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Strategy Around the Q3 CPI Release[1]

Strategy Around the Q3 CPI Release[1]

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10/24/2011

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24 OCTOBER 2011CONTRIBUTOR
Shane LeeSenior Rates Strategist
+61 2 9226 4632Shane.Lee@anz.com
STRATEGY AROUND THE Q3 CPI RELEASEINTEREST RATE STRATEGY
ANZ RESEARCH
INTRODUCTION
In this note we look at the risks around the CPI using data published by Bloombergon economists’ expectations for the quarterly increase in the trimmed mean of theCPI basket.At the end of each quarter, economists build bottom-up forecasts of the CPI usingdata from private sector data vendors on such items as automotive fuel, rents, fruitand vegetables, utilities etc. Using this approach it’s possible to get a good handle onprice movements of around 50%of the basket. However, it leaves the unknownprice movements (the remaining 50%) to be determined by an econometric modeland this is probably where there is most room for error.
We find that if automotive fuel prices rise and rise by more than 1.5% thenthere is a 77% probability that the trimmed mean outcome will exceedexpectations. Conversely, if fuel prices fall and fall by more than 1.5% thenthere is a 43% chance that the outcome will be below expectations.Data for Q3 suggests that fuel prices fell by 1% in the quarter. Thehistorical relationship between actual and expected trimmed mean outcomesand fuel prices implies that it is more probable that economists’ expectationswill be met.
The Bloomberg survey indicates that economists are expecting a 0.6% rise in thetrimmed mean that would put the YoY rate at 2.7%, up from a revised 2.5% in Q2.Indeed, this should be sufficient for the RBA to consider a modest 25bps rate cut atits 1 November Board Meeting. We expect the trimmed mean measure of consumerprices to rise by 0.5% in the quarter. The range of forecasts is from 0.5-0.8%.
OUTCOMES VS ECONOMISTS’ EXPECTATIONS
Bloomberg have published data on actual underlying CPI results against economistestimates since Q3 2006. On average, economic forecasters under-estimatedinflation in both 2007 and 2008 as it continued to climb well beyond 3% (Figure 1).This trend continued throughout 2009 and in Q1 2010. In the remainder of 2010,they over-estimated inflation, while in the first half of 2011 it was under-estimated.Of course the ABS revisions have changed the actual outcomes over thisperiod and most notably the Q2 2011 result. However, these revisions weremade using a new seasonal adjustment process that was not used prior toQ3 2011 and should not impact our analysis of actual verses expectedinflation outcomes.
 
Strategy Around the Q3 CPI Release / 24 October 2011 / 2 of 5
FIGURE 1. QUARTERLY INCREASE IN TRIMMED MEAN
00.20.40.60.811.22006 2007 2008 2009 2010 2011 2012
Economists' Estimate Actual
%
 
Source: Bloomberg
The Bloomberg data provides us with 20 observations of outcomes matchedagainst expectations. Automotive fuel has some well understood “secondround” impacts on other items within the CPI basket and this highlights therisk that large increases in fuel prices can bring to the inflation outlook.Fuel prices have risen by an average of 0.6% in each quarter since Q3 2006(Figure 2). However, over this period there have been significant pricevolatility and some large quarterly movements. The largest fall was in Q42008 (18.2%) and the largest rise was (9.1%) in Q2 2007.
FIGURE 2. QUARTERLY TRIMMED MEAN SURPRISE AND FUEL PRICES
 
-25-20-15-10-505102006 2007 2008 2009 2010 2011 2012-0.5-0.4-0.3-0.2-0.100.10.2
Surprise (RHS) Automotive Fuel Prices (LHS)
% %
 
Source: ABS, Bloomberg
 
Strategy Around the Q3 CPI Release / 24 October 2011 / 3 of 5
The data shows that fuel prices have increased on 13 out of the 20 quarterssince 2006. In 10 of these quarters where the increase has been more than1.5% there has been a positive surprise on the underlying trimmed mean.In other words, there is a 10/13 (77%) chance of a positive surprise if thefuel price rises and rises by more than 1.5% in the quarter.Throughout sample period, fuel prices fell in 7 out of 20 quarters. On 3 of these 7 occasions (43%) fuel prices have fallen by more than 1.5% whenthere has been a downside surprise to the quarterly change in the underlyingtrimmed mean.In Q3 2011 we estimate that fuel prices fell by 1.0% and this suggests thatthe result should be in line with the consensus estimates for this release i.e.we see a lower probability of a surprise outcome.
MARKET IMPLICATIONS
3-year bond futures have sold-off by over 50bps since the 5 October peak due mostlyto a general improvement in global risk appetite. However, we still think the frontend of the curve looks expensive as we are still only looking for a modest easing inpolicy. We have initiated a trade, selling 3-year bond futures (target 95.78, stop96.38),Local economic data has generally printed stronger than expected; most notably theSeptember employment report. However, retail sales, building approvals and homeloan approvals were also better than expectations in August. Furthermore, businessand consumer confidence are continuing to improve from their August lows. However,downside risks have emerged from Europe and the RBA has opened the door toeasing policy.While the improvement in market sentiment over the past few weeks is likely to betested by the outcome of developments in the EU and G20, the most important pieceof local data for local interest rate markets is undoubtedly the Q3 CPI.There is probably more uncertainty around this CPI release than normal and this hasadded to tensions in markets. The ABS is calculating the seasonally adjustedunderlying inflation measures using a new seasonal adjustment measure from the Q3CPI onwards. This has already introduced a large downward revision to the Q2 data.On top of this, the CPI basket will be changed, with a skew towards higher inflationservices.A low outcome in line with our expectations will probably see the RBA ease policy on1 November. However, it’s unlikely that the market will rally strongly, even on theback of a relatively low trimmed mean rise provided the RBA indicate that there willbe only limited future policy easing.

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