We face the apparently contradictory situation in which inflation is strongly rising and yet the Reserve Bank will keep the possibility of interest rate cuts on the table

By David Hargreaves

Brace yourselves, because the country could be entering a fairly confusing period.

It could be that we will be watching inflation rising very sharply - and yet the Reserve Bank will continue to contemplate the possibility of cuts to official interest rates.

Frankly, that's weird and ain't the way it is supposed to be.

What is supposed to happen is that when inflation goes up interest rates go up too. Not the other way around.

But of course the current situation stems from what is seen as imported or 'tradeable' inflation versus non-tradeable inflation.

The most 'tradeable' of tradeable inflation of course is that provided by fuel costs. If these are rising as they are at the moment, then up goes inflation.

Also, we've got the situation where the cost of imported goods will be going up sharply due to the fact that our New Zealand dollar has tanked in value in recent months.

The upshot of all this is that economists are on average picking that 'headline' inflation as reported by Statistics New Zealand will be 0.7% for the September quarter, bringing the rate of annual inflation up to 1.7%. The figures are being released on Tuesday.

The RBNZ of course targets inflation of between 1% and 3% with a focus on the 2% midpoint. 

In its last forecasts made in the August Monetary Policy Statement the RBNZ forecast inflation of just 0.4% for the September quarter, making the annual rate 1.4%. Clearly it's going to be some way off with its pick and yet is unlikely to be unduly concerned.

Governor Adrian Orr has kept stressing the possibility that the Official Cash Rate, which has now sat on 1.75% since November 20016 could be dropped if the economy shows signs of sharply slowing.

And that's the key thing here. Even though inflation's now sharply on the move and could, economists argue, be set to go in the near future above the RBNZ's targeted 2%, the real question will be the extent to which increased costs to businesses through higher fuel costs and increased costs of imported goods can be passed on - without causing a slowdown in the economy.

The belief at the moment clearly is that such costs won't in large part be passed on and that slower economic conditions may be coming and that therefore the spike in inflation we are currently seeing will be temporary.

Personally, I think there's a risk that the spike won't be temporary and that we might see the spectre of the dreaded 'stagflation' in which we see meaningful levels of inflation and yet slower economic conditions and rising unemployment. That would not happen overnight, but I reckon it's a risk in the next two years.

The economists speak

In their previews of the release of the latest inflation figures, the bank economists have been tossing up the slightly contradictory picture being offered by the rising fuel prices particularly and the possibility of an economic slowdown.

BNZ senior economist Craig Ebert is picking a 0.8% inflation figure for the September (1.8% annual rate), stressing that the upcoming inflation figure is not just all about rising petrol prices, and he says headline CPI inflation is heading to around 2.5% (year on year) by the middle of next year.

This, he says, "will reinforce the stronger wage inflation track we envisage. This is by way of the indexation that still permeates NZ wage negotiations".

"With respect to core CPI inflation, we’d also point out that most every measure is already on the up (and running at annual rates markedly higher than ex-fuel CPI measures portray).

"The Reserve Bank’s sectoral factor model of CPI inflation, for instance, nudged up to 1.7% in Q2, from 1.6% in Q1, and 1.5% in Q4 of 2017. We think it stands a good chance of rising further on the basis of Q3’s figures. This is underpinned by the fact we are picking a 2.5% annual increase in the Q3 non-tradables component of the CPI, and with upside risk, compared to the August MPS expectation of 2.4%.

"If we’re right on the outlook for core and headline CPI inflation then it will, in the first instance, make it difficult for the RBNZ to cut its cash rate any further. Or at least it should. Stronger inflation would also recommend care about what’s driving any prospective slowdown in economic growth – cooling demand, or supply constraints – in order that monetary policy responds in the appropriate manner.

Kiwibank chief economist Jarrod Kerr and senior economist Jeremy Couchman say (picking a 0.7% September quarter figure) that for now the RBNZ can still argue that recent stronger inflation is being driven by cost-push factors that it can look through. These factors include higher world oil prices, a weaker currency and Government induced price hikes (such as petrol taxes and a chunky minimum wage hike).

"Looking through these factors and there is still the possibility that growth cools, and with it underlying inflation, on the back of flaky business confidence," they say.

"This justifies the cautious approach taken by the Bank.

'Something more substantial to inflation pressure'

"In our view, there is something more substantial to the current rise in inflation pressure. Yes, cost-push factors are likely to be a feature of inflation in the coming quarters – we have already seen further increases in petrol prices over Q4 to date. But we also expect the engine of inflation to speed up as GDP growth strengthens heading into 2019. As a result, we believe that the RBNZ will ultimately be forced to begin hiking the OCR earlier (May 2020) than they have signalled."

Westpac senior economist Michael Gordon explains that rising fuel prices "are a mixed bag" for monetary policy, adding to inflation up front, but weighing on activity over the medium term.

"Higher inflation caused by petrol prices certainly wouldn’t prevent the RBNZ from cutting the OCR if there were signs that the economy were faltering. But in the near term, it could make it harder to sell the idea that OCR cuts are needed for the purpose of generating more inflation," he says.

Gordon's also picking a 0.7% inflation rate for the September quarter and within that he says the single biggest contribution is a 6% rise in petrol and diesel prices, stemming from a trifecta of rising world oil prices, a falling exchange rate and the introduction of a regional fuel tax in Auckland.

"Together, these account for a 0.3 percentage point rise in the CPI for the quarter. The impact on the December quarter is shaping up to be even greater, given the high starting point for fuel prices and a nationwide increase in petrol taxes in October.

"Over time, higher fuel prices will also affect travel prices, and any items where transport makes up a significant portion of costs. While the lags can be long, oil prices have been rising for some time, and there is now clear evidence of rising prices in areas such as domestic airfares."

ASB economist Kim Mundy's picked a 0.7% inflation figure for the September quarter too.

She says in what is "becoming a rather familiar story", cost pressures outside of housing and petrol are expected to remain rather benign.

'Consumers starting to feel it'

"However, many consumers will be starting to feel the impact of rising fuel and household-related costs on their wallets, despite still-subdued inflation elsewhere. Transport and housing include a high proportion of necessities and therefore it is harder for consumers to substitute away from these goods or delay their spending as prices rise. There is a risk that this weighs on demand in other sectors of the economy. This also has implications for a business’s ability to pass through higher transport-related costs to the consumer."

Over the medium term, Mundy says, the risks to the inflation outlook remain skewed to the downside.

"Soft business confidence suggests that the NZ economy lost momentum over the second half of the year. Below-trend economic growth creates additional spare capacity in the economy and could see medium-term inflation fall.

"With risks to the growth outlook still skewed to the downside we expect the RBNZ to look through the near-term jump in inflation and continue to wait for evidence of a sustained lift in underlying inflation. We believe this is still some time away and do not expect the RBNZ to raise the OCR until early 2020.

'OCR could be lowered'

"There remains the risk that the OCR could be lowered if the trend in inflation weakens."

ANZ chief economist Sharon Zollner and economist Miles Workman are picking a 0.8% inflation figure for the September quarter and 1.8% annual inflation. 

They say In the broader context a strong quarterly inflation figure won’t change their view on where underlying inflation is heading over the medium term.

"On that front, sharply lower hiring and investment intentions, credit headwinds, margin squeeze, slipping export prices, a softening housing market, waning immigration, and policy uncertainty together suggest economic activity may struggle to keep inflationary pressures elevated. And the RBNZ is attempting to generate a sustained increase in core inflation," they say.

"While an upward surprise to non-tradable and/or core inflation would present something of a communications challenge for the RBNZ, we doubt it would do much to delay an OCR cut should the Bank deem the growth outlook to be deteriorating."

We welcome your help to improve our coverage of this issue. Any examples or experiences to relate? Any links to other news, data or research to shed more light on this? Any insight or views on what might happen next or what should happen next? Any errors to correct?

We welcome your comments below. If you are not already registered, please register to comment or click on the "Register" link below a comment.

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current Comment policy is here.

23 Comments

Okay so the inflation dilemma exists but rates can't go down yet nor can they go up.. So to the brakes put on the kiwi dollar falling as quickly as it has means that the next piece of forward guidance... (If Mr Orr has read the 'Guvnor's handbook' on saying something but doing nothing) will be that 'interest rates may go up if inflation persists' thereby buying a little more time as a warning to the borrowers to slow down the extent to which they are taking on debt and to get their so called 'houses' in order... Again he needs to do this without actually doing anything, because he can't, a move either way is still too risky and there just aren't enough clear signs that inflation is killing people, but it will... Six or seven more months of forward guidance still, but all the while doing nothing, let's see what the risks are that materialise. I'm still taking bets on rate increases in the second half of next year to put the breaks on lending and a floor under the NZ dollar. Another 10-15% fall in the kiwi would be too far a fall too fast for rates not rise and that could happen.

So are you still standing by your prediction that RBNZ will raise rates next year, while at the same time NZ will be in recession (a bizarre contradiction)? And that OCR will be 3.5% before end of 2021 (double what it is now)?

BLSH, of course I do.

The FED Rate is 6 times higher than it was in November 2016 (less than 2 years ago) and 3 times higher than it was last February.. Yeah little ole NZ can see the cash rate double in over 2 years. You'd be daft not to think it could. In September 2019, NZ will get the second quarters results confirming that we have had had 2 negative quarters and are in a 'technical recession' The first quarter we will hear about in May next year. All signs pointing that way.

I suspect sunstroke from too much time on the course.

Imported inflation without wage price growth is what we are likely to see and that will squeeze businesses that are what I would call 'discretionary spend companies.' Unemployment will rise and there will be a negative feedback loop on subsequent spending in the consumer economy. A good 'double measure' of Stagflation, will only be tempered when interest rates rise and those that have seen the purchasing power of their savings reduced , decide to spend because they are at parity again. There will be some collateral damage along the way but that will mostly be those that have geared themselves too close to the margin on the assumption of never ending asset price inflation. It's already happening in Australia.. Don't think that the US economy is really that strong if the FED keeps withdrawing QE at $60,000,000,000 a month. Remember that the US have been buying $4 of growth with $7 of debt. Before you started University do you remember the FED tightening from 2004-2007 to take the steam out? House prices started falling in 2006. Recession followed in 2008. Australia and NZ will lead the way into recession this time around because their households (and banks) are amongst the most highly exposed to changes in the inflation rate.

Inflation is nothing more than a tax. We need to go on the gold standard.

‘But of course the current situation stems from what is seen as imported or 'tradeable' inflation versus non-tradeable inflation.’

I’m sorry but this is garbage. Which you rightly question later in the article.

My understanding of the theory is the RBNZ gets worried about inflation based on the potential for a self-fueling cycle - cost increase, wage increase, cost increase. They also restrict the data to things they influence rather than things outside of their control.

So,

Let’s start with tradeable inflation. Clearly the RBNZ is causing a large part of this with their interest rate policy. Low interest rates are dropping the dollar increasing costs, not least of all fuel. You can’t say ‘but it’s external’ when it’s caused by your monetary policy.

Second, there is a lot of evidence of domestic inflationary pressures. Costs have gone up, particularly for housing (again due in no small part to monetary policy), and workers are trying to get increases. In some sectors they have succeeded, others they are still trying. Primarily the big success is in public sector but there are workforce supply constraints all over the place. Those public sector increases will migrate to the private sector - sure as little apples grow on trees as my maths teacher used to say - and then costs will go up and the whole cycle repeats again.

This situation has been bloody obvious for the last six months. While I understand why the RBNZ has chosen not to raise rates, what I cannot fathom is why they’ve stuck to this ‘equally up or down’. If they’d been hawkish they could have propped up the dollar a little bit and delayed the next increase. That is why you jawbone. Now they are probably going to have to act earlier precisely because they gave the wrong direction.

And as for housing. Oops. There goes the last leg of the stool.

Also, can the RBNZ cut if inflation is pushing the top of the band? I know their mandate has been broadened but I thought if it was a choice between growth and inflation they had to choose inflation.

For the RBNZ, there is an unambiguous and clear quantitative target for CPI, yet a potentially ambiguous qualitative target for employment.

Refer - https://www.rbnz.govt.nz/monetary-policy/policy-targets-agreements/pta2018

1. Monetary policy objective

a) Under Section 8 of the Act the Reserve Bank is required to conduct monetary policy with the goal of maintaining a stable general level of prices.

b) The conduct of monetary policy will maintain a stable general level of prices, and contribute to supporting maximum sustainable employment within the economy.
2. Policy target

a) The price stability target will be defined in terms of the All Groups Consumers Price Index (CPI), as published by Statistics New Zealand.

b) For the purpose of this agreement, the policy target shall be to keep future annual CPI inflation between 1 and 3 percent over the medium-term, with a focus on keeping future inflation near the 2 percent mid-point.

c) The Bank will implement a flexible inflation targeting regime. In particular the Bank shall, in pursuing the policy target:

have regard to the efficiency and soundness of the financial system;
seek to avoid unnecessary instability in output, employment, interest rates, and the exchange rate; and
respond to events whose impact on inflation is expected to be temporary in a manner consistent with meeting the medium-term target.

I'd guess you've answered your own question!?
Q:" I understand why the RBNZ has chosen not to raise rates"
A: " As for housing (that's the) the last leg of the stool."
For all the hoo-ha about housing capital costs not being part of the inflation equation, they are. Bust that last leg, and inflation in any meaningful way drops like a stone.....

I love the connection between this article and the previous one on rents. Apparently inflation is 1.8% but rents are up 10% in two years.

up
10

I think you are confusing the measures of inflation. There are two types of inflation, one is measured by the RPI - (Rich person's Inflation Index) and the other PPI - (Poor Person's Inflation index). The two are very different measures and mustn't be confused when setting appropriate monetary policy.

RPI - requires a cushioning of debt payments so that one can continue without the need to go to work, whilst one's tax relief and other income related tax benefits mean that one can still golf, fish and dine out regularly without too much work and effort.

PPI - well who really gives a stuff about that anyway.. As long as they can eat and put petrol in the car to get to work.... and let's not forget, pay the rent!!!

The housing rental component of the CPI puzzles me.

If it makes up around 10% of the CPI – and say rentals went up 25% annually and nothing else – would the CPI record a 2.5% increase – hardly a breath taking jump overall.

Except that the 25% increase would wipe a large number of people/ families out – especially Auckland.

If not addressed the CPI can easily meander along but underneath for many the purchasing power for every day goods and services is being gradually squeezed out?

Simplistic I know - but if I'm right, I wonder if we have the importance of this component adequately accounted for in light of changing demographics and home ownership numbers.

“And the RBNZ is attempting to generate a sustained increase in core inflation," they say.

Well then, perhaps it behoves both business and wage and salary earners to attempt a sustained increase in overall remuneration and help the poor old RBNZ out.

It's a complicated thing alright. Interpretation is also a factor, based on your current beliefs, or where you sit just at the moment. I'm blowed if I know. What I do know that it is costing me a small fortune to fill up the car. The cost of my daily coffee has also increased and the weekly shopping bill is not getting any smaller. We're mortgage free which is a blessing, but many are not. The good news is that if interest rates go up, house prices will go down, and to be fair, they all need to settle down a bit. Mr Xi has stopped the Tsunami of money & people coming from the Far East (thank God) which I believe was one of the key drivers for us in the South Pacific for the past decade. It's the same in Australia. Let's get used to tough again as it all needs to settle down a bit, especially globally. As for the aptly named Reserve Bank Govenor - Mr Orr - it could be up orr down. And that's a fact.

You know the other thing I remember from Econ 102? Monetary policy has an 18 month lag. So what they are doing today impacts early 2020. So they think they need more inflation in early 2020.

So now, even from the top banking man we have lies, damn lies and statistics. All I know is that the cost of living in going up in leaps and bounds but our income is not.

Mind you a half percentage increase in term deposits rates will not cover expenditure increases.

My question is can the Reserve Bank truly show leadership or is it really only a reactionary force ? Sounds to me is that its trying to tilt the pinball machine but really it has no control. What will be very interesting is if inflation keeps flying and interest rates begin to climb quickly in the USA, the Reserve Bank does one thing and then all the banks do the opposite.

Can't have house prices falling, now can we? So, its rent increases and petrol increases and tax increases and USD increases instead. Pick your poison, it seems, unemployment or cheap houses?

They tend to go hand in hand during a recession, but may be difficult to avoid..

Unemployment and cheap houses but not employment and cheap houses it seems.

This time is diffrunt.

Every time is different, but the outcomes are the same.