Weekly Economic Commentary 24 July 2023
Analysis and forecasts of the economy and markets, along with previews of data for the week ahead.
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New Zealand inflation down, but definitely not out.
Inflation in New Zealand has slowed from the eye-watering rates of over 7% that we saw last year. However, while inflation is ‘lower’, it is not ‘low’ by any stretch of the imagination. Underlying price pressures remain strong, and inflation is set to linger at elevated levels for an extended period. As a result, we continue to forecast that the RBNZ will need to raise the OCR again.
Consumer prices rose by 1.1% in the June quarter. That saw the annual inflation rate dropping to 6.0%, down from 6.7% in the year to March and well below the peak of 7.3% that we reached last year.
At first blush, the June quarter inflation result was close to our own forecast and the RBNZ’s expectation. However, digging into the details of the latest inflation report, there were actually a number of red flags for the central bank. The most important of those was the continued strength in domestic inflation (aka non-tradable prices). The RBNZ pays particular attention to non-tradables inflation given its close connection to the strength of domestic economic conditions, and they had expected it to fall from 6.8% in the year to March to 6.3% now. But instead, non-tradables inflation has actually held at higher levels than the RBNZ expected, nudging down only slightly to a still strong level of 6.6% in the year to June. That’s despite the sharp rise in interest rates since the RBNZ began raising the OCR more than 18 months ago.
Looking more closely at those domestic inflation pressures, there has been particular strength in the prices of services, which are up an average of 6.1% over the past year. That’s consistent with the ongoing tightness in the labour market and related strength in wage growth. We expect those conditions will see domestic inflation remaining elevated well into the new year.
And we’re not just seeing strength in the domestic components of inflation. Excluding the volatile food and fuel categories, prices for imported goods have also continued to rise at a rapid pace, increasing 6.5% over the past 12 months. That’s despite an easing in supply chain pressures, and it points to ongoing firmness in households spending appetites.
Putting this altogether leaves us with a picture of simmering underlying price pressures. That’s been reflected in the various measures of core inflation which are continuing to run at levels of around 6% – well outside the RBNZ’s 1% to 3% target band. Notably, the RBNZ’s own ‘sectoral factor model’ of core inflation is yet to show any signs of easing, having remained stubbornly high at 5.8% for three quarters now. (Core inflation measures smooth through the quarter-to-quarter swings in the prices of volatile items like petrol, and instead track the broader trend in prices.)
In their most recent policy update, the RBNZ signalled that they expected to keep the OCR at the current level of 5.50% for some time, noting that they viewed the risks around the inflation outlook as being “broadly balanced.” However, with non-tradables inflation surprising to the upside, and price and wage pressures remaining strong, the RBNZ may have a tougher task ahead than they had anticipated.
We actually expect that headline inflation will fall over the remainder of this year. As in other regions, New Zealand’s current high levels of inflation are in part a hangover from the disruptions to global supply chains and the related cost increases we saw in the wake of the pandemic. However, with the impact of those factors fading, imported inflation is set to continue easing.
But the current high levels of inflation aren’t just a result of supply-side cost pressures. What really lit a fire under inflation over the past couple of years has been the strength of domestic demand. That’s meant many local businesses were able to pass on at least some of the increases in their operating costs into output prices. And that is very important for the Reserve Bank because if demand remains firm, inflation is likely to linger at high levels even as cost pressures continue easing.
On this front, we’re actually seeing mixed indications regarding the strength of domestic demand. GDP growth has cooled following the sharp rise in interest rates over the past year. In addition, a significant tightening in financial conditions still lies ahead for many households as they roll on to higher fixed mortgage rates.
But while activity is cooling, that’s a slowdown after strong growth in recent years. For now, the level of economic activity remains elevated, and the labour market is still stretched. The related firmness in demand and wage growth means that we are continuing to see strong price growth in some parts of the economy. On top of that, there are signs that the economic cycle may still have some legs, such as the turnaround in net migration and related indications that the housing market may be heating up again.
Inflation has already lingered above the RBNZ’s target band for over two years now, and the RBNZ’s own forecast show it remaining above 3% until the latter part of next year (meaning more than three years away from target). However, with domestic inflation stronger than expected and pricing pressures remaining ‘sticky’, there’s a risk that inflation could take even longer to drop back. As a result, we continue to forecast that the RBNZ will need to raise the OCR again.
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