BNZ economists say they hope the Reserve Bank will 'eventually accept' there are a number of relative price increases such as insurance and rates that can be 'looked through'

There's a "very real" chance the Reserve Bank (RBNZ) will continue to be surprised on the "upside" by domestically sourced inflation, BNZ economists say.

In BNZ's latest Markets Outlook publication, head of research Stephen Toplis says he hopes the RBNZ will "eventually accept that there are a number of relative price increases such as insurance and rates that can be looked through".

"Nonetheless, it has been made abundantly clear that more progress needs to be made on this [domestic inflation] front."

Annual inflation, as measured by the Consumers Price Index (CPI) was 4.0% as of the March quarter, down from a peak level of 7.3% in mid-2022. However, much of the fall has been driven by so-called 'tradable', or imported, inflation, while 'non-tradable' or domestically sourced inflation has been what the economists like to call 'sticky'. It fell only to 5.8% in March, from 5.9% as of December - when the RBNZ had forecast it would fall to 5.3%.

The RBNZ, which is forecasting that the 'headline' overall inflation figure will get back into its targeted 1% to 3% range by the end of this year (it forecasts 2.9%), is picking annual non-tradable inflation to be 4.7% by the end of 2024.

"We will be monitoring this very closely," Toplis says, "but fear it could be as late as next year before annual non-tradables inflation falls below 5.0%."

The CPI inflation figures for the June quarter are due to be released on July 17. Before that, however, on July 10, the RBNZ will be having its next review of the Official Cash Rate, which has now been 'on hold' at 5.5% since May 2023. (interest.co.nz will do a full preview of the OCR decision closer to the time.)

Toplis is expecting no change to the OCR in next week's decision and thinks the RBNZ will "stick to its knitting".

"It will likely acknowledge that economic activity is faltering but continue to warn that it is in no rush to respond to that," he said.

Financial markets are currently fully pricing-in a cut to the OCR in November 2024 - but the RBNZ's not forecasting changes till the second half of NEXT year.

"We too believe rate cuts will eventually occur sooner than the Q4 2025 indicated in the [RBNZ's] May Monetary Policy Statement," Toplis said.

"But while we understand that markets, focused on the demise of the economy, want action now we, equally, stress that it remains inflation that is the focus of the central bank and it, rightly or wrongly, has been giving a clear message that there is much work to be done on this front."

OCR clarity by November

Nevertheless Toplis does believe the RBNZ will be in a position by the time of its November OCR review to "give clear updated guidance as to the easing track ahead".

"We still don’t think the RBNZ will ease in November but will instead set things up for a first move in February."

Toplis said there are two "necessary" developments that need to occur before the RBNZ lowers the OCR, along with a series of "desired" outcomes that also need to occur.

In the 'necessary' category is getting headline CPI inflation back under 3%.

"We are forecasting annual inflation will still be 3.5% in the June quarter. However, we are angling for it to be 2.8% in the September quarter. At the May MPS the RBNZ was forecasting 3.0%. The September CPI is published on October 16. If our forecast proves correct, then this potentially makes the November Monetary Policy Meeting live for a rate change.

"We think a secondary necessary condition is that the [US] Fed has begun easing. The Fed easing in and of itself doesn’t mean the RBNZ needs to follow suit but if the Fed moves it (a) suggests weakness in the US economy which will dampen global demand and (b) might help support the NZD [kiwi dollar] on an interest rate differential basis."

Other key factors to take into consideration Toplis said are: non-tradable inflation, fiscal policy, and productivity.

Toplis said on the fiscal policy front, the RBNZ will want to feel more confident fiscal policy is not only not adding to inflation but countering it.

"This will require some satisfaction the negative fiscal impulse the Government is forecasting can be achieved."

Higher than expected unemployment 'will be a driver' of OCR cuts

He said the productivity issue is a difficult one and he thinks perhaps the unemployment rate becomes "a good near term proxy" for likely shifts in productivity.

"Given this we think a weaker than expected labour market will also eventually be a driver of the Bank’s decision to ease earlier than it currently assumes. But it might take a while for the Bank to reach this conclusion," Toplis said.

Unemployment was 4.3% and rising as of the March quarter. The RBNZ is forecasting unemployment to hit 5.0% by the end of 2024 and peak at 5.1% in June of next year.

BNZ economists are picking that unemployment will rise faster and further. They think unemployment will be 5.3% by the end of this year and will peak at 5.5% in the March quarter of 2025.

Toplis noted that the RBNZ "already has a steep rise in the unemployment rate built into its near-term forecasts". However...

"We think the surprise will be that the increase continues unabated rather than the unemployment rate peaking at the 5.1% the RBNZ currently assumes," Toplis said.

"The data are not likely to seriously surprise the Bank for several quarters but its forecasts could well change earlier based on the ongoing deterioration in the economy."