Roger J Kerr says the landscape has shifted dramatically on the inflation front

By Roger J Kerr

In my last interest rate market commentary on 17 December 2017 I highlighted two major factors that would push both short-term and long-term interest rates higher in 2018, namely:-

  • NZ inflation outcomes - fuel prices, food prices, wages increases and construction prices.
  • US Treasury Bond yield movements – rising US inflation, Fed lifting short-term interest rates and bond portfolio managers shortening their duration i.e. selling bonds, sending yields higher.

News and developments over the past month have arguably reinforced my views with significant price increases occurring for oil and other commodities.

On the US Treasury Bond market front, the market sentiment has certainly shifted to the negative with the previous resistance at 2.50% broken and more and more market participants talking about a “bear” market for bonds and thus even higher yields.

Latest US inflation numbers were sharply higher, therefore, the Fed look very much on track to increase interest rates again in February.

Over recent years very low long-term interest rates in Europe, the US and Japan have worked to keep US yields at the lows.

Improved global growth and higher oil/commodity prices have now changed that situation outside the US, freeing up the environment to allow US long-term yields to increase.

On the local inflation front, the CPI figures for the December quarter being released next week on 25 January will provide some pointers for what could occur over the remainder of the year.

After a number of years of low inflation in NZ due to imported global deflation, low oil prices and a lack of wage inflation due to high inwards immigration, the landscape has now dramatically changed with all these factors no longer present.

Some will contend that the potential for a much weaker housing market in NZ will prevent the RBNZ from raising the OCR this year.

Time will tell on this view, however the housing supply/demand situation in Auckland remains in under-supplied mode, therefore it is difficult to expect a major collapse in house prices.

Borrowers who still believe that 90-day floating interest rates will remain well below fixed swap rates over the next several years may be finally realising the risk/reward on this view has shortening odds.

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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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46 Comments

Even Bill Gross is talking about a light bear market for bonds. Sentiment has changed. There's still too much money sloshing around for inflation pressure to hit hard, but you never know what might happen.

e: I realised I should be a bit more clear. There is a lot of money sloshing around in the form of cheap debt and that's allowing some questionable business models to function as they don't need to turn a profit to survive. This is causing price distortions (especially in shale oil) which is keeping prices artificially lower than what they should be.

There’s been a lot of bankruptcies here in shale oil companies even with cheap money my friend

Despite the cheap money, shale producers have managed to achieve some pretty good production efficiency gains over the last few years. Their break even thresholds have dropped a fair bit since advent of the industry. At $70 there will more rigs coming on line this year for sure.

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It is puzzling how the raising of interest rates is not considered relevant to housing inflation when house prices are going up, but interest rates suddenly become relevant when there is a risk of house prices going down. It seems monetary policy is looked on as being highly asymmetric, to protect certain favored parts of the economy.

Monetary Policy dictates that consumer prices MUST rise each year. That's the lunacy of it. How that is achieved is of secondary importance. But as long as we are told and believe that 'prices are rising, you must bargain for higher wages' and as long as we do as we are told, that's going to be the way things stay.
The problem that the Monetarists have right now is that 'the people' aren't buying it - literally - and are beginning to realise that they are in fact better off if prices fall. That revelation might prove fatal to Monetary Policy unless it's stamped out pretty quickly...

"Monetary Policy dictates that consumer prices MUST rise each year."
Yes. Simply because that is so much better than the opposite.

Also, "Monetary Policy dictates that weighted average consumer prices MUST rise each year."

Of course another alternative is that we have zero inflation, which would have pleased Friedman endlessly. Achieving that is extremely, extremely difficult though.

Yes, the best way to shrink a households mortgage is to gain wage increases.
Far better than shrinking incomes, and static mortgages.

Sure....IF wage rises come from increased Productivity, not just a 'hand out' because some set of figures on a spreadsheet tell us that "We MUST get a pay rise to keep up" doing the same old thing....

Why is it better than the opposite?
More goods/services produced for a lower price at an increasing quality level is the cornerstone of Capitalist economics.
Pull out a Supply/Demand graph in any text book, and that...is the objective. "Increased production and lower prices'
Rising prices devalues Work Effort because no matter what, disposable income NEVER keeps up. That is part of The Game....
Lower prices are actually a sign that an economy is working, not the reverse ( as we are bullied and terrified into believing!)
What is compulsory is the theory that "Prices MUST rise" when wages will go far further with rises in productivity and....falling prices.

That isn't what deflation facilitates.
You are naively thinking in the short term.
In the medium to long term, deflation is really bad.

"More goods/services produced for a lower price at an increasing quality level is the cornerstone of Capitalist economics."
Deflation actually does the opposite of this. Supply comes from demand signals. Low cost comes from economic scale; two factors that deflation does not promote.

"Rising prices devalues Work Effort because no matter what, disposable income NEVER keeps up. That is part of The Game...."
Really?
Wage growth hasn't kept up with inflation in modern times?
Interesting assertion you make...Got any data to back that one up?

"Lower prices are actually a sign that an economy is working, not the reverse ( as we are bullied and terrified into believing!)"
As I said, lower prices come from increased production. Longer term deflation does not in any way facilitate this.

Ideally speaking we would have zero net inflation, right?
As I said, though, this is all but impossible in any real world market system.

The age-old two sides of economics discussion. Supply Side and Demand Side. Which is the egg?
Did BluRay players arrive as a result of demand, discs in the rental stores etc, or did players arrive in the stores first? Both and neither!
The Short Term is all you and I have! 70 years is about it, and the last half of that has been a disaster. If it hasn't been why are we either having this discussion or why did '87 '00 '08 etc happen? Answer: What we have doesn't work! It's been Short Term, and now we have to face the Long Term and using what we have been for the past couple of decades is going to have consequences that perhaps Libya and Syria fortell for all of us. Extreme examples perhaps. But not that long ago Lebanon was the France of the ME and Beruit its Paris and Naru was the richest place on the planet on a per capita basis. Have a look at them today. And as I have written elsewhere when too many don't have enough, the pitchforks are going to come out and loading 'us' up with more unpayable debt, isn't the answer. Lower prices is. (NB: I don't consider Deflation lower prices as such. For me it's reduced money supply)

bw,

"The age-old two sides of economics discussion. Supply Side and Demand Side. Which is the egg?"
Ahh, what?
There is no debate over this. Demand leads supply. Primarily producers adjust supply relative to demand. Some may opt for some short term over supply, exceeding a given profit maximisation point. However I don't know any producer who has built a sustainable enterprise on systematic oversupply of goods to a market....
Maybe you can enlighten us?

"The Short Term is all you and I have! 70 years is about it."
Whilst reading up on supply and demand, also read up on what is short/medium/long term in economics speak.

"(NB: I don't consider Deflation lower prices as such. For me it's reduced money supply)"
Again, a read up on basic economic terms and monetary policy might be in order.

So "Build it and they will come" isn't a theory?

Not unless you take your economic advice from Wayne's World or Governmental institutions.

So I'll take that as a 'yes'
Money supply side deflation
From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money and/or the amount of money supply per person

I'll let you hunt that out..

Oh, and have you ever run a retail store/operation? I have. And I can tell you, opening the doors and waiting for the customers to come into an empty space and ask you to supply something, doesn't work! You have to Supply it/something first - and hope they buy it.

I'll quote you.
"I don't consider Deflation lower prices as such".
That was what I was primarily objecting to.

"Oh, and have you ever run a retail store/operation? I have."
Good for you.

Have you ever been an economic consultant?
I have.

What you are arguing is latent demand.
By your logic, if supply leads demand, I could go setup a brothel next to the Gloriavale commune and become successful. Because once I supply debauchery, they will flock to buy it.
That is not the case.
Hence why you are wrong.

It would be successful if the demand was there ...after the supply! So thx for the example.
Frankly, I see merit in both arguments of Supply and Demand. I simply accept there are two ways of looking at the same marketplace. I don't exclude one because that's my dogmatic belief....just as I have written, Deflation is viewed as different things to different people.

That isn't what deflation facilitates.
You are naively thinking in the short term.
In the medium to long term, deflation is really bad.

That depends. Deflation gave rise to companies like Uniqlo who were able to build on the consumer need for low-cost clothing with a minimum level of acceptable level of quality. Now that the Uniqlo business and brand have developed, the company is able has been able to diversify their product portfolio and offer because consumer perception has changed (greater quality at reasonable prices). .

Without the deflationary macro-environment, companies such as Uniqlo wouldn't have come into existence.

Thank you for that one anecdotal example.
That must surely be the case for every industry/producer.

My whole world view has been turned upside down.

My pleasure. We all have to start somewhere.

....and that's why lower prices are just ...lower prices. Deflation, again for me and I accept it's not a widely held view, is a Monetary Phenomenon, not a retail price of goods one.

"Deflation, again for me and I accept it's not a widely held view, Monetary Phenomenon, not a retail price of goods one."
There is an absolute horde of economic measurement literature that would object to that view.

But hey, over 100 years of index literature or the view of bw.
Choose which one you will.

nymad, you are a hero and fighting the good fight.

There is no way I would have the patience to argue with this moronic logic.

Deflation is bad.
Low, controlled, inflation is good.
End of.

Economists are beginning to revise their opinion about the ill effects of deflation. This article will examine the case for good deflation.. The country has a low unemployment rate (3.4%) numbers and its economy is expected to grow by between 1% to 1.5%. Wages have declined by 0.6% on an annualized basis but have been offset by the drop in prices. In fact, there has been a net increase in spending power, when wage gains are compared to the fall in prices. .

https://www.investopedia.com/articles/markets/111715/can-deflation-be-go...

Oooo look, what's this, another investopedia link...

https://www.investopedia.com/terms/d/deflationary-spiral.asp

Thx for that. And as an Economic Consultant, the previous poster nymad would probably advise his clients to "Keep both eyes open and be flexible to new ideas". That's what I suggest we all do.

Naive? BW did you see what nymad called you ?
However you could explain to nymad how clever you are

The OCR here isn't that important as we have a relatively high rate. The rates that really matter are the big players especially the Fed. They want to put their rate up 3 times this year and they'll get at least one or two increases off the back of US confidence. Their rate will push up the rates our banks can borrow at.

The biggest banks have a big push to hit the $1b profit target so they aren't going to wear any additional costs.

The western property bubble is going to be under a lot of pressure this year.

Peri
Agreed the statement that some how housing is sacred as pertaining to the OCR is farcical

Problem with Rogers 2 scenarios is they are both unlikely scenarios .

His thinking e is rooted in the inflationary era of the 1970s, 80's and 90's and while things are not perfect , the inflation bogeyman is not part of the act ( for now at least)

There is no indication of any serious domestic inflationary pressures

And while things are stable in the US , the Fed is not likely to tinker with interest rates

Bond markets however look to be ready for a correction , but thats entirely another issue

That said , its more likely that some shock wlll come along and upset the applecart

It could be a war , a recession , a sever asset price correction ( stocks and bonds) a Chinese banking or credit meltdown or some other catastrophe much like the GFC .

The Kiwi$ is still strong , and very stable , and while construction costs are going up, we dont buy new houses every day ( well most of us dont ) .

Diesel has gone up 20cents a litre in the past 8 weeks , but its way below its peak price

So I dont see inflation as a likely problem for us

Labour promising $20/hr minimum wage in 4 years. That's 27% in 4 years. All other wages will follow suit. Not inflationary?

A better answer is not to raise wages, but to lower prices....

How do we do that in NZ, given many of our industry is labor intensive?
Ask any company what their key variable cost is; I'll give you a hint...it's a 5 letter word (american spelling), starting with 'l'.
Given that productivity growth is effectively dead in NZ, how do you propose that we lower prices?

Um, Um .. Lamps? Lance? Laser? Lasso?

American spelling you say, maybe lasso - but that's the same in UK English - think Ralph think!

Laugh?

simple stop the flow of low cost labour which would increase labour cost so the business either innovates or dies. Innovation could be in the form of automation which would then increase productivity so more could be produced for less.

This would lead to higher wages for those businesses that can afford it and productivity gains

I wonder if rents will rise by 27% in over 4 years.?

It may be inflationary , but it may not be . Jobs will be more casualised than they already are , more callcentres will move offshore , Maccers will go up in tandem with the minimum wage but not everyone is going to get a pay rise of 27%.

And it may never happen , because the coalition of the losers wont get to 2020

They continue to make spectacular cock-ups , and Parliament has not even re-opened yet .

They have annoyed the Aussies over the remaining aggressive criminal element on Manis Island.

Jacinda Ardern continues to think she is running a Benevolent Society .

The Greens has become obsessed with counting the LGBT commmunity in the next census for a reason known only to themselves . Frankly who cares what anyone's sexual preferences are ?

Winston Peters has faded into the background

The housing minister has now ackowledged they are unlikely to build 100,000 more houses than National achieved .

Grant Robertson thinks he is treasurer of the Students Union , so watch the budget blow-out explosion , its going to make Kim Jong Un's missile program look like a kindergartens fireworks display .

The fiasco of getting rid of measuring school kids progress in School on a National Standard without putting something else in its place will do a disservice to future Kiwi kids who will continue to leave school unable to read or write properly .

They have not hit the ground yet , and they are bumbling around like moles in the dark

Didn’t you effectively vote this lot in?

The point is “Boatman” the FED is tinkering

Boatman,
If your New Year's resolution was to make even less sense than you did in 2017, you have gotten off to a good start.

Sorry but the 90d bill rate just fell to record all time lows in Nov / Dec. For everyone that is talking a 25bp hike from the RBNZ, effective interest rates just fell 25bp in the last two months. Maybe less time forecasting and more time looking at what is actually happening right now, something that nobody seems to pay attention to.

Interest rates falling to record all time lows on the back of the data we have seen recently really only means one thing, major excess capacity in the economy. There is a very high statistical chance that the economy began to enter recession in Nov/Dec, '17, given the moves in housing volumes in Q2-Q3, its about right on time considering that 3/3 recessions in the last 30 years were preceded by falling volumes of this magnitude in the months before.

That and New Zealand dollar deposit rates fell from 3.4% to 2.1% in a few days at the same time.

Take a look if you don't believe me.

NZs economy was on course for recession the moment foreign investment decreased
It’s a tiny economy a couple of islands of 5 million people what did anyone expect ?
The way people tell it here you’d believe the world couldn’t wait to move to Remmers a cold place in any kiwi winter. Heck most of the homes don’t even have central heating !

Tomorrow at 5pm is the last day to challenge your Auckland valuation. Do it later and you may have to pay money.

The FED will tell us what direction interest rates go.

They can't afford to spook people by "signalling" rapid rate hikes. So they don't.

Surely it'll be a coming tho!

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