Subsidies exaggerate the improvement in underlying inflation

Government subsidies have exaggerated the improvement in underlying inflation, slightly in the case of the Q4 result and more meaningfully in terms of the signal from the monthly CPI about the momentum in inflation heading into Q1.

The CPI in Q4 brought good news for the RBA, with underlying inflation slowing by more than it had expected.

The trimmed mean CPI - which is the RBA's preferred measure of underlying inflation - rose by 0.8% after a 1.2% rise in Q3, such that annual inflation slowed from 5.1% to 4.2%.

This was below the RBA's forecast of a 1.1% increase in the quarter, practically the mirror image of what happened in Q3, when a 1.2% rise in the trimmed mean CPI exceeded the RBA's then-estimate of a 0.9% increase.

Given the better-than-expected starting point, the RBA seems likely to lower its near-term forecasts for inflation when it formally updates its outlook in the revamped Statement on Monetary Policy on Tuesday, as well as potentially forecasting inflation nearing the midpoint of the 2-3% target band in late 2025 rather than 2026.

Such a positive revision to the outlook points to a clear risk that the new Monetary Policy Board adopts a neutral monetary policy stance next week.

The result was also a little better than the market had forecast, where the consensus had anticipated a 0.9% rise, although it had been in line with recent data on the CPI excluding volatile items and holiday travel, which is a useful monthly proxy for the trimmed mean CPI.

Surprisingly, the monthly proxy rose by less than 0.2% at the end of last quarter, which at face value suggests that there could be a further sharp improvement in underlying inflation in Q1.

For example, if the proxy series were to increase at a similar rate over each month in Q1, it would point to a 0.5-0.6% increase in the trimmed mean CPI in the quarter, well below both RBA and market forecasts.

However, it is worth noting that recent government policies exaggerate the improvement in underlying inflation, slightly in the case of the trimmed mean CPI in Q4 and more meaningfully for the signal from the monthly proxy in December.

In September, the federal government raised the maximum rate for Commonwealth rent assistance by 15%, where about 1.3 million low-income renters receive this assistance.

The ABS treats direct subsidies as an effective reduction in the price of a good or service, such that the increased assistance reduced the quarterly increase in rents from 2.5% to 2.2% in Q3 and from 2.2% to 0.9% in Q4 (rents actually fell by 0.4% in October when the increased assistance was fully captured in the data).

Rents have the second-largest weight in the basket of goods and services that makes up the CPI, so this change affected underlying inflation.

On CCI’s calculation, the trimmed mean CPI excluding this effect rose by 1.2% in Q3 and 0.9% in Q4, with annual inflation slowing to 4.3%.

This indicates that inflation still improved in Q4 – and still by more than the RBA had anticipated late last year – but that the increased rental assistance slightly flattered the improvement.

More interestingly, state government policy also held down the monthly proxy for the trimmed mean CPI in December, with electricity prices falling by almost 6% in the month thanks to the latest round of government financial support to households.

State government electricity subsidies to low-income households are common, but have been larger recently, funded by the Commonwealth government in response to surging power prices.

The Commonwealth might decide to fund another round of state subsidies heading into winter given it is still running a monthly budget surplus, but retail prices might fall this year if lower wholesale prices are sustained.

Excluding this latest state subsidy to get a cleaner read on the pulse of inflation at the end of Q4, CCI estimates that the monthly proxy would have increased by about 0.3% in December had it not been for this round of financial assistance.

Assuming that the monthly proxy continues to grow at a similar rate over the first few months of this year, this suggests that the trimmed mean CPI could increase by around 0.8-0.9% in Q1.

This still represents a significant improvement from last year, but suggests that published monthly proxy for December understates the momentum of underlying inflation heading into 2024.