Weak inflation suggests spare capacity

Annual inflation continues to run low, suggesting there’s still some capacity in the economy that will help the Reserve Bank keep interest rates at record lows well into next year, writes Thomas Coughlan.

Annual inflation is still running low at 1.5 percent, according to Consumers Price Index released by Statistics NZ on Tuesday.

The CPI measures the change in price of a “basket” of certain goods and services over the quarter gauge inflation. Inflation is one measurement of an economy’s performance. If inflation runs low, it can be an indication that the economy is underperforming and has spare capacity. If prices spiral out of control then the economy is overheating.

The figure represents a marked improvement on the anaemic 1.1 percent registered in the year to March 2018 and slightly lower than market expectation, which forecast 1.6 percent inflation. 

Wins for the Reserve Bank
One organisation that correctly forecast yesterday’s data was the Reserve Bank, which got the figures bang-on in its Monetary Policy Statement released all the way back in May. 

And the Reserve Bank is the organisation that matters most — it’s the Bank’s job to get inflation as close as possible to 2 percent, ideally keeping it between 1 and 3 percent. 

In that sense, yesterday’s figures may reassure the Bank that it’s on the right track. It forecasts inflation rising throughout the year, before it hits 2 percent towards the end of next year. 

Once inflation rises towards the midpoint, there is a good chance the Bank will raise rates to ensure the economy doesn’t overheat. But the bank's last forecast in May was that the first rate hike would not be until September 2019 and the bank’s bang-on forecasting of Tuesday’s CPI data would mean this was unlikely to change, economists said.

Governor Adrian Orr’s most recent OCR decision stressed that the bank was well positioned to manage change in either direction — up or down — as necessary. That position is unlikely to be changed by yesterday’s CPI data. 

Digging deeper, the data also confirmed Orr’s comments made at the last OCR decision that inflation would nudge up as fuel prices increased and capacity constraints were felt across the economy. 

Petrol prices rose 3.2 percent over the quarter and construction costs for new dwellings, excluding land, rose 1.1 percent in the quarter and 3.9 percent over the year. However, it eased in Auckland and most of the strength is now in the regions.

Both of these numbers could rise. The increase in fuel costs did not capture the fuel taxes that came into effect on July 1 and the capacity constraints responsible for the rising cost of construction may worsen as KiwiBuild ramps up, although Housing Minister Phil Twyford is determined that streamlining construction processes and the visas for skilled construction workers will ultimately bring costs down. The Reserve Bank also has a mandate to look through one-off increases in fuel prices.

Inflation? Yeah Right

But there’s still some skepticism that a return to the 2 percent midpoint is around the corner.

Independent economist Shamubeel Eaqub told Newsroom on Monday that economists forecasting imminent inflation were “the boy who cried wolf”.

Bank economists have voiced their scepticism too.

ANZ’s Miles Workman and Liz Kendall said that the Reserve Bank will be “looking for inflation to increase in a consistent, broad based way from here” and said that a rate hike was “a long way away yet”.

KiwiBank’s Jarrod Kerr and Jeremy Couchman said that a rate hike was “still some way off” but that the 2 percent target was in sight “one day”. 

They forecast the CPI hitting 2 percent by the end of the year. This is far ahead of the Reserve Bank’s outlook, which doesn’t see the CPI hitting 2 percent until December 2020.

**Time for some shock and Orr?** 

Kerr and Couchman said that inflation had been too weak for too long and that it would be “prudent” for the bank to let it run slightly above 2 percent for a period. 

This echoes the sentiment of Eaqub who told Newsroom that the bank was more concerned with inflation running too high than inflation running too low. 

“We’re very happy to somehow give the Reserve Bank a pass for undershooting inflation, but really clamp down on them when they overshoot, well the tradeoff has to be symmetric as well,” Eaqub said. 

But this sentiment has not taken hold at the Bank, which forecast in May it would nudge rates up to keep inflation at 2 percent from December 2019 until at least June 2021. 

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