Kiwibank economists say central banks will ultimately need to have looser inflation targets than they do now to accommodate a "world of rapidly rising, climate-related, costs".
In the latest Inner Kiwi publication, Kiwibank's chief economist Jarrod Kerr said the "structural lift in inflation" makes targeting a rate of 2% in years to come, that much harder.
Our Reserve Bank (RBNZ) has an inflation target of 1% to 3%, with a specific goal of achieving 2%. Just last month RBNZ Governor Adrian Orr gave a speech in which he highlighted that the current 2% mid-point inflation target remains appropriate for New Zealand.
As of the December quarter our annual rate of inflation was 4.7%, down from a high of 7.3% in mid-2022.
Kerr said the impacts of climate change on inflation are "multifaceted, and structural".
"More frequent severe weather events will cause more damage, which will become increasingly expensive to rebuild from and insure against, forcing price hikes in affected industries. The floods and cyclone that ripped through the North Island last year are an unfortunate example. The rebuild cost is estimated at over $13 billion, and growing. Lost crops hurt exports by around $1 billion, and caused a spike in some food prices (like apples). But there are structural changes. Insurance costs and council rates are being marked higher in response."
This structural lift in inflation therefore makes targeting 2% in years to come, that much harder," Kerr said.
"The current war on inflation aside, central banks will have to get a little more creative.
"Looking through large increases in food prices, insurance premiums, council rates and other costs like (re)building supplies, will prove difficult. We’re (inevitably) going to ask the question, is 2% the right target?
"No… Targeting 2% in a world of rapidly rising climate related costs, would require a crushing of non-related costs to compensate. Punishing Peter to pay Paul is problematic and painful.
"We suspect the conversation will shift towards higher, looser, targets. But not just yet.
"Because central banks place an appropriately large weight on their credibility. Central banks need to break the inflation beast that reared its ugly head following over-stimulation from Covid.
"Once the beast is broken, over 2024/25, then we’re going to hear more about climate related inflation into 2026. 'Higher for longer' interest rates will make way for 'higher for longer' inflation targets," Kerr said.
Kerr has referred to this subject previously in an Of Interest podcast.
In terms of the immediate inflation battle, however, Kerr does see the RBNZ as achieving "soft landing nirvana" - doing just enough, and not too much, to control inflation by nudging the economy back to optimal levels.
"Getting inflation back to 2% is seen as the optimal run rate, at least for now. We have seen the heat come out of goods markets and asset markets, like housing. But we need to see a little more heat come out of labour markets, and services. It’s a monumental task. Because using blunt tools to orchestrate a soft landing is not something we see much in history. But it’s one traders are betting on. And our central bank is buying in. Will they get there? We think so. And when they get there, they can unwind restrictive policy, returning to more neutral settings."
Kerr forecasts inflation falling below 3% this year, and he expects it to push toward 2% next year. He is forecasting that the RBNZ will start cutting the Official Cash Rate, currently at 5.5%, in November of this year.
"We forecast substantial declines in interest rates this year and next. The great unwind of heavy-handed hikes will help households and hampered businesses, producing a better outlook. The glass half empty will turn full. 2024 will be a better year than 2023, and 2025 will be better than 2024."
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