ANZ sees Australian inflationary pressures remaining weak, with downside risks

• The RBA has continued to miss its inflation target for over two years. ANZ expects that trend will continue.

• ANZ forecasts annual headline inflation in the December quarter will slow to its weakest since the middle of 2016. The bank sees underlying inflation remaining below the RBA's target and says there are downside risks.

• It will be watching one part of Australia's next inflation report closely for clues as to whether wage pressures are helping to lift prices.

• Financial markets are pricing in a 50% chance the RBA cash rate will be cut by November.

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Australia's December quarter consumer price inflation (CPI) report will be released in two weeks time, providing the latest snapshot of price pressures facing households.

ANZ Bank's Australian economics team thinks it will be weak, with downside risks.

"Our forecast is for a 0.4% rise in headline inflation in Q4, pushing the annual rate down to 1.6%," say Jack Chambers and David Plank, economists at ANZ.

"A sharp fall in petrol prices is the largest negative for the headline figure, while retail price deflation continues to be a drag. Domestic air travel and tobacco prices will make positive contributions."

Should ANZ be on the money, the year-ended increase would be the weakest since the June quarter of 2016, a period that just happened to coincide with the last time the Reserve Bank of Australia (RBA) cut official interest rates.

For the key underlying inflation reading -- of more importance when it comes to the outlook for RBA policy settings -- Chambers and Plank believe a similar result to that seen in the prior quarter will arrive, although they admit the risks to this view are to the downside.

"Core prices are expected to rise 0.5% quarter-on-quarter, which would leave the annual rate unchanged at 1.8%," they say.

"We see the risk to core inflation for the quarter as very much to the downside."

While the RBA's underlying inflation forecast is similar to that predicted by ANZ, the expected undershoot in headline CPI will likely lead to downward revisions in the RBA's next forecasts when they are released in early February.

"The forecast for core inflation is consistent with what the RBA published in its November Statement on Monetary Policy (SoMP)," says Chambers and Plank.

"However, the evolution of headline inflation has been slower than expected, so we expect February’s SoMP to include a downward revision to the RBA’s near-term headline CPI forecast."

In November, the RBA forecast headline inflation in the year to December to grow by 2%.

Shifting rates outlook

The RBA missing its inflation target has become the norm rather than the exception in recent years with underlying CPI remaining at or below its 2-3% medium-term target since the beginning of 2016.

Over the past month Australian financial markets have moved to price in a 50% chance of a 25 basis point rate cut in the RBA cash rate by November, a stark contrast early December last year when a similar probability was attached to a rate hike over this period.

For much of last year the RBA made it clear that it thinks the next move in the cash rate is likely to be higher, albeit unlikely in the near-term, banking on above-trend GDP in the coming years to help reduce unemployment and lift wage and inflationary pressures.

Partially explaining why financial markets are now pricing in the possibility of a rate cut this year, Australian economic growth slowed sharply in the year to September, casting doubt as to whether GDP would lift at an annual pace of over 3% both this year and next as the RBA expects.

While ANZ, like the RBA, sees the next move in the cash rate as being higher, forecasting two 25 basis point increases in the second half of 2020, Chambers and Plank say they'll be watching one part of the inflation report in particular for clues as to whether wage pressures are helping to boost price pressures.

"A sustained lift in core inflation will require higher domestic market services inflation. In turn, that would require higher wages," they say.

"On this front, the Q3 CPI figures showed an encouraging acceleration in domestic market services inflation to 1.8% year-on-year.

"An additional up-tick would be a good sign that higher unit labour costs are feeding through to domestic inflationary pressures. We’ll be paying particular attention to this component of the CPI when the Q4 figures are released."

The ABS will release Australia's Q4 CPI report on Wednesday, January 30.