The focus of most analysis of the June quarter CPI has been the impact of banana prices and petrol costs on the headline result.  Certainly the Prime Minister and Treasurer appear to be pressuring the RBA not to hike interest rates because, according to Mr Howard, "both of them have gone up ...because of forces no government can control."

And sure, fruit and petrol added 1.0 percentage points to the 1.6% qq rise in the June quarter CPI.  But to discount the whole inflation result because of a couple of big ticket increases is spurious, disingenuous and not all that helpful for assessing RBA policy deliberations and longer term inflation performance.

What has been over-looked is the incredible deflation impetus from what could be dubbed the China effect - clearly a factor "no government can control."

The so-called China effect is the tendency for many goods prices to be falling because of the transfer of production to the low cost Chinese manufacturing sector.  In the year to the June quarter, Australia enjoyed a significant deflationary effect from China, without which, headline inflation would have been around 5.2%.

Note, for instance, the following which are China and / or manufacturing related which occurred in the year to the June quarter 2006:

Clothing and footwear:                                  -1.7%   [Weight in CPI 3.70%]
Furniture and furnishings:                               -0.3%   [Weight 2.99%]
Household appliances, utensils and tools:       -0.8%   [Weight 1.68%]
Audio, visual & computing:                            -4.7%   [Weight 2.68%]
Sports & recreation equipment:                      -3.5%   [Weight 0.51%]
Toys, games and hobbies:                              -1.9%   [Weight 0.49%]
Motor vehicles:                                              -0.9%   [Weight 4.67%]

These items make up one-sixth (16.72%) of the overall CPI basket and the weighted average decline of these items over the year to the June quarter was 1.7%.

Without these items, the CPI increase would have been a tub-thumping 5.2% over the year to the June quarter, a horrendous outcome that would surely undermine the competitive position of the economy.  So 'thank-you' China that Australia's inflation position is not prompting the RBA to hike 50, 75 or even 100 basis points next week!

To offset this, of course, there is a perfectly valid argument to suggest the effect of petrol on inflation is also a China-effect.  The booming conditions and massive growth in demand for energy from China is a large driver of the strong and now sustained lift in energy prices.

So let's remove the impact of the 24.6% rise in petrol prices over the past year from the CPI ex-China.  Petrol has a 4.54% weight in the CPI basket, so inflation, ex-China and ex-petrol, is 4.2% over the year to the June quarter.

And then there is the issue of bananas.  Yes, it is entirely reasonable to expect falling banana prices once the plantations come back into production later this year.  So let's strip out the effect of the 64.2% rise in fruit prices over the past year.  Fruit has a weight of 1.50% in the CPI.

This leaves our modified inflation rate, which is calculated to be the overall CPI less the China-effect, less the petrol-effect, less the fruit-effect, at 3.5% in the year to the June quarter.

This is probably a fair measure of the current inflation problem in Australia.  It is why the RBA will hike interest rates for a seventh time on 2 August, it is why there is a strong likelihood of an eighth rise before the end of 2006 and unless we see general inflation pressures ease in the next three to six months, there is a risk that the RBA will need to hike interest rates a ninth time to 6.5% in the early months of 2007.

PROLOGUE:  So what is driving the inflation surge in Australia?

Many services prices are rising strongly.  In the year to the June quarter, services prices rose 3.3%.  Of those services where labour costs are a significant input, the price increases have been even higher.  This reflects the skills shortage which has only intensified with the recent jump in employment.

Note the annual increases:

Child care:                                         +12.4%
Hairdressing and personal services:     +3.7%
Education:                                          +5.8%
Pet services, incl veterinary:                +3.9%

Some evidence of a pick up in dwelling rent has come through in the June quarter too.  Certainly the anecdotes suggest low vacancy rates and a substantial pick up in rent.  Rent rose 0.9% in the quarter, the highest quarterly rise since June 2001.  The annual increase, at 3.0%, was also at a 5 year high.