ANZ RESEARCH

INTEREST RATE STRATEGY STRATEGY AROUND THE Q3 CPI RELEASE

24 OCTOBER 2011 CONTRIBUTOR

Shane Lee Senior Rates Strategist +61 2 9226 4632 Shane.Lee@anz.com

INTRODUCTION In this note we look at the risks around the CPI using data published by Bloomberg on economists expectations for the quarterly increase in the trimmed mean of the CPI basket. At the end of each quarter, economists build bottom-up forecasts of the CPI using data from private sector data vendors on such items as automotive fuel, rents, fruit and vegetables, utilities etc. Using this approach its possible to get a good handle on price movements of around 50% of the basket. However, it leaves the unknown price movements (the remaining 50%) to be determined by an econometric model and this is probably where there is most room for error. We find that if automotive fuel prices rise and rise by more than 1.5% then there is a 77% probability that the trimmed mean outcome will exceed expectations. Conversely, if fuel prices fall and fall by more than 1.5% then there is a 43% chance that the outcome will be below expectations. Data for Q3 suggests that fuel prices fell by 1% in the quarter. The historical relationship between actual and expected trimmed mean outcomes and fuel prices implies that it is more probable that economists expectations will be met. The Bloomberg survey indicates that economists are expecting a 0.6% rise in the trimmed mean that would put the YoY rate at 2.7%, up from a revised 2.5% in Q2. Indeed, this should be sufficient for the RBA to consider a modest 25bps rate cut at its 1 November Board Meeting. We expect the trimmed mean measure of consumer prices to rise by 0.5% in the quarter. The range of forecasts is from 0.5-0.8%. OUTCOMES VS ECONOMISTS EXPECTATIONS Bloomberg have published data on actual underlying CPI results against economist estimates since Q3 2006. On average, economic forecasters under-estimated inflation in both 2007 and 2008 as it continued to climb well beyond 3% (Figure 1). This trend continued throughout 2009 and in Q1 2010. In the remainder of 2010, they over-estimated inflation, while in the first half of 2011 it was under-estimated. Of course the ABS revisions have changed the actual outcomes over this period and most notably the Q2 2011 result. However, these revisions were made using a new seasonal adjustment process that was not used prior to Q3 2011 and should not impact our analysis of actual verses expected inflation outcomes.

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FIGURE 1. QUARTERLY INCREASE IN TRIMMED MEAN

% 1.2 1 0.8 0.6 0.4 0.2 0 2006 2007 2008 2009 2010
Actual

2011

2012

Economists' Estimate

Source: Bloomberg

The Bloomberg data provides us with 20 observations of outcomes matched against expectations. Automotive fuel has some well understood second round impacts on other items within the CPI basket and this highlights the risk that large increases in fuel prices can bring to the inflation outlook. Fuel prices have risen by an average of 0.6% in each quarter since Q3 2006 (Figure 2). However, over this period there have been significant price volatility and some large quarterly movements. The largest fall was in Q4 2008 (18.2%) and the largest rise was (9.1%) in Q2 2007.
FIGURE 2. QUARTERLY TRIMMED MEAN SURPRISE AND FUEL PRICES
%
10 5 0 -5 -10 -15 -20 -25 2006

%
0.2 0.1 0 -0.1 -0.2 -0.3 -0.4 -0.5 2012

2007

2008

2009

2010

2011

Surprise (RHS)

Automotive Fuel Prices (LHS)

Source: ABS, Bloomberg

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The data shows that fuel prices have increased on 13 out of the 20 quarters since 2006. In 10 of these quarters where the increase has been more than 1.5% there has been a positive surprise on the underlying trimmed mean. In other words, there is a 10/13 (77%) chance of a positive surprise if the fuel price rises and rises by more than 1.5% in the quarter. Throughout sample period, fuel prices fell in 7 out of 20 quarters. On 3 of these 7 occasions (43%) fuel prices have fallen by more than 1.5% when there has been a downside surprise to the quarterly change in the underlying trimmed mean. In Q3 2011 we estimate that fuel prices fell by 1.0% and this suggests that the result should be in line with the consensus estimates for this release i.e. we see a lower probability of a surprise outcome. MARKET IMPLICATIONS 3-year bond futures have sold-off by over 50bps since the 5 October peak due mostly to a general improvement in global risk appetite. However, we still think the front end of the curve looks expensive as we are still only looking for a modest easing in policy. We have initiated a trade, selling 3-year bond futures (target 95.78, stop 96.38), Local economic data has generally printed stronger than expected; most notably the September employment report. However, retail sales, building approvals and home loan approvals were also better than expectations in August. Furthermore, business and consumer confidence are continuing to improve from their August lows. However, downside risks have emerged from Europe and the RBA has opened the door to easing policy. While the improvement in market sentiment over the past few weeks is likely to be tested by the outcome of developments in the EU and G20, the most important piece of local data for local interest rate markets is undoubtedly the Q3 CPI. There is probably more uncertainty around this CPI release than normal and this has added to tensions in markets. The ABS is calculating the seasonally adjusted underlying inflation measures using a new seasonal adjustment measure from the Q3 CPI onwards. This has already introduced a large downward revision to the Q2 data. On top of this, the CPI basket will be changed, with a skew towards higher inflation services. A low outcome in line with our expectations will probably see the RBA ease policy on 1 November. However, its unlikely that the market will rally strongly, even on the back of a relatively low trimmed mean rise provided the RBA indicate that there will be only limited future policy easing.

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INFLATION MARKET IMPLICATIONS The Australian inflation market continues to trade cautiously considering global uncertainties facing global markets. As result the Australian markets in ZCS and BEIs have built in a risk premium for a further deterioration in world growth, we have also seen a fall in traded volumes as investors shift to more conventional nominal securities in this risk off environment. So we see the market already moving towards discounting a relatively mild CPI outcome. We still continue to see longer-term inflation risks through higher energy prices and wage pressure with a large pipeline of infrastructure projects coming on line in 2012. Ten-year ZCS are currently holding around 2.85% while the IX20 real yield is around 1.80%. Should we see resolution come out of Europe and rebound in commodity prices from the very accommodative offshore monetary policies as we saw post GFC we should see the inflation outlook stabilise. We see the 2.78% level as important for ZCS while we would expect to see strong support for real yields around 20bps below current levels. As a hedging solution we recommend to buy future 25% inflation protection at current levels and 50% coverage should we move to the middle of the RBA inflation band in the 3 to 10-year tenors. The Australian economy remains well supported by the resources sector which continues to grow to meet Asian demand with 2012 earmarked for some very large infrastructure projects. And looking ahead the passage of the carbon tax should put as much 0.7% into headline inflation in the next 2 years from July. The IX20 offer the most liquidity and best pick up to longer term inflation fundamentals.

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