RBA Inflation Target Set to Surface as Disasters Fuel Prices

(Bloomberg) -- Philip Lowe is on track to reach a milestone that has eluded him since taking the helm of Australia’s central bank 40 months ago: his inflation target. But given the circumstances, he’d doubtless prefer not to be.

The combination of drought and wildfires that first parched and then scorched Australia’s east coast has left not only communities devastated, but crops incinerated and distribution networks in disarray. That’s set the scene for a spike in fruit and vegetables. Some of it will come through in the final quarter of 2019 -- with data due out Wednesday -- and the rest in the first quarter.

“Apples will definitely have an issue,” reckons Peter, a 40-year veteran stall holder at Sydney’s Paddy’s Markets, who gave only his first name. The key growing regions in New South Wales were destroyed and prices are already up 50%-60%, he said, adding avocados have doubled in the past two weeks.

“Farmers were focused on defending properties and protecting families rather than picking fruit,” he said, and roads were cut, halting transport in fire-ravaged areas.

Australia’s inflation hasn’t reached the mid-point of the Reserve Bank’s 2%-3% target in more than half a decade as developed world price weakness infiltrated Down Under. A sharp rise in headline inflation would therefore shock markets, which are pricing in further RBA cuts this year.

“We have seen before these extreme events can have a big impact on food prices,” said Michael Blythe, chief economist at Commonwealth Bank of Australia. He doesn’t expect the impact to be of the same magnitude as Cyclone Yasi’s 2011 crop destruction that sent banana prices shooting up 377%.

But, Blythe notes, after a prolonged period of low inflation, “another 0.1 or 0.2 percentage point on top of what is now seen as normal has more shock value.”

Australia’s quarterly inflation averaged 0.5% over the past decade, and adding Blythe’s numbers would bring CPI to 0.6%-0.7%. If Wednesday’s data records a number of 0.6% for the fourth quarter -- CBA’s forecast -- and then lifts to 0.7% in the current quarter, this would raise the annual rate to 2.5%, the midpoint of the RBA’s target.

The median estimate of economists is that consumer prices advanced 0.6% in the final three months of 2019 from the prior quarter, and 1.7% from a year earlier.

The RBA traditionally looks through short, sharp price increases.

Australia’s labor market, meanwhile, remained strong through to the end of last year, with unemployment unexpectedly dropping in December. That’s the latest in a series of results that exceeded expectations as measured in Citigroup Inc.’s Economic Surprise Index.

Yet there are factors pushing the other way, too.

Intense competition for thrifty Australians’ cash among major supermarkets could see them opt to absorb price rises rather than pass them on.

Then there’s improved data collection at the Australia Bureau of Statistics, which produces the inflation report. It’s now able to obtain a more granular view of food spending patterns using barcode data. This allows the bureau to capture the substitution that typically occurs when the price of one product increases sharply.

For example, a banana price shock today would have a smaller impact on CPI than it did in 2011 as CPI weights would adjust to reflect the temporary change in purchasing patterns. Food and non-alcoholic beverages account for 15.75% of consumer price inflation, the second-largest component.

“We utilize scanner data to effectively re-weight the products each quarter,” says Randal Markey, an official at the ABS. “The method we use captures substitution within expenditure classes, switching bananas for apples, but not across expenditure classes, e.g. switching bananas for broccoli.”

Back at Paddy’s Markets, Peter, who has seen plenty of price shocks in his four decades, reckons rises in certain items like cauliflower, lettuce and avocados will prove short lived.

“Australia is a vast country and it doesn’t take long before other regions that were unaffected can fill in the gaps,” he said.

That suggests Governor Lowe shouldn’t get too attached to a stronger inflation reading. It’s unlikely to last.

--With assistance from Tomoko Sato.

To contact the reporter on this story: Alexandra Veroude in Sydney at averoude4@bloomberg.net

To contact the editors responsible for this story: Nasreen Seria at nseria@bloomberg.net, Michael Heath, Malcolm Scott

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