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Australian Inflation Jumps, Interest Rate Rise Looms

Inflation in Australia jumped past all expectations last quarter as the cost of petrol, food and health care climbed, greatly adding to the risks of a rise in interest rates as early as August.

The Australian dollar hopped toward 18-year highs while bond futures dived as the market priced in a better than 60% chance the Reserve Bank of Australia (RBA) would hike to 6.50% next month.

"Obviously, across the board very strong inflation, both the core measures and the headline measures," said Stephen Walters, chief economist at JPMorgan. "Clearly, this significantly increases the risk of a rate hike next month," he added. "When the numbers come in that big it does imply that the RBA needs to move sooner rather than later."

The government's measure of consumer prices (CPI) rose 1.2% in the first quarter, topping market forecasts of a 1.0% gain, driven mainly by fuel, food, rents and health costs. Petrol alone jumped 9% in the quarter, adding 0.56 percentage points to the CPI.

The annual pace of consumer price inflation still slowed to 2.1%, from 2.4% in the first quarter. But again that was above forecasts of 1.9% and analysts were worried this marked a turning point.

"The concern is that this is the period when inflation rates are supposed to be dipping ahead of a large lift in annual inflation later this year," said Stephen Roberts, research director at Lehman's Grane Securities.

"At this stage the implications are that annual inflation of all measures will be running above 3.0% into 2008. It will be the critical part for the RBA," he added.

The central bank aims to keep inflation within a 2% to 3% target bend over the medium term. It raised rates three time last year to pull inflation back into the band but the strength of the economy, an unemployment rate at 33-year lows and a lack of spare capacity are testing it again.

Pressures Grow For Tightening

"It looks like the pressure on the Reserve Bank is to increase rates sooner rather than later," declared Joseph Capurso, an economist at Commonwealth Bank. "The period of low underlying inflation is over."

The RBA focuses on measures of underlying inflation, which exclude the most volatile price moves in any one quarter, in the hope of detecting the underlying trend in price pressures.

Yet these also jumped past all expectations, showing rises of 0.9% in the quarter when analysts had looked for a more moderate 0.7% increase.

"With the labor market tightening and spending in pretty good shape it looks like the risks to inflation are on the high side, so we think rates are going up in August," said Capurso.

One restraining factor on the RBA could be the strength of the Australian dollar, which has surged to two-decade peaks in trade-weighted terms this month.

This was certainly the argument of Treasurer Peter Costello, who is desperate to avoid a rate rise ahead of a tough election later this year. He told reporters consumer prices should remain contained in the period ahead, helped by the strong local dollar.

Yet, analysts harbored doubts. "With the economy expanding strongly, the global growth outlook good and the RBA's focus on these statistical measures, it suggests the chance of an August hike is now greater than 50/50," said Scott Haslem, chief economist at UBS.

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