by
Dr Stephen J Nash | Oct 24, 2012
While the RBA focuses on the core inflation rate, investors, and especially retirees, are impacted by the headline CPI. Higher headline readings on inflation generally support the case for higher allocations to inflation linked bonds (ILBs).
Today, the Australian Bureau of Statistics (ABS) will release the quarterly consumer price index (CPI). The following is a summary of data available at this time, from various sources.
Types of inflation
While the headline CPI impacts consumers, and especially retirees, the RBA pays most attention to the trimmed mean and weighted mean inflation figures. As the RBA indicate, there are several alternative ways to measure underlying inflation.
- The first type is an ‘exclusion measure’, which “Typically, the excluded items are those that are volatile and/or display pronounced seasonal patterns, and those that are subject to administrative price setting ... (fruit, vegetables and automotive fuel), retaining just over 90 per cent of the CPI basket” (RBA, Statement on Monetary Policy, May 2002, p.55).
- The second type of measure uses statistical techniques to exclude extreme individual price movements, yet uses all parts of the CPI basket. As the RBA comment,
Each quarter, the CPI components, and their weights in the CPI, are ranked by the size of their price movement in the quarter. The trimmed mean is calculated as the weighted mean of the central 70 per cent of the quarterly price change distribution of all CPI components; that is, the top and bottom 15 per cent of the distribution are trimmed. In practice many of the ‘volatile’ items removed from the exclusion measures considered above will often be excluded from this measure too. However, the trimmed mean excludes extreme movements in any item, while small movements in usually volatile items will remain in the calculation. The weighted median is the inflation rate for that item which is in the middle of the total distribution of price changes; that is, it trims away all but the midpoint of the distribution so that half the component weights are on one side of the median, and half on the other (RBA, Statement on Monetary Policy, May 2002, p.55).
Market expectations
Market expectations of the CPI, via Bloomberg, were published on 19 October, and are as follows:
Source: Bloomberg 19 October 2012
Table 1
Prior survey data for the past quarter, with regard to headline inflation, was 0.638%, compared to an actual result of 0.50%. This was also the case for the past few surveys, so the market seems to be overestimating headline inflation. Hence, I expect more of the same with the survey this time. Of most interest in this release will be the “pass through” of the carbon price/tax to the headline CPI. This is expected to impact the CPI through utilities charges, which appears in the CPI under the sub-category of housing. Some market participants are expecting a quick pass through, while others anticipate that the pass through would be over a longer period.
ABS position on carbon price adjustment
As the ABS indicate:
The ABS will not be able to quantify the impact of carbon pricing, compensation or other government incentives and will not be producing estimates of price changes exclusive of the carbon price or measuring the impact of the carbon price. Any changes in the prices charged by companies for their outputs, paid by companies for their inputs or paid by consumers, will be reflected in the suite of price indexes compiled and published by the ABS. Further information on the expected impacts of the introduction of carbon pricing is available in the publication Strong Growth, Low Pollution - Modelling a Carbon Price (The Treasury, 2011) (Source: ABS, 6401.0 Consumer Price Index, Australia, June 2012, Introduction to carbon pricing, link)
Treasury position on carbon price adjustment
Treasury estimates the short term impact of the carbon price/tax will be 0.7% in 2012/13. As the Treasury indicate:
A carbon price of $23/t CO2-e in 2012 13 has a small one-off rise in the consumer price index of around 0.7 per cent (Source: Strong Growth, Low pollution, Modelling a Carbon Price, Overview, Australian Department of Treasury, ISBN 978-0-642-74719-8July 2011, p.8).
Treasury indicates that the medium term impact of the carbon price/tax will be minimal, around 0.9% over 4 years, as the Treasury indicate, “Beyond 2015-16, implications for ongoing inflation are minimal, though the prices of some goods rise” (Source: Strong Growth, Low pollution, Modelling a Carbon Price, Overview, Australian Department of Treasury, ISBN 978-0-642-74719-8July 2011, p.8)
See Figure 1 below, for the Treasury numbers, which shows Treasury estimates of CPI, with CPI estimates going forward of around 2.5%, without the carbon price/tax.
CPI impact from carbon pricing compared with history
Source: Strong Growth, Low pollution, Modelling a Carbon Price, Overview, Australian Department of Treasury, ISBN 978-0-642-74719-8July 2011, p. 9
Figure 1
RBA position on carbon price adjustment
The RBA has indicated that the impact on impending CPI may be minimal. As the RBA have indicated:
There was little new information on prices over the past month. Liaison suggested that the introduction of the carbon price had not yet had a significant effect on downstream price pressures, with only isolated examples of suppliers attributing price increases to the carbon price. There was no evidence that the carbon price had raised medium term inflation expectations (Source: RBA Minutes, 4 September 2012)
Investment implications
Several implications of a higher headline CPI are apparent:
- Easing still in place - A higher headline CPI should not, all else being equal, delay a rate cut by the RBA, as the RBA focus on the underlying rate, which is expected to remain stable
- Proximity to retirement and headline CPI - As one approaches retirement, a higher headline rate of inflation tends to impact those who have lower incomes, and retirees generally have lower incomes, when compared to those who are in the workforce. Specifically, the lower the income, the more is typically spent on items that are excluded by the RBA, such as the volatile price sectors of food and fuel. This means that headline CPI counts a lot for most retirees
- ILBs needed - While the RBA may well ignore the headline CPI, those retirees on low incomes cannot afford to ignore the headline increase. These realisations underlie the need to match future liabilities, or future spending, with the headline CPI, with assets that also increase with the headline CPI, such as inflation linked bonds (ILBs)
- Equities cannot deliver - While investors imagine that there is a strong relationship between equity returns and the CPI, there is little evidence to support that claim, so having a security that is directly tied to the headline CPI, like an ILB, is the best way to insure against higher CPI
Conclusion
Exact timing of the carbon price/tax impact on headline inflation is difficult to estimate, however some impact can be expected today. Hence, a headline CPI figure of around 0.9% for the headline quarterly result would tend to make sense, all else being equal. All we know for sure is the official forecasts are for an impact on the headline CPI for the year ended June 2013 of around 0.7%, as noted above. Also, bear in mind that seasonal movements in fuel and food prices can overwhelm the impact of the carbon price in any particular quarter for headline inflation, making prediction of the quarterly headline CPI somewhat difficult. Even if the carbon price does not deliver a higher headline CPI this quarter, the impact of the carbon price should deliver a higher headline CPI by the end the financial year. This means that insuring against inflation is all the more important, and ILBs help provide that insurance, while also providing adequate investment returns of over 4% above inflation. Sydney Airport 2020, 2030s and Envestra 2025 ILBs all provide returns in excess of 4% above inflation.
For more information please call your local dealer. All prices and yields are a guide only and subject to market availability. FIIG does not make a market in these securities.