Australia's central bank prepares to hit brakes

SYDNEY - Australia's consumer prices rose at their fastest pace in almost six years last quarter as fuel and fruit costs surged, cementing expectations of a rise in interest rates next week.

Bonds and equities dived as investors fully priced in a rate rise to 6.0 per cent at the Reserve Bank of Australia's policy meeting next Tuesday, and speculated about a further tightening later in the year.

"Inflation blew past everybody's expectations and makes it very hard for the RBA not to hike next week," said Rory Robertson, interest rate strategist at Macquarie Bank.

The consumer price index (CPI) jumped 1.6 per cent in the second quarter, far above median forecasts of a 1.0 per cent increase. That was the biggest gain since GST was introduced in 2000.

The index was up 4 per cent on a year earlier, again well above forecasts of 3.4 per cent and the fastest pace since June 2001.

"If there was any doubt before about the Reserve Bank hiking next week, it's gone," said Stephen Koukoulas, chief strategist at TD Securities. "Now we are going to get people talking about a further rate rise beyond that one as well."

Australia's central bank aims to keep inflation at an average 2-3 per cent over the course of a business cycle. It has already raised rates once this year, to 5.75 per cent in May.

Since then a run of robust economic indicators has heightened the risk of inflation becoming embedded in expectations and led the market to price in rates of 6 per cent or higher by year-end.

The jump in consumer inflation was partly due to one-off factors such as cyclones which ruined Australia's banana crop and lifted fruit prices by a huge 52 per cent last quarter.

That added 0.5 percentage points to the rise in the consumer price index, while petrol added another 0.5 percentage points.

Australia's Treasurer Peter Costello seized on the rises in fuel and fruit to argue that, barring one-off factors, inflation was still moderate.

However, analysts doubted such distinctions would stay the central bank's hand on rates.

"You could argue that some of this is temporary and will unwind," said Su-Lin Ong, senior economist at RBC Capital Markets. "But if you exclude the effect of GST, this is still the highest inflation rate in more than a decade and doesn't give the RBA much wiggle room.

"After all, CPI is what consumers face every day and it has to affect their wage and price expectations."

The central bank's own measures of underlying inflation also rose by more than expected. These strip out the most extreme price moves in a quarter, from whatever source, and are critical when setting monetary policy.

Both measures of underlying inflation rose by a higher-than-expected 0.9 per cent in the second quarter, lifting average annual growth to 2.9 per cent from around 2.7 per cent in the first quarter.

- REUTERS