Australia's inflation surge just made an RBA rate rise more likely

Australia's inflation rate surged 1.1% in March, driven by a record jump in fuel prices, making an interest rate hike next Tuesday more likely.

The consumer price index (CPI), released today, rose to 4.6% in the year to March, the first major economic indicator to show the impact of the war in the Middle East.

A measure of underlying inflation - the annual "trimmed mean" - came in at 3.3%. This measure is closely watched by the Reserve Bank of Australia (RBA) and is also above its 2-3% target band.

For the RBA, which meets next week to decide on interest rates, the message is clear: inflation is moving in the wrong direction again, and quickly.

This is not a normal inflation shock. It is being driven by a sharp rise in global energy prices following the war in the Middle East.

Higher interest rates will not bring down global oil prices. But they can help prevent a fuel shock from becoming a broader and more persistent inflation problem.

Fuel prices are just the beginning

The immediate driver of the March inflation surge is fuel.

Global oil prices have risen sharply, pushing up petrol and diesel prices at the pump.

The Australian Bureau of Statistics said fuel prices jumped 32.8% in March - "the largest monthly increase since the series began in 2017".

This feeds directly into CPI, making it one of the fastest channels through which global shocks affect domestic inflation.

But fuel is only the first-round effect. The bigger concern is what comes next. Higher fuel costs raise transport costs across the economy. Businesses then face a choice: absorb the increase, or pass it on to consumers.

Some will try to absorb it at first, especially if consumers are already cutting back. But margins cannot be squeezed indefinitely. Over time, more of these costs are likely to be passed on in the form of fuel surcharges and show up in final prices.

This is how a temporary shock can turn into persistent inflation.

Higher costs for businesses

The March CPI largely captures the initial impact of the oil shock. The second-round effects - where higher costs spread more broadly - take time.

These effects are already beginning to appear. Businesses are facing higher operating costs, not just from fuel but also from supply disruptions and rising input prices. As these pressures build, price rises can spread beyond petrol and transport.

Even if oil prices stabilise, the earlier jump in fuel costs will continue to flow through the economy. Transport costs affect food, retail, construction and many services. Airlines, delivery firms, supermarkets and builders all face higher costs when fuel prices rise.

That means inflation could remain elevated for some time, even if the initial shock fades.

A broader view of inflation

While the monthly CPI attracts attention, the RBA still places weight on the quarterly CPI.

The March quarter figures give the RBA a broader read on inflation than the monthly data. Annual inflation in the March quarter was 4.1%, while annual trimmed mean inflation was 3.5%.

The quarterly figures show inflation has been building even before the February 28 start of the war in Iran. It points to broader price pressures, making the case for a rate rise stronger.

The economy also takes a hit

The fuel shock is not only an inflation problem. It is also a growth problem.

Higher petrol prices reduce household purchasing power, leaving less money for discretionary spending. That weighs on retailers, restaurants, travel businesses and other parts of the economy that depend on consumer spending.

For businesses, higher fuel and transport costs raise production costs. Some may delay hiring or investment. Others may lift prices and risk losing customers.

This is the difficult part for the RBA. A fuel shock pushes inflation up while also weighing on economic activity. This creates a risk of stagflation, when inflation stays high even as growth slows. That makes the RBA's policy decision much harder.

But if business and consumer expectations about future inflation start to rise, the damage could last well beyond the current shock.

If businesses expect costs to keep rising, they are more likely to raise prices. If workers expect inflation to stay high, they are more likely to seek larger wage increases. This can turn a one-off shock into a more persistent problem.

The RBA will want to avoid that. That is why the bank is likely to act at its May 4-5 meeting.

Why a rate rise now?

The case for a third rate rise (following three cuts last year) is not that the RBA can reverse the fuel shock. It cannot.

The case is that inflation was already too high before the latest shock, and today's CPI figures suggest the return to its 2-3% target will take longer than expected.

Market pricing already points in the same direction. The ASX RBA Rate Tracker shows that, as of April 28, markets were pricing a 76% chance of a rate rise to 4.35% next week.

Today's CPI figures make that pricing look more justified. A rate rise would signal that the RBA remains committed to bringing inflation back to target.

We're at a turning point

The March CPI release marks a turning point.

It shows how quickly global shocks can feed into domestic inflation, and how difficult they are to contain once they begin to spread.

Fuel prices have lit the spark. The risk now is that the fire spreads through the broader economy. That is why the RBA is likely to raise interest rates next week.

TheConversation.com

Author: Stella Huangfu - Associate Professor, School of Economics, University of Sydney

https://theconversation.com/australias-inflation-surge-just-made-an-rba-rate-rise-more-likely-281540