There’s good news in the inflation figures, according to the AMP’s chief economist, Dr Shane Oliver.
The fall in headline inflation was largely driven by an 18% plunge in petrol prices and by falls in prices for cars, deposit and loan facilities and pharmaceuticals.
Weakness was also evident in prices for various household items and electronic equipment and as a result the underlying rate of inflation (as measured by an average of the RBA’s mean and median inflation series) fell to 0.75% in the quarter, which is well down on the 1.1% to 1.3% readings over the previous four quarters.
On a year ended basis underlying inflation fell to 4.3% from 4.7%.
Quite clearly the slump in demand in the economy combined with the reversal in petrol prices is now driving inflation lower.
This is likely to have a lot further go.
The recessions of the 1970s, 1980s and 1990s all knocked inflation sharply lower as the slump in growth took pressure off costs and made it harder for companies to raise prices and we are likely to see exactly the same thing happen this time around as the economy slides into recession.
While higher prices for imported items thanks to the lower $A will slow the fall in inflation, it will be hard to see retailers being able to pass such cost increases on to consumers in the tough environment that is now unfolding.
Just as the strong $A didn’t stop inflation rising over the last few years, the falling $A won’t stop it falling over the year ahead either.
So while both headline and underlying inflation are still above the RBA’s 2 to 3% target range, both are likely to fall sharply over the year ahead.
In fact headline inflation is likely to flirt with deflation on a year ended basis and a slide in underlying inflation well below the 2% level is quite possible next year if economic recovery is slow to arrive.
For the RBA, the December quarter inflation figures confirm that inflation is yesterday’s story.
The fall in inflation with a further decline in prospect clears the way for additional rate cuts which are necessary given the worsening collapse in global growth and the likelihood that Australia has entered a recession.
Next week we see the RBA cutting the cash rate by another 0.75%, taking it to a record low of 3.5%.
The risk is that the cut will be another 1%.
By mid year the cash rate is likely to have fallen to around 2.5%.
Falling inflation will put a lid on bond yields (despite the increase in bond supply flowing from likely budget deficits and financial rescues) and if anything will ultimately see 10 year Australian government bond yields push even further below the 4% level.
