Inflation – are we out of the danger zone?

New Zealand isn’t yet out of the inflation danger zone, say economists. What’s more, household and business expectations for inflation could result in a self-perpetuating cycle.

The annual rate of inflation is falling, dropping from a high of 7.3% to 5.6% in the space of just over a year, but still a long way off the Reserve Bank of New Zealand’s target zone of 1-3%. The reality is that prices are still rising, albeit more slowly than they were last year.

The Reserve Bank’s biggest weapon against inflation has been rising interest rates, and while it has signalled that further hikes to the Official Cash Rate, currently at 5.5%, are unlikely it doesn’t see its job as done.

In its Financial Stability Report, released at the start of the month, the bank highlighted why cuts to the cash rate weren’t on the cards. “Globally, core inflation remains elevated and central banks are expected to keep monetary policy tight for some time. While the global economy’s adjustment to higher interest rates has been relatively benign so far, the full impact is still to be seen.”

In Australia, growing worries around inflation resulted in a 25bp hike in the country’s cash rate on Melbourne Cup Day. The Reserve Bank of Australia’s new governor, Michele Bullock, had flagged her concerns back in September when she warned that consumers’ inflation expectations were becoming “unanchored” from reality.

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“The longer a central bank permits inflation to remain outside that target, the more likely it is that inflation expectations will shift. And if they do, it will require even higher interest rates and unemployment to bring inflation back to target,” she said in her speech.

After pushing the cash rate to 4.35% on Tuesday, an act that will add A$100 a month to the standard mortgage bill, Bullock said: “Inflation in Australia has passed its peak but is still too high and is proving more persistent than expected a few months ago.”

She warned that fresh data “suggests that the risk of inflation remaining higher for longer has increased”.

In the wake of the Australian increase, OneRoof asked economic experts about the inflation situation in New Zealand, and what the odds were of another cash rate hike for Kiwis.

Ray White economist chief Nerida Conisbee

Conisbee, who is based in Australia, said inflation expectations by households and businesses were similar on both sides of the Tasman.

“The problem is when people expect inflation to remain high, they adjust what they do accordingly. Particularly in relation to wage growth,” she said.

“People are now seeing an opportunity [for pay increases] because unemployment is so low [and] they believe that inflation is going to continue. Why wouldn’t you ask for a pay rise if you’re in the best negotiating position you’ve ever been in?

“That obviously feeds inflation and then the next problem is that businesses start to charge more as well. So we get this accelerating problem where high inflation means people think there’s going to be more inflation, so they change their behaviour. That fuels even more inflation.”

Ray White economist chief Nerida Conisbee: “The problem is when people expect inflation to remain high, they adjust what they do accordingly." Photo / Supplied

If you’re a plumber, said Conisbee, you would be charging more because of higher inflation, and because interest rates were high your expectations were that costs would rise further. “The building industry is a good example because it has been so problematic in terms of inflation. They’re probably still pricing things [more expensively] than they otherwise would have if they felt that inflation was under control.”

While Conisbee said New Zealand was out of the worst of the inflation danger zone, there were still some issues to watch. “We may see one or two more [official cash rate] increases. We don’t know for sure.”

Threats include fuel price rises as a result of growing instability in the Middle East and worsening vacancy levels in New Zealand’s rental market, which is pushing up rents.

“Rental increases are very strong in New Zealand at the moment. It is being driven by a lack of housing and that is not going to be solved any time soon. Rising interest rates could actually constrict housing development even more.” That in turn leads to fewer homes being built for a growing population and rents going up, she said. “If interest rates have to be kept high or raised to counter this, it perpetuates the problem.”

ASB chief economist Nick Tuffley

Tuffley doesn’t believe New Zealand is completely out of the danger zone either. “Inflation is still high. And there’s always that risk that it takes longer than expected to come down,” he said.

“That’s where the whole risk around inflation expectations and the influence on our behaviour becomes an issue.”

He said the Reserve Bank could afford to sit and wait because there were signs the medicine it was dolling out was having an impact.

Tuffley also cited rising oil prices as a problem. “We’ve got oil prices shooting up again. That’s likely to delay the fall of headline inflation.”

Conflict in the Middle East has heightened fears around inflation and global stability. Photo / Getty Images

Domestically, the key risk was the labour market, Tuffley said. “We’ve had all the extreme labour shortages that drove wages up very sharply. People wanted to get compensated for the high inflation we were having. Now we’re seeing signs that there are a lot more people available to work. Unemployment is going up, and wage growth is starting to slow,” he said.

“But it’s the speed of that slowdown in wages and how quickly that translates into less cost creation for businesses that is going to be pretty important. If it’s a really slow process, then inflation will remain elevated for a while.”

Tuffley predicted inflation would likely fall to within the Reserve Bank’s target band by the end of next year. “That’s then three years of being outside the target band.”

He said the housing market revival in New Zealand did pose some risks. “If it takes off and drives real acceleration in housing construction costs, or improves our mood so much that the wealth effect starts to pick up and we spend more, then those things would contribute to inflation holding up for longer.”

However, Tuffley doesn’t believe that New Zealanders’ inflation expectations were unanchored from reality. “The Reserve Bank does quite a number of [surveys] and the news is encouraging. Inflation expectations did [go] up when headline inflation was shooting up, but they are on the way down gradually.”

Kiwibank senior economist Mary Jo Vergara

Vergara said the battle to tame inflation in New Zealand was going better than most economists had expected but there were still risks. “Inflation has fallen from 7.3 to 5.6%, so we’re getting that deceleration we were hoping for,” Vergara said.

“But getting down to 2%, that’s really difficult. It’s a slow crawl.”

She added: “We obviously saw oil spike a couple weeks ago, but it seems to be contained for now. But you can’t rule out an escalation [in the Middle East conflict] to neighbouring countries, which are also big players in the oil market. That’s obviously one risk that we can’t really control for.”

Kiwibank senior economist Mary Jo Vergara: "Getting down to 2%, that's really difficult. It’s a slow crawl.” Photo / Fiona Goodall

Downward movement of inflation rates also hinged on the housing and labour markets, she said. If prices or wages accelerated more strongly than expected, that could affect the ability to contain domestic inflation.

Vergara said longer term inflation expectations may have become unanchored. “The longer term inflation expectations – five to 10 years ahead – are above the 2% target. So they’ve actually become unanchored. That fear, or idea that the inflation we’re seeing today is more persistent. That’s coming through in those expectations.”

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