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Analysis: Australia's home-brewed inflation a hangover for central bank

The Central Business District is seen from the air on a sunny winter afternoon in Sydney August 24, 2013. REUTERS/Daniel Munoz
The Central Business District is seen from the air on a sunny winter afternoon in Sydney August 24, 2013. REUTERS/Daniel Munoz

By Wayne Cole

SYDNEY (Reuters) - The laudable desire of Australians to be well educated and healthy is proving an expensive one as escalating costs add to inflationary pressures even as the broader economy slows.

The stubbornness of domestic inflation is proving most unwelcome to policymakers who want to keep interest rates at rock bottom levels as Australia struggles through the autumn of a historic mining boom.

It means that the Reserve Bank of Australia (RBA) could be forced to close the door on further rate cuts when it holds its first policy meeting of the year on Tuesday.

The central bank might also have to ratchet back the rhetorical campaign for a weaker local currency given the risk higher prices for imported goods could further fuel inflation.

"Higher near-term inflation and risks from the exchange rate make it hard for the Reserve Bank to keep a weak easing bias and it will likely shift to neutral," said Kieran Davies, an economist at Barclays in Sydney.

"Further out, we see the bank remaining on hold for the rest of the year, with hikes starting in Q1 2015 assuming the economy is picking up by then."

The central bank has held its policy rate steady since cutting it to a historic low of 2.5 percent back in August, but had stated there was scope for further easing if needed given inflation was low.

So it would have been blindsided when its favored measures of underlying inflation spiked by a steep 0.9 percent last quarter. The annual pace of inflation picked up to 2.6 percent, well above the 2.25 percent the central bank had expected.

While that is still well within the RBA's long-term target band of 2 to 3 percent, it had thought it would take until the middle of this year for inflation to reach just 2.5 percent.

If third and fourth quarters are added together and annualized, as the central bank's policy wonks like to do, then inflation is already running at 3 percent.

The central bank will now almost certainly have to revise up its forecasts for inflation when it releases its quarterly economic outlook on Friday.

A LOWER SPEED LIMIT?

Much of the problem is home made with inflation in many service sectors proving very "sticky" despite sluggish wage growth and falling unit labor costs.

Up until last year a strong Australian dollar had flattered the picture by tamping down prices for imported goods. But with the currency having fallen, the stubbornness of domestic inflation is being revealed.

Culprits include long-term changes in spending habits and demographics, including the escalating cost of education.

While putting a child through 13 years of private schooling can easily cost A$250,000 ($218,000) in fees alone, it is insanely popular with an increasingly affluent, and aspiring, middle class.

No less than a third of all students in Australia go to independent schools of one form or another.

Add in the cost of uniforms, laptops and the like, and parents in Sydney can look forward to spending upwards of half a million dollars, according to a survey by the Australian Scholarships Group.

Another structural pressure is health costs, linked both to an ageing population and the escalating price of ever-more advanced medical care.

Dental work is so expensive there is a thriving business in medical tourism, with Australians travelling to Thailand and Malaysia to get the work done at less than half the cost.

As a result, annual inflation for education is running at 5.6 percent, and has not been under 5 percent since 2008. Inflation in health care is not far behind at 4.4 percent.

Add to that the ever rising costs for child care, utilities and government charges and taxes, and it is an inflationary mix.

"There are influences on some parts of the CPI that don't respond to the economic cycle or the RBA," says Michael Blythe, chief economist at Commonwealth Bank of Australia in Sydney.

He estimates such services account for about 60 percent of domestic CPI and 38 percent of the overall index.

The rigidity of domestic inflation could in turn foretell a decline in the economy's speed limit - how fast it can grow without creating excessive price pressures.

This limit used to be thought of as around 3.5 percent but years of sluggish productivity and under investment in infrastructure may have lowered it.

Paul Bloxham, chief economist for Australia at HSBC in Sydney, estimates the economy's speed limit may now be as low as 2.6-2.8 percent. If so, it would have unwelcome implications.

"Lower potential growth means that Australia has less room to accommodate any pick-up in demand, as it could more quickly translate into rising inflation," said Bloxham.

"It is also likely to mean that the natural rate of unemployment may be higher than it has been in the past," he added. "This could leave the RBA with less room to move to support demand than previously."

(Editing by Neil Fullick)

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