Adrian Orr’s great inflation hunt

Incoming Reserve Bank Governor Adrian Orr's first big task will be to find out whether a widening globlal recovery will generate the usual inflation and interest rate pressures. Bernard Hickey reports.

This is the year that many expect inflation to finally rear its head after a decade of being missing in action. There are early signs overseas that coordinated expansions in the European, US, Japanese and Asian economies may finally be generating some warmth under wages and prices.

In theory, that would filter through to New Zealand and put upward pressure on our interest rates just as incoming Reserve Bank Governor Adrian Orr is getting his feet under the desk from the end of March. Orr and the market will get the best indication of how 2018 is shaping up with the release of December quarter inflation figures on Thursday.

The big news in financial markets since the beginning of the year has been a rise in expectations about US inflation and a rise in the 10 year Treasury bond yield over 2.6 percent. It had been stuck around 2.3-2.4 percent for most of last year because of doubts about Donald Trump and continued weak wage inflation. 

The chart below shows the so-called 10 year break-even rate, which is the best measure of long term inflation expectations in global financial markets. It measures the difference between a regular 10 year Treasury bond yield and an inflation-linked yield -- essentially stripping out the inflation expectations of the world's most liquid financial market.

The 10 year breakeven rate has risen sharply in the last three weeks from 1.88 percent to 2.05 percent in the last month, in part because of enthusiasm about the surprise cut in the corporate tax cut to 21 percent from 35 percent passed through the Congress in late December. There may be plenty of geo-political noise around US President Donald Trump and North Korea, but the global economy is rediscovering the cylinders that have have been misfiring since 2008.

However, it is yet to show through in substantial pick-up in wage inflation despite strong jobs growth and US unemployment falling to 4.1 percent by December, which is seen as below the official measure of full employment at 4.65 percent.

The same is true in New Zealand. Our unemployment rate was 4.6 percent in the September quarter, which is seen as close to our (unspecified) full employment rate, but wage inflation has remained low.

The latest information on New Zealand inflation came last week with the publication of ANZ's monthly inflation gauge. It showed prices rose 0.3 percent in seasonally adjusted terms in December from November and were up 2.8 percent from a year ago. This annual inflation rate was unchanged from the previous month.

The inflation is not widespread though. Two thirds of the 0.3 percent increase in prices came from the Housing and Household Utilities part of the economy, which includes rents, new house building costs, rates, household energy and property maintenance. Rents rose 0.8 percent in the month and the cost of buying new housing rose 0.9 percent.

Once the effects of housing inflation are excluded, prices rose just 0.1 percent for the month, which is unchanged from the 0.1 percent to 0.2 percent range for the last eight months. Annual ex-housing inflation is barely above one percent.

"The generalised inflation story remains elusive," ANZ's Sharon Zollner wrote in the inflation gauge report.

More information is due shortly though. Consumer Price Index data for the December quarter is due on Thursday morning at 10.45 am. Economists expect quarterly inflation of around 0.4 percent and annual inflation of 1.9 percent, which would be unchanged. The Reserve Bank forecast in November it saw inflation of 0.3 percent and 1.8 percent respectively for the quarter and year.

So when will the inflation come?

Has something changed in the guts of the economy that means it can tolerate fast growth and low unemployment without generating widespread inflation? These will be the big questions for those watching the economy and thinking about interest rates this year. It will be the biggest task for Orr, who isn't due to start until the end of March. 

The next official indication of how the bank views inflation is due with its next Official Cash Rate decision and Monetary Policy Statement on February 8, but it will be seen as a holding statement until his first Monetary Policy Statement as Governor on May 10.

However, one headwind beating down inflation has strengthened in recent weeks. The New Zealand dollar rose over 73 US cents last week for the first time since the election in September and is up from a late November low of 68 cents. This is partly due to surprising US dollar weakness in recent weeks.

Most market economists do not see the Official Cash Rate here needing to rise until much later this year, and the Reserve Bank itself forecast in November that it saw rates on hold until late 2019 at least.

The speed of any rate hikes will depend in large part on whether Orr thinks something has changed in the bowels of the economy to let it run faster without much more inflation, or whether he sees an inevitable 'reversion to the mean' of the relationship between inflation and growth.

His last public comments in mid November suggested he is in the 'reversion to the mean' camp.

He pointed in a speech as NZ Super Fund CEO to firming growth in Japan and a 'goldilocks' situation in the global economy where growth was currently neither too hot or cold. He regularly referred to the idea that markets and economies eventually return to their long-term patterns.

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