Low inflation permanent or not?

Roger J Kerr sees a local economy well-placed to face stresses, sees inflation as a risk, and suggests how corporate borrowers can hedge interest rate risk

21st Jul 15, 8:48am by Roger J Kerr

By Roger J Kerr

If you believed all the now overly pessimistic forecasts on the NZ economy you would buy into the RBNZ slashing the OCR by 0.50% this Thursday.

While the probability of a 50 basis point cut has increased over the last week, it remains quite low.

Governor Wheeler will probably not do it as it would seem to be panicking on the economy which is not justified.

While some key economic indicators have deteriorated and it looks like 2% GDP growth instead of 3%, it is hardly Armageddon for the NZ economy. It is easier for the RBNZ to provide guidance of the future by cutting 0.25% this week and then cutting again at the MPS in early September. A 0.50% cut now could lead to a conclusion of the cuts coming to an end, which is not the future guidance they want to deliver.

The latest inflation data has not provided any fresh clues as to why non-tradable inflation continues to track so low when the economy has been reasonably robust and capacity utilisation of manufacturers has been running higher.

Technological advances continue to reduce prices in many service areas of the economy and partially explains the failure of the old “strong economic growth = rising inflation” maxim to occur over recent years.

However, the RBNZ would be unwise to wed themselves entirely to these new low inflation paradigms as being permanent.

My observation is that right now in the NZ economy local government rates bills are sharply higher, electricity prices are on the rise again and imported consumer good/building materials will definitely be going up in price due the pronounced NZD currency depreciation. Food and commodity prices have been falling over recent months; however my gut feel is that from current levels the greater risk is price increases, not further falls. Grain prices in the US have already started to turn upwards due to climatic and supply variables.

Borrowers should already have longer-dated fixed rate swaps in place and thus be well hedged against further increases in five to 10 year market swaps rates due to US Treasury Bond yields continuing their journey higher.

For shorter terms out to four years the recent reduction in market interest rates and the flat yield curve provides an opportunity for borrowers to examine purchased options and collar options on 90-day rates.

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Roger J Kerr is a partner at PwC. 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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35 Comments

by notaneconomist | 22nd Jul 15, 1:25pm 1437528343

At the end of the day people only have so much money to spend so all those who are creating inflation are competing against those who are in deflationary mode......I'd be watching retail spending figures very closely.......if people are forced to pay more for Council rates, electricity, rent etc, then that will leave them with less money for retail spending and that flows through to the tax-take etc!!

While the NZD might be creating inflation in the price of goods I don't believe that it is sustainable and think retail will suffer closely followed by Tradies......RBNZ has a dilemma but it is of their own making!!

by steven | 22nd Jul 15, 2:32pm 1437532353

Indeed. It isnt "if" its when, IMHO my power has gone up, rates will soon, petrol probably will unless crude does a face plant. Meanwhile wandering around various stores on the rare occasion I get time like DSE, Briscoes, Noel Lemon etc I cant but have the feeling the staff on the ground look rather fewer than I recall. So I wonder on how much cutting retail stores have left before closing shops start. Laying ppl off isnt just about lost PAYE its the double whammy of WINZ payments as well.

I wonder if Interest tracks commercial occupation rates.

by sharetrader | 26th Jul 15, 6:59pm 1437893982

and if you have in Auckland more of peoples wage going on paying higher mortgages and higher rents with wages being suppressed by high immigration, consumer spending must suffer and along with it any sustainable growth

by MortgageBelt | 26th Jul 15, 6:15pm 1437891359

The RBNZ made a misjudgment by raising interest rates 4 times in 2014 unnecessarily. The inflation target has been undershot for several years now due to a misjudgment on global conditions and misperceptions about impending inflation.
NZ is now in catchup mode, needs to undo the 4 hikes, then still consider more cuts.
Where is the analysis of the last 18 months by commentators?
Unemployment is higher than it needs to be, regional economies are struggling, small business borrowers are paying high interest rates relative to all other developed countries, farmers need interest rate relief, etc.

by bw | 26th Jul 15, 7:00pm 1437894033

"The inflation target has been undershot for several years" . So what?! Pick any 'target' or global rational economic measure you like and tell me that any of them have been adhered to over the last 6 years....Go back a shade over a decade, when the price change of housing was included in the inflation figure, and not the rent component that took its place, and calculate what the inflation figure would look like. In fact go back to that same time, before there was even an OCR and see where the market might have set wholesale rates today. The inflation target has been undershot....give me a break! In a World where 'whatever it takes' is the only target that matters, expect more lunacy from those who have little idea what they are doing to continue...until it all breaks. Then, and not until then... might we go back to adherence to targets.
(NB: Here's a great illustration for you! "When the unemployment rate gets back down to 6.5% we'll start to normalize (raise) interest rates". That's what the Fed said when unemployment was threatening 10%, if you believed the figures. And where is it today? 5.3%. And where are interest rates? Still 0.25%. And where were they when unemployment back went through 6.5% some time back? 0.25%. How's that for sticking to targets!)

by MortgageBelt | 26th Jul 15, 6:59pm 1437893984

The Auckland housing market is completely ruined due to NZs open door policy on foreign buyers and high immigration, high international students, etc, which is disconnected from mortgage rates influence and NZ wage earners.
Mortgage rates of 10% would have little effect on Auckland prices.

With Govt spending relatively tight, and an unnecessary tight monetary policy NZ is unprepared for the next 2 years. If the RB is going to err, then it should err on the side of looser policy not tighter

http://croakingcassandra.com/2015/07/23/how-about-giving-inflation-a-ch…

by bw | 26th Jul 15, 7:08pm 1437894536

Forget about New Zealand just for a tick. We have en economy that doesn't rate on any grand scheme of things that matter. Really, Auckland housing market and all. What does matter if is the state of The Big Boys, and if we had been smart, we'd have prepared our tiny flee-bite of an economy for what is likely to happen when it all comes unglued. We needed to de-lever our population and get it ready to ride out the tide of debt collapse that inevitable. The best defense was the one that the RBNZ had set about delivering to us. Squeeze the capacity to take on more debt out of the economy. Was it going to hurt? Hell, yes! But no change comes without pain. None. Someone always has to lose. But the sad thing is we will ALL now lose. Not just the farmers, who should have been stopped fro over expansion by higher capital costs some years back; not just the retailers, and the Auckland mortgage holders and the young unemployed, and the pensioners....ALL of us. And it was all so avoidable.
(Worth a read http://charleshughsmith.blogspot.co.nz/2015/07/we-need-crash-to-sort-wh… )

by MortgageBelt | 26th Jul 15, 7:28pm 1437895691

So your argument is to keep rates high to lower people's level of debt? Well, ok, but if property and farms are driven up high, then debt still follows up the asset inflation.
Perhaps you are right in that NZers should have been told that the world has been in a state of emergency since 2008, and to get out of debt asap.

by Anarkist | 26th Jul 15, 8:12pm 1437898329

The only people who gain from such a scenario are those who have liquid cash assets and/or are on good terms with the banks. They swoop in and buy up all the assets everyone else is having to sell under financial distress at firesale prices.

I have consistently argued that it was the reckless actions of Alan Bollard, egged on by bank economists such as Stephen Toplis who advised the Reserve Bank governor to raise interest rates, which in my view precipitated the recession, when public spending would have adjusted on its own with high energy and food costs and rising housing costs.

I am actually on record for predicting precisely what came to pass. I commented on an article written by Matt Nolan and economist at Infometrics on the matter of changes to the Reserve Bank's interest rate policies which were touted by the Labour government at the time. I actually am rather proud of my prescience and another article on Kiwiblog, but unfortunately the comments were all deleted.

I commented under the moniker jamesey

http://www.tvhe.co.nz/2008/07/03/re-thinking-interest-rate-policy-askin…

http://www.kiwiblog.co.nz/2007/07/pity_dr_bollard.html

Just discovered the director of an Aussie economic consultancy agreed with me. Only came across the article today.

" New Zealand's Reserve Bank is to blame for the current recession and for severely constraining economic growth over the past three decades, a leading Australian analyst suggests.

Rob Mellor managing director of BIS Shrapnel, Australia's largest independent economic consultancy says the Reserve Bank's "excessive" interest rate changes drove the local economy into recession well before it was struck by the global financial crisis.

"New Zealand can't blame the world economic downturn for the recession it's in. I don't know what the conventional wisdom is [in New Zealand], but if that's the perception, that's the wrong perception," says Mellor. "
http://www.stuff.co.nz/business/industries/economy/1997967/Reserve-Bank…

by bw | 26th Jul 15, 8:30pm 1437899457

What else would you expect Rob Mellor to say ! "He has 33 years' experience in forecasting building activity and is a regular commentator on prospects for the residential property market."

by Anarkist | 26th Jul 15, 9:23pm 1437902596

Well how about Keith Rankin, lecturer of economics at Unitec?

"The signs are not good however. The Reserve Bank continues to ignore the fact that, since 2000, rising interest rates have preceded rises rather than falls in domestic (ie "non-tradable") inflation.
The "anti-inflation" policy that the Bank continues to pursue simply doesn't work. It makes the
problem worse. If we use the 1980s as a guide, then my prediction today is that New Zealand will face a severe financial crisis after the next election. I also suspect that the election will be held early, for example June 2008. Like 1987, it might be a good election to lose."
http://rankinfile.co.nz/20070420BoomGloom.pdf

by Stephen Hulme | 26th Jul 15, 7:26pm 1437895565

Mortgage rates of 10% would have little effect on Auckland prices.

Proof please, other than your prejudicial deductions.

Furthermore, highlighting the obvious incompetency of central banks adds little to your case, especially so, from a recent ex-RBNZ employee who had little to say when he was on the payroll.

ZIRP&NIRP have not treated Sweden well.

The data are relentless: house prices keep rising, mortgage burdens keep growing, disbelief keeps mounting.

“To say that it’s not a threat, not a potential problem, that would be totally wrong,” Michael Wolf, the chief executive officer of Swedbank AB said in a June 11 interview at his headquarters outside Stockholm.

Finance Minister Magdalena Andersson calls the development “worrying” and has assured Swedes the government is planning steps to tackle the imbalance. Those will include proposals to boost the housing supply. Swedish apartment prices jumped an annual 13 percent in May. In Stockholm, where household debts average 482 percent of disposable incomes, apartment prices in some areas soared more than 25 percent over the past 12 months. Read more

The dissonance between the haves and havenots is not playing out well.

“In the last 15 years the gap between the rich and the poor has grown enormously and of course it has racial connotations – you find very rich people that are white people and the poor people are non-white people,” he added. Read more"

As I have said to you before, be careful what you wish for.

by MortgageBelt | 26th Jul 15, 7:31pm 1437895875

Proof: 2007/2008

by Stephen Hulme | 26th Jul 15, 7:40pm 1437896444

Incomprehensible, 0/10

by steven | 27th Jul 15, 8:54am 1437944076

Housing prices were going up pre-the recession/GFC until the GFC was caused by excessive oil prices which collapsed the world's economy.

by MortgageBelt | 26th Jul 15, 7:45pm 1437896714

Mortgage rates in 2007/8 at 10 or 11% were having little effect on house inflation.
Not exactly proof, but if 30% or more Auckland houses are bought directly or indirectly with no NZ borrowing then that effect should be able to be modelled.

by Stephen Hulme | 26th Jul 15, 8:11pm 1437898283

They were not given time to bite.

by Anarkist | 26th Jul 15, 9:33pm 1437903221

Perhaps because with Bollard being egged on by nutjob monetarist bank economists such as Stephen Toplis overshot on interest rates, which paired with historically high fuel and food prices precipitated a recession that preceded the global credit crunch. See my comment above.

by Grant A | 26th Jul 15, 10:10pm 1437905437

Letting inflation get to above 4% because you didn't go early and hard enough was more the problem back then and was always going to cause an overshoot as they had to scamble

by Anarkist | 26th Jul 15, 10:12pm 1437905535

So precisely when would you have recommended the Reserve Bank have hiked interest rates? Like 2004 perhaps? They made 5 consecutive OCR hikes in 2004 and they appear to have negligible effect. Pretty easy to pass judgement when you're dealing in retrospective hypotheticals

by MortgageBelt | 26th Jul 15, 10:17pm 1437905858

Any chance of 4% inflation in the next 2 years?

by bw | 27th Jul 15, 8:09am 1437941347

Inflation at +4% in the next 2 years? A good possibility! But...it depends on 'where from'. There has to be a clearing of asset, retail and wages prices first - all have to go a lot lower. Then we could see that inflationary boost, along with higher interest rates ( in a vain attempt at ameliorate inflation). When, you ask! Probably post November 2016, when we know 'who gets in'.

by steven | 27th Jul 15, 9:02am 1437944577

Uh, so we'd see a "significant" drop is wages first, which would cause deflation, but then afterwards we'd see inflation? So at best we'd be playing catch up on losses and to see "decent" wage drops strongly says far larger unemployment has to happen so ppl take lower paying jobs. Really we'd be in such deep doo doo once deflation takes hold that its hard to imagine all this in just 2 years, 5+ maybe 10+ yes.

I think our next election should be Nov 2017 btw? I cant see Labour getting a show myself their lurch to the left will come out again in the run up and they'll tank again as ppl run (left and right) to the likes of NZF,a nd maybe Crazy Colin (now having such nut jobs as MPs, that is frightening).

by bw | 27th Jul 15, 9:09am 1437944940

It's not our election I'm referring to!

by steven | 27th Jul 15, 8:51am 1437943898

per annum or total? ie 4% per year or 1% per year?

The former frankly seems very unlikely ppl are simply not earning more. Especially as the RB will be busily killing our economy long before that. The latter 1% per year, well we should be so lucky.

by bw | 27th Jul 15, 9:03am 1437944603

Per annum. As I wrote, it depends on 'where from'. If, say, wages have halved, it conceivable that emerging wage demands may come from that low point and inflation will emerge from that base. Now if wages haven't adjusted that far, but asset prices have, then it makes it even more likely that we'll see rises from their lower base. Containment MUST be the order of the day at that point, and higher ( normaler, if you like!) interest rates will be a significant part of that process. When we get the economic cat back in the bag, we must not let it escape again.....

by bw | 26th Jul 15, 8:22pm 1437898937

As matter of interest, Rodney District/Whangaparaoa,a dormitory region just north of Auckland, property prices fell 22% after the Bollard rate rises and didn't 'recover' for 18 months thereafter.Tauranga fell something similar, and to this day has only just retaken the levels it saw in 2007. If you don't know that I'm not surprised as no one ( ie: the press and the TV news) didn't want/weren't allowed to report it!

by MortgageBelt | 26th Jul 15, 9:44pm 1437903861

Well, sure - I thought we were talking about Auckland.
Many provincial cities have not yet recovered price-wise from 2008.
But Auckland seemed (and still seems) immune to interest rate movements.

After all, both RBNZ Governors have mainly expressed concern about Auckland housing.

Currently, there is a massive disconnect in prices between Auckland and most other cities in NZ.
Normally Tauranga, Hamilton, Napier etc would follow slowly behind, lagging, but still influenced. Not so currently.

by sharetrader | 26th Jul 15, 7:05pm 1437894300

ask anybody if they think their cost of living only rose by the inflation figure given by the RB for the last year and most will come back with a much much higher figure.
they will quote higher power, rates, rents, tradesman prices etc etc

by steven | 27th Jul 15, 9:14am 1437945253

you have never been able to explain whey you have been wrong for 7? years on inflation. So rather than "gut feel", maybe consider constructing a model on wages and the impact on price increases which is simply total.
ie if you earn $100 and that is all you have and some prices go up you have to buy less or none of something, ergo, no inflation until wages rise.
This is why you have been wrong for 6~7 years, fundamentally if ppl are not earning they cannot pay more overall so for every sector in inflationary mode there has to be the equivalent in deflationary mode.

by Stephen Hulme | 27th Jul 15, 9:43am 1437947014

Simple - the money is not finding it's way to main street - I have made it my business to own that which is subject to future financial returns being pulled forward to today as interest rates have collapsed - asset inflation, not wage inflation.

Fekete worked it out many years ago.

Thus, then, while Keynes was hell-bent on impounding the “unearned” interest income of the “parasitic” rentiers with his left hand, he would inadvertently grant unprecedented capital gains to them in the form of exorbitant bond price with his right. Read more

by steven | 27th Jul 15, 10:30am 1437949838

and the very fact Fekete see's Keynes as a charlatan is enough to say fekete is IMHO. Not only that low interest rates cause deflation? no cart before horse, lowering the interest rate is a response to dis-inflation and eventual deflation, it is a symptom and not the cause. Now it may well be it enables mis-investment but that says as much about greed/speculation in the financial sector as anything.

PS yes the money is indeed not in main street which is why QE is looking like a bigger failure than outright printing.

by Stephen Hulme | 27th Jul 15, 10:56am 1437951411

Well, what NZ taxpayers owe in the future is being passed to foreigners today in the form of higher coupon bond prices.

I am just documenting the government coupon debt sector. Uridashi, Eurokiwi &.Kauri bonds amount to ~another NZD 40 billion and I cannot hope to disclose the privately indebted corporate sector.

by steven | 27th Jul 15, 11:13am 1437952390

thanks for the links.

If you look at the 1 week we see that the trend on bonds appears to be a long term downward trend, hardly higher just looking at that chart, or what am I missing? Plus 3.320% hardly seems Greece by a long way, in fact in terms of PPP's / Corporate bonds etc NZ govn potential borrowing is extremely cheap.

Bit more than "documenting" when you quote someone as far out there a fekete IMHO. I suppose it depends on which bit of the economy you concentrate on to give you the "facts" you want. To be it has to be overall "health"

The corporate bond sector is one nasty looking piece of work to my mind, next blood on the floor after the debacle of the finance sector, though I wonder on commercial property as being even worse. So we have a rock star economy? hmm no.

by Stephen Hulme | 27th Jul 15, 11:19am 1437952754

If you look at the 1 week we see that the trend on bonds appears to be a long term downward trend, hardly higher just looking at that chart,

Remain ignorant and don't give up the day job.

I posted a yield chart for the NZGS 4.5% 27's - which represents the price discovery metric for coupon bonds. Prices move inversely to yield.