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Australia's CPI surprises on upside at 1.3%q/q

Australia's CPI surprises on upside at 1.3%q/q in March quarter

Headline CPI printed at a higher than expected 1.3%q/q in the March quarter (JPMorgan 1.2%, consensus 1.1%), following a 0.9% rise in the previous three months. Annual inflation growth surged to 4.2% (JPMorgan 4.1%, consensus 4.0%), up from 3.0% in 4Q, and soaring well above the RBA's 2-3% target range. More importantly, though, the trimmed and weighted means spiked 1.2% and 1.3%, respectively, over the March quarter, putting both underlying inflation measures above 4%oya for the first time on record.

The main drivers of inflation were broadly as expected: soaring energy prices, particularly for automotive fuel (+5.4%) and electricity (+6.0%), food prices (+2.1%), house purchase costs (+1.7%) and rents (+2.0%), and other financial services (+2.0%). In particular, the financial service component—carrying a significant 8% weighting in the CPI—rose sharply as the spread between deposit and lending rates widened further in 1Q, owing to the fallout from the global credit crunch.

The major surprise in the CPI print was the 4.0% spike in the health component; this, according to the ABS, was primarily due to a rise in pharmaceutical prices (+13.1%). Drug prices rose as a result of the cyclical reduction in the proportion of consumers who qualify for subsidized medications under the Pharmaceuticals Benefit Scheme at the start of each calendar year. The partial offsets stemmed from falling prices of imported clothing and footwear (-2.4%), owing to the 2% appreciation of AUD against the US dollar over the quarter. Also logging falls were household contents and services (-0.6%), communication (-0.1%), and recreation (-0.3%).

Inflationary pressures will remain at large in 2009. The economy has little spare capacity, the labour market is tight, which eventually will lead to higher wages, and there is another round of personal income tax relief likely to be delivered in July. Although there are signs that domestic demand is easing, a spike in contract coal prices means the terms of trade will provide a substantial boost to national income in 2008.

Normally, a 1%-plus quarterly print on core CPI and a clear breach of the inflation target would make an RBA rate hike at the next Board meeting a near certainty. That said, the recent marked change of tone of RBA verbiage towards a more balanced commentary, and growing signs of a sudden loss of momentum in the domestic economy, mean the RBA will probably look through this uncomfortably high CPI reading, while officials assess signs of weakness in upcoming domestic data. Indeed, next week will likely see a further moderation in credit growth, and a slump in retail sales.

Furthermore, with the upside surprise in 1Q CPI likely to spark fresh speculation that the RBA will hike interest rates in May (markets now price a 25% probability of a 25bp hike in May, compared to nearly zero prior to the release of the CPI print), consumer confidence will likely fall even further from the current 15 year lows.

As such, the RBA will likely leave the cash rate steady at 7.25% in the near term, unless there a significant signs of a rebound in the domestic economy to accompany the deteriorating inflation outlook. Additionally, there already is substantial policy tightening in the pipeline given the RBA has hiked interest rates four times since August, and domestic banks have raised rates on standard variable mortgages by more than, and outside of, the rises in the official cash rate. If there is a material and sustained improvement in domestic conditions, however, RBA officials will find it a challenge to explain why they were not raising the cash rate when both headline and core inflation is tracking well above target.

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