optimism from the encouraging headline monthly CPI result include the rapid increase in unit labour costs in the year to Q1 2023, future increases in electricity prices, ongoing wage increases and a rise in petrol prices after a 6.7 per cent on-month fall in May.

Capital Economics head of APAC Marcel Thieliant said that while headline inflation “plunged”, this would not assuage the bank’s concerns about soaring unit labour costs and rising inflation expectations.

He still expects the RBA to lift its cash rate by 25 basis points at each of its next three meetings, and rate cuts would only be likely from the June quarter of 2024.

NAB senior economist Taylor Nugent said the persistence of underlying inflation in the monthly CPI data would be of little comfort to the RBA, particularly as its recent decisions to increase rates after the April pause were centred around an assessment of upside risks to inflation from “sticky services inflation” and shifts in wage and price setting behaviour.

Core inflation measures and services indicators in the CPI data show that concern was well founded.

It comes as central banks globally focus on services inflation and their expectation that firms should absorb rising labour costs in margins as demand slows.

That would be at risk if there was a more persistent shift in price setting behaviour among firms after easily passing on price increases over the past couple of years.

The RBA has flagged concern in the recent minutes that some firms were “indexing their prices, either implicitly or directly, to past inflation”, and that this “created an increased risk that high inflation would be persistent”.

In this regard the ABS did note for restaurants/takeaway that “higher costs of ingredients, rents, utilities, and wages were passed on” in the latest period.

“The CPI data suggest firms are continuing to pass through a large share of input cost increases, which if sustained would challenge the RBA’s forecasts of getting inflation back to 3 per cent by mid-2025,” Mr Nugent said.

But while the RBA’s hawkish bias argues for a rise in July, its decision to pause in April – before a full forecast update and full quarterly CPI – before restarting its rate increases in May is a “precedent that makes July less certain,” he said.

Originally published as Core inflation will ensure the RBA maintains an upward rates trajectory