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CEO AllenWargent Property Buyers, & WargentAdvisory (institutional). 6 x finance author.

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Tuesday, 26 July 2016

Hold on to your hats

Huge release

I don't normally bother previewing data releases, but on Thursday week comes a potentially momentous, absolute whopper of a release!

So it's worth spending a bit of time discussing the inflation result, what is likely to be reported, and what it all means. Firstly, here's the back story...

Weak inflation

Annual non-tradables inflation - which one might take to be a reasonable proxy for domestic price pressures - fell to just 1.7 per cent in March 2016.

That's the weakest result since before the Sydney Olympics, when TLC was number one with "No Scrubs" (chart-topping singles being the default measure for things that happened ages ago, of course). 

This reflects softer than implied employment conditions, with under-utilisation and under-employment in evidence across all states and territories.

In other words, there has been plenty of spare capacity in the labour market, wages growth has been slow, and price pressures weak. The flagging red line in the chart below tells the story.

In theory at least, a correspondingly weaker dollar and the "pass through" effect therefrom should partially help to offset the weakness in domestic price pressures.

But as the blue line in the chart above shows, that basically ain't happened, and the dollar has actually been pretty much stable for the past year now, with the odd wobble.

The market forecasts headline inflation of 0.4 per cent for the June quarter, which would take the annual headline result all the way down to just 1.1 per cent, well below the Reserve Bank's 2 to 3 per cent range.

Remember that from its mandate the Reserve Bank of Australia has:

" ‘inflation target’ and seeks to keep consumer price inflation in the economy to 2–3 per cent, on average, over the medium term. Controlling inflation preserves the value of money and encourages strong and sustainable growth in the economy over the longer term."

Such a weak annual result would suggest that interest rates will be cut to a record low of just 1.50 per cent on August 2.

And indeed 24 of 25 surveyed economists do believe that this will transpire, in turn potentially supplying a massive boost to asset markets as cash in the bank delivers even lower returns.

Certainly the last paragraph of the Minutes of the July meeting suggested that the door has been left open for a rate cut. 

It's not a shoo-in just yet, however. The market forecast range suggests that the headline result could be anywhere from 0.3 per cent to 0,8 per cent. 

The headline inflation figures can be a bit volatile, and so the Reserve Bank looks at the core or underlying inflation figures, these analytical series stripping out the volatility and outlying results. 

Underlying inflation

In the year to March the inflation picture was mixed, but generally soft.

In particular, weak wages growth has contributed to very soft price pressures in food and beverages, clothing and footwear, household goods, and recreation and culture (holidays).

It's been argued that overdue supermarket competition from cost-cutting Aldi has contributed to lower food prices, but Aldi surely can't explain the weak inflation across so many sectors. 

Westpac forecasts that the underlying measures - the trimmed mean and weighted median readings - will come in at an average of just 0.35 percent for the June quarter, well under 2 per cent annualised and supporting the need for a further rate cut.

Housing key

Partly, that's a result of the above factors. But the most important factor this quarter, explains Westpac, is housing. 

Rent and construction costs generally aren't all that volatile, so are almost certainly going to be included in the core inflation measures, and construction costs have fallen away outside Sydney and Melbourne.

Moreover, rental pressures have also steadily dissipated as new apartments and houses are built. 

Indeed, rental price inflation hasn't been this low since the reintroduction of negative gearing rules in 1987 saw rental price growth drop from sky-high levels in the period during and immediately after quarantining.

Rental price growth has softened almost everywhere, but has been particularly soft in the resources capitals of Darwin and Perth, where annual rental prices have actually been falling since the second quarter of 2015.

A key point of note is that the Reserve Bank expects an underlying result of 0.5 per cent in June. So if Westpac is right, then the RBA may be moved to act on August 2.

The wrap

Piecing it together, you can see that with a punchy inflation print in June 2015 dropping off the annual result this quarter, the annual headline result is certain to be very soft. 

But it's the underlying inflation result which is key.

If you're a homeowner, you should hope for underlying inflation of 0.4 per cent or lower in the June quarter, because if that happens interest rates will almost certainly be cut next week to a record low of just 1.50 per cent. Stay tuned.