Aussie Inflation Eases

Well, maybe it was too good to last. After the raft of better-than-expected economic data over the past couple of months, the Australian economy finally posted a key figure that fell short of the consensus forecast.

The country's Consumer Price Index (CPI), one of the main measures of inflation, rose 0.6 percent sequentially during the first quarter, following a rise of 0.8 percent in the fourth quarter of 2013.

The latest result was two-tenths of a percentage point below economists' expectations. On a year-over-year basis, the CPI increased by 2.9 percent, which was three-tenths of a percentage point below the consensus forecast.

The most significant price rises this quarter were for tobacco, up 6.7 percent, automotive fuel, which rose 4.1 percent, medical and hospital services, which climbed 1.9 percent, and pharmaceutical products, which increased by 6.1 percent.

Tobacco and medical expenses rose due to changes in government policy, including an increase in a federal excise tax for the former and a reduction in subsidies for the latter.

At the same time, furniture prices fell 4.3 percent, maintenance and repair of motor vehicles dropped 3.3 percent, and international holiday travel and accommodation decreased by 2.4 percent.

While consumers typically dread the prospect of inflation, when an economy is emerging from a period of weakness a rise in prices can actually signal a further rebound. And central banks have the ability to choke off inflation before it gets out of control, except during periods of stagflation, when weak growth is accompanied by rising prices.

By contrast, disinflation, or even outright deflation, can quickly spiral out of control. When that happens, even an extraordinarily accommodative monetary policy can do little to offset fearful human psychology, such as what occurred during the Global Financial Crisis.

In fact, inflation targeting is the p! rimary mandate of the Reserve Bank of Australia (RBA). The goal of the central bank's monetary policy is to achieve an inflation rate of 2 percent to 3 percent, on average, over the course of a cycle.

The RBA defines the inflation target as a medium-term average, rather than as a rate (or band of rates) that must be held at all times. This allows for flexibility in policymaking as the bank waits for the effect of a change in interest rates to flow through to the economy, which for some sectors can take as long as two years.

The central bank has been on a rate-cutting cycle since late 2011, with the last decrease in the benchmark cash rate this past August bringing short-term rates to an all-time low of 2.5 percent. Prior to the latest data on the CPI, traders had been betting the RBA would be forced to hike rates later this year, particularly after the surprise jump in the CPI for the fourth quarter.

But with the slackening in inflation more recently, most central bank watchers now believe interest rates will be stable for the duration of 2014. Indeed, financial markets are pricing in a 56 percent chance of a rate hike over the next year, down from 92 percent prior to the CPI release, according to data aggregated by Credit Suisse.

That's good news at this stage of the cycle because policymakers are keen for non-resource sectors to lead the economy now that mining investment is on the wane.

And a rate hike at this juncture would not only threaten the strength of rate-sensitive sectors such as real estate, it would also boost the exchange rate and undercut exports.

In response, the Australian dollar, which had been in rally mode in the three months since hitting a three-year low of USD0.868 in late January, continued its long-awaited correction. The aussie currently trades near USD0.929, down about 1.4 percent from its year-to-date high.

Equity investors also appreciated the fact that the RBA now has additional breathing room to hold rates steady. The S&P/! ASX 200 h! it a post-Global Financial Crisis high of 5517.8, with a total return of 118.9 percent since its bottom in March 2009.