Roger J Kerr says interest rate markets will be forced to adjust pricing upwards as the Federal Reserve remains on track for further rate rises

By Roger J Kerr

New Zealand has enjoyed the benefits of very low inflation and very low interest rates (if you are a borrower and not an investor!) for many years now and for that reason the chorus from pundits and commentators has grown stronger that it is never going to change.

The supportive arguments are that the world economy is a different place since the GFC with global loose/loose monetary policy, permanently low energy prices and technological advancements continuing to drive the cost of doing business downwards, thus no pressure to increase selling prices on consumers. Adding to the argument is the total lack of wages increases in the US, Aussie and NZ over recent years.

The counter-argument is that it is only a matter of time before the traditional economic relationships re-emerge and strong economic growth causes demand to exceed supply for capital, labour and resources, which in turn forces up inflation and ultimately interest rates.

The “inflation is dead” camp mentioned above believe that these economic “cause and affect” relationships do not work anymore due to technology i.e. the previous economic models are redundant! Well, the recent statement from the US Federal Reserve that they are still on their stated track for one further 0.25% interest rate increase this year and four more next year confirms to me that they do not believe their economic models on predicting future inflation are out of date.

The Fed have always been of the view that the pull back in US inflation earlier this year was purely temporary. The interest rate markets never believed it. However, recent data suggests the Fed are on the right track. Eventually the interest rate markets will be forced to adjust their forward pricing upwards and that means higher US bond yields and NZ swap rates (beyond three years) over coming months.

I have spent the last two months travelling around the US as a tourist, and whilst purely anecdotal observations, I noticed a lot of “hiring” signs placed outside all sorts of business premises.

Whilst US wages have yet to move significantly upwards, the changing demand/supply equation will inevitably require a higher price response. The US National Parks we went to were crowded with European tourists, so that tells you the US dollar is too weak! Seemed to be a hell of a lot of road improvements going on as well!

Most local financial market and economic commentators would expect higher NZ interest rates if we get a Labour/Greens/Winston coalition Government due to fiscal deficits, higher debt and higher inflation from a lower NZ currency value and higher wages from a squeezed labour supply due to reduced immigration.

The other worrying aspect for me from the stated policies of these three political parties is to review the Reserve Bank charter to a dual mandate of both stable inflation and employment.

They will say the US Federal Reserve has this dual mandate, so why not NZ? The reality us that there are major differences between the two economies. The US economy is 80% domestic, New Zealand is export dependent. Our employment conditions move with how well the export economy is going and that comes back to export commodity prices. There's not a lot the good people at the Reserve Bank can do to change those economic and market forces.

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Roger J Kerr contracts to PwC in the treasury advisory area. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com

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2 Comments

The Fed have always been of the view that the pull back in US inflation earlier this year was purely temporary. The interest rate markets never believed it. However, recent data suggests the Fed are on the right track.

Hmmm....

Monetary officials continue to maintain that inflation will eventually meet their 2% target on a sustained basis. They have no other choice, really, because in a monetary regime of rational expectations for it not to happen would require a radical overhaul of several core theories. Outside of just the two months earlier this year, the PCE Deflator has missed in 62 of the past 64 months. The FOMC is simply running out of time and excuses.

The updated estimate for the PCE Deflator in August 2017 was 1.43%. Despite a large contribution from gas and energy prices that boosted the CPI, indicated consumer price inflation here was basically unchanged from the last two months. In fact, the rate of growth has settled down right about where we thought it would going back to last autumn; the predictable contribution, and then withdrawal, of oil price base effects largely concluded. Read more

"I have spent the last two months travelling around the US....The US National Parks we went to were crowded (etc etc) "

Good for you Roger. Now I have no way of knowing how many times you've done a trip like that, but I did it for the first time in 1979 when I went to do a relief in the New York and Los Angeles offices, and I can tell you that what I saw as " crowded', even back then was viewed as just "business as usual" for the locals. If you've been a few times you will have a comparative reference, but what we see from New Zealand as crowded, lots of For-Hire signs etc, really isn't.....