Kiwibank economists say the Reserve Bank may well have to tolerate higher inflation in the short term to avoid raising interest rates into a slowing global economy

The idea of interest rate hikes any time soon now looks "more premature" than it did before the current Middle East conflict, Kiwibank economists say.

Rapidly spiking global oil prices are prompting concerns of similar spikes in inflation.

This is problematic in New Zealand, where our annual inflation rate of 3.1% as of the December quarter was already running above the Reserve Bank's 1% to 3% target rate.

The Official Cash Rate (OCR) has effectively been put on hold at 2.25% for now. There's been a sharp rise in wholesale interest rates and the financial markets are now virtually fully pricing in the chance of a hike to the OCR in September. However, economists say this sharp rise in the rates is largely reflective of current liquidity pressures in the market due to the global situation.

In Kiwibank's weekly economics commentary, chief economist Jarrod Kerr and economist Sabrina Delgado say the Reserve Bank "may well have to tolerate higher inflation in the short run to avoid tightening into a slowing global economy".

"Yes, inflation will likely spike further in the near term. But central banks, the RBNZ included, will need to (and are supposed to) look through the near-term noise," the economists say.

"Looking to the medium‑term instead, where monetary policy is targeted towards, the weakening growth outlook simply matters more."

They say that with supply shock induced inflation, "it’s the damage to demand that is likely to dominate".

The economists say that for households, higher petrol prices at the pump will just add to the cost-of-living crisis "we keep hoping (and thinking) will end".

Input costs are going to go up "across the board for firms".

'Not all businesses will be able to pass on costs'

"But in an already fragile demand environment, not all businesses will be able to pass on the costs to consumers. It will be uneven. Sectors like retail and construction, which are amongst the weakest, will struggle to pass through higher costs. Mixing together tighter margins, falling profitability, and a shell shock wave of uncertainty, businesses will be more likely to pull back on investment, hiring, and growth-oriented decisions… reinforcing a weaker growth environment," Kerr and Delgado say.

BNZ head of market research Stephen Toplis, in BNZ's latest Markets Outlook, says the RBNZ has a big "headache".

"Does it adopt an easier monetary policy stance because of lower growth, or does it adopt a tighter stance because of rising inflation?

"This comes down to how much the Bank is willing to look through the short-term shock, what assumptions it makes as to the longevity of the shock and how much weight it places on the actual data (rising inflation) as opposed to forecasts of lower growth and lower medium term inflation," he said.

This is a conundrum faced by central banks across the planet, Toplis said.

"But New Zealand’s starting point of rising inflation expectations, inflation outside the target band, and likely ongoing elevated inflation, even in the face of what looks to be weaker-than-expected growth, makes the task that much more difficult."

Toplis said that the BNZ economists get the sense that under new Governor Anna Breman, the RBNZ will adopt a conservative approach if it can.

'Greater than 50% chance of a hike in September'

"Barring anything even more outlandish than what we are currently witnessing (a brave assumption!) occurring between now and the April 8 Monetary Policy Review, we think the RBNZ will hold the line at that meeting. But, with the information set we have, we still think there is a greater than 50% chance that the Bank ultimately brings forward its first hike to September noting that this was our central view anyway."

In Westpac's Weekly Commentary, senior economist Darren Gibbs Westpac noted that the RBNZ’s standard approach is to "look through" a near-term lift in inflation caused by higher oil prices, where that lift reflects a supply shock (due to geopolitical events or other temporary disruptions).

"In part this is due to the accompanying downside risks for growth, which could pose downside risks to inflation beyond the near-term (higher domestic petrol prices will reduce household disposable incomes, depressing demand elsewhere in the economy). It also reflects the expectation that any monetary policy response to a temporary inflation shock would only impact the economy after the shock had already passed, thus serving to amplify the cycle in inflation.

"That said, the RBNZ will be mindful of the risk of a further uplift in inflation expectations should inflation remain in the upper part the RBNZ’s target band for an extended period, especially with the post-Covid surge in inflation still front of mind for many households and businesses."

Given the current level of spare capacity in the New Zealand economy, the Wespac economists think there is less risk of a meaningful lift in inflation expectations than would otherwise be the case.

"However, the risk is not negligible. For this reason, the RBNZ will also likely be reluctant to ease policy further even if the outlook for the economy were to weaken materially.

'It would be folly to rule out further monetary policy easing'

"But it would be folly to entirely rule out the possibility of further policy easing if the impact on the global economic outlook and export commodity prices was to prove severe. In the past, the more serious episodes of Middle East tensions have sometimes led to large falls in business confidence and output. While we are not expecting that this time, those downside risks can’t be ruled out," Gibbs said.

In the near term, faced with "such two-sided uncertainty",  the Westpac economists think that the RBNZ will likely become even more wedded to the 'on hold' stance that it communicated at last month’s OCR review.

"As the conflict plays out, the RBNZ will assess how this is impacting the economic outlook and the medium-term path of inflation. Fortunately for the RBNZ, it will not have to publish updated forecasts until the next Monetary Policy Statement in late May.

"However, RBNZ Governor Breman is scheduled to give an address to a BusinessNZ CEO Forum on 24 March, touching on the current economic outlook. This might provide some insight into the RBNZ’s early thinking. We expect the RBNZ to communicate a more dovish message compared to current market pricing, which this week has been leaning towards a greater chance of the OCR being hiked sooner than December."

In ASB's Economic Weekly, ASB senior economist Kim Mundy said from the RBNZ’s perspective, it can look through a one off price shock (especially one that was generated externally).

'Can't ignore second-round impacts'

"But what the RBNZ can’t ignore is the second-round impacts, especially in a scenario where the price rises are sustained. With the conflict looking likely to continue for some time, and many carriers being unwilling to risk ships and crew, the risk of these second round impacts become more elevated. Higher oil prices can feed into higher prices for food, transport and raise manufacturing costs.

"It can also impact inflation expectations. Any move higher in expectations in coming reads will be unwelcome news for the RBNZ, given inflation is already sitting outside of the target band and many inflation expectations readings were trending higher before war broke out."