Economic activity is moderating
Early signs of inflation rising from low base
But RBNZ likely on hold for a considerable time
A key theme for the New Zealand economy in 2018 has been the potential crossroads facing the economic outlook. For the past 5 years, we have seen strong economic activity and low inflation keeping interest rates low and asset prices high. However, looking forward there are signs that economic activity is moderating at the same time as inflation pressures are emerging.
Market commentary and media coverage has focused primarily on the slowing pace of economic growth, with weak business confidence, cooling construction and housing markets, and a turn down in net migration. This has reinforced the view that the Reserve Bank of NZ (RBNZ) will keep the Official Cash Rate (OCR) on hold for a considerable period, with the market pricing a small chance of a cut in the OCR by the end of 2018.
However, there has been less focus on the change in the New Zealand inflation outlook, despite the threat of deflation abating considerably. The period of low Consumer Price Index (CPI) inflation through 2015 and 2016 was a key catalyst for the OCR being cut to record lows through 2016, as the RBNZ looked to avert the threat of inflation expectations becoming stuck near the bottom of the 1-3% target range.
While the most recent annual CPI inflation outturn was broadly in line with expectations at 1.5%, most economists are now forecasting CPI inflation to sit comfortably at 2% by the end of this year. Part of this is driven by reasonably transitory factors, like the strength of oil prices and the weakness of the NZD. However, there are early signs of a more persistent underlying lift in wage and price pressures, as seen in changes in minimum wages, increased wage demands and union activity, and in business surveys of pricing intentions.
The chart below shows a range of different underlying measures of NZ inflationary pressures, which use alternative approaches to strip-out transitory factors and outliers. The RBNZ’s favoured measure is the so-called Sectoral Factor Model – the bold line. After being stuck around or below 1.5% for most of the period since 2012, this measure has begun to rise noticeably. Now sitting at 1.7%, it is almost at the mid-point of the RBNZ 1-3% target range for inflation.
While in our view the risk of deflation has reduced considerably compared to the 2015-2016 period, we believe that it will be far too early for the RBNZ to announce victory, at either the upcoming August Monetary Policy Statement or in the months ahead. After a long period of inflation sitting below target, the RBNZ will want to see further evidence that the economy is even more comfortably away from the threat of deflation before changing stance. In addition, the moderation of leading indicators of economic activity and lending activity may also give reason to pause further with interest rates.
However, if underlying inflation does continue its journey higher and settles around 2% (at the same time that the labour market remains around full employment), then eventually we believe the conversation will move to whether it is necessary to keep the OCR at record lows. That would be an easier narrative for the RBNZ to communicate in an environment where the US Federal Reserve continues to lift the US Fed Funds Rates, especially if the Bank of England, European Central Bank and Bank of Japan also begin the process of scaling back their programs that are keeping global interest rates low.
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