Why inflation will slump below 2% (leaving room for a rate cut)

There have been some interesting assessments of Wednesday's inflation print. As a quick reminder, here are the figures:

Source: ABS

Headline CPI came in at 0.4% for the quarter and 2.4% for the past year.

The Reserve Bank's preferred measures (the so-called trimmed mean and the weighted median, which I've circled) came in at 2.2% and 2.6% for the past year respectively. While, the RBA looks at both readings, its job is to maintain price stability and is perhaps therefore more inclined to place emphasis on the trimmed mean which negates the impact of outlying results.

Here are the recent quarterly headline inflation figures in a chart:

Source: ABS

The important thing to note is that there was a very large spike in the September 2012 quarter, caused by the introduction of the carbon price.

In particular, we have seen a huge increase in the price of electricity, up by more than 17% over the past year. Being British by birth, I can't say I'm shocked: in the UK electricity prices jumped by more than 20% at the end of 2011, so perhaps it was only a matter of time before Australia copped it too. I expect the prices of electricity and energy, petrol, alcohol and tobacco to continue to be slugged in the future.

Moderate readings

However, the recent inflation data has shown moderate readings for the past three releases, and thus next quarter, when the 2012 effect of the carbon price 'drops off', in the absence of a sizeable increase in inflation next time around, the CPI rate will likely slump to below 2%.

Seasonally adjusted, the last three readings have been 0.5%, 0.1% and 0.5% - so some simple maths dictates that a reading of 0.8% or lower would see inflation drop below the 2-3% target range.

As I noted previously, it's likely that there will be an increase in petrol prices next quarter, and the falling Aussie dollar could also send certain readings higher, but it's doubtful whether this would be enough to see inflation of above 2%.

Inflation of below 2% rarely signifies a booming economy, it has to be said, and what this means is that the Reserve Bank probably retains the room to cut interest rates again should it so wish.

It seems as though the market has gradually come around to this point of view too after initially seeming uncertain, probably having been spooked by the higher-than-expected weighted median reading of 0.7% for the quarter.

The ASX 30 Day Interbank Cash Rate Futures August contract is trading at 97.395, which indicates a 72% expectation of an interest rate decrease to 2.50% at the next RBA Board meeting on August 6: a cut in August is now deemed to be significantly more likely to be delivered than not.

The Aussie dollar also now seems to be pricing in a potential cut, having fallen all the way back to around 91.5 cents after initially having headed north.

Futures markets imply that the interest rate easing cycle is not quite done yet. The yield curve remains inverted, suggesting one more interest rate cut to 2.50%, before the cycle at long last reversing later in 2014.

Source: ASX