A steep rise in the Reserve Bank’s inflation forecasts to above its target range is the clear reason its board shifted decisively away from further rate cuts at Tuesday’s meeting.

Bureau of Statistics figures for the December quarter, released two weeks ago, show inflation was much higher than expected by most analysts at 2.7 per cent over 2013.

That number was also higher than the Reserve Bank’s November forecast of 2.5 per cent.

The unexpected spike in consumer prices has prompted the RBA to lift its year-to-June inflation forecast in the latest quarterly Statement on Monetary Policy (SOMP) by half a percentage point from 2.75 per cent to 3.25 per cent – just outside its 2-3 per cent target range.

The bank expects its preferred underlying measure of inflation, which excludes the most volatile price movements, to remain within the target range but, at 3 per cent, it too is uncomfortably close to slipping beyond.

Indeed, the bank forecasts both headline and underlying inflation to be anywhere from 2.25-3.25 per cent for the years ending in December 2014 and June 2015, indicating a concern that its preferred measure of inflation may also slip beyond its target.

A major factor contributing to the rise in consumer prices has been the fall in the Australian dollar, which makes imported goods more expensive.

After several years of generally falling, the cost of ‘tradable’ items – those that are imported or compete with imports – has risen for three quarters in a row, at an accelerating pace.

Given the lag between currency shifts and consumer price changes, it is likely that tradable inflation would have further to rise even without a continuation of the Australian dollar’s decline.

A special analysis of recent developments in domestic retail prices is also indicative of the bank’s inflation concerns.

The bank’s analysis finds that it is not only a rising Australian dollar that has helped contain inflation over recent years, but also move by retailers to squeeze the profit margins of wholesalers and other suppliers.

The bank speculates that recent retail prices rises may reflect not only the pass through of the costs of a falling dollar, but also an effort by wholesalers to recover some of those lost margins.

Next move as likely to be up as down

After its meeting on Tuesday, the Reserve Bank governor Glenn Stevens indicated it was likely that the official cash rate would stay on hold for some time.

“On present indications, the most prudent course is likely to be a period stability in interest rates,” he said.

That sentiment was repeated in the SOMP.

“Based on the outlook for inflation and activity as it currently stands, the board’s view is that a period of stability in the policy rate is likely,” it noted.

Economists have interpreted these statements as indications the bank is now ‘neutral’ – that is, the next move in rates is as likely to be up as it is down.

That interpretation is reinforced with an increased level of confidence in Australia’s economy by the RBA, which has lifted its economic growth forecasts, although not by as much as its inflation expectations.

The bank is now expecting Australia’s economy to grow 2.75 per cent over the year to June, up from its November prediction of 2.5 per cent.

It has also lifted all its longer term GDP forecasts by a quarter of a percentage point as well.

The future of interest rates will depend largely on whether growth and inflation are at the top or bottom end of those forecasts – if both are at the top end of the December 2014 forecast, at least one rate rise before year’s end would seem likely, if at the bottom a further rate cut might be possible.

The most disastrous outcome would be for inflation to be at the top of the forecast range, while growth was stuck at the bottom, for that would present the bank with a substantial dilemma.