To say that last week's domestic inflation result was a surprise would be an understatement. Shock would be a more appropriate term to describe the big jump in inflation during the final quarter of 2013.

In today's editorial we will dissect the 4Q13 CPI data and explore what it means for future RBA interest rate policy.

The CPI numbers

According to the Australian Bureau of Statistics, the Consumer Price Index (CPI) gained 0.8% in the last quarter of 2013. Trimmed mean CPI, which strips out the impact of volatile items like food prices, climbed 0.9%.

On an annualised basis, headline inflation came in at 2.7% with core inflation running at 2.6%. Both measures were above economist expectations and crucially, above levels that could provide scope for further RBA interest rate cuts.

The RBA aims to keep inflation within its 2% – 3% target band, so core CPI at 2.6% argues the case for essentially a neutral interest rate policy.

Behind the result

Even after stripping out notoriously volatile food and beverage prices, inflation shot up during the last quarter. This is despite other data painting a dire assessment of the Aussie economy.

Of the major ex-food CPI groups, recreation & culture (+2.1%) recorded the most significant price increase over the quarter. Recreation and culture includes prices of things like domestic and international holiday bookings.

The spending on travel was likely more of an anomaly as the sudden drop in the Aussie dollar and the Christmas holiday period encouraged consumers to book holidays.

Price growth was negative in the clothing and footwear category, suggesting that even though the lower dollar has increased import inflation, retailers are not passing on the higher costs to consumers.

Household spending was another key takeout, with rising building materials and labour costs pushing up the price of new dwellings.
Recent history

To help us determine whether the December quarter CPI reading will alter RBA interest rate policy, we need to put the figures into historical context.

Below we graph the five year trend in the RBA cash rate (green line) and core inflation (white line), whilst the red dotted lines represent the RBA's inflation target band of 2% – 3%.

As the chart shows, inflation has been rising steadily since bottoming out below 2% in mid-2012. Yet even after the 4Q13 result, core CPI of 2.6% is still comfortably inside the RBA's target band.

Moreover, there have been multiple occasions in the last two years where inflation was this high and didn't deter the RBA from cutting the cash rate to its presently record low 2.5%.

Robust housing activity is underpinning price growth within the economy but inflation in other discretionary sectors like clothing remains subdued.

The real economy is still not firing on all cylinders, as the December jobs report highlights. Moreover, the Federal Government has been hinting strongly in recent weeks of further budgets, which are likely to act as a further drag on the economy.

The RBA would be mindful of this and there is a definite need for the central bank to lower interest rates further (to help depress the Aussie
dollar and fasten the economic rebalancing towards the non-mining sectors).

The March quarter CPI figures have taken on extra importance following the 4Q13 inflation jump.

Another significant rise in price growth would push inflation towards the upper band of the RBA's target band and make it difficult for Governor Glenn Stevens to implement another cut - even though economy needs all the help it can get.

Weekly Market Wrap: Inflation Jump is a post from: Australian Stock Report Market Pulse Blog