Inflation outlook gets worse, and better

Inflation outlook gets worse, and better

Hand pumping gas into car

It looks like inflation in New Zealand this year is going to be perhaps 1% higher than thought just a few weeks ago as a result of Russia’s invasion of Ukraine. The movement away from using oil and gas from Russia has placed sharp upward pressure on energy prices. There have also been large increases in prices for many metals and minerals, and food prices are rising assisted by reductions in grain exports from Russia and Ukraine.

The hike in the expected peak rate of inflation in New Zealand to near 7.5% from around 6.5% has led some people to start fretting about interest rates going a lot higher than previously thought. I disagree.

Higher inflation does as a rule mean higher interest rates are needed to compensate lenders for loss in purchasing power of their money, and because central banks will want to impose restraint on their economies to get inflation back down. But that restraint to a large extent will come from the very factor pushing inflation higher – increased oil prices.

These act as a tax on the households and businesses in countries which are oil importers such as New Zealand. The sapping of household budgets in particular will mean weakness in our spending on other things – weakness which the Reserve Bank was wanting to see anyway in order to place pressure on businesses to not raise their prices all that much.

For businesses the pressure to in fact boost their prices has grown. But that is where things get interesting. The Reserve Bank is going to have to send stronger messages to the business sector warning about the recessionary consequences which will follow if prices are jacked up too much.

For that reason, the chances have increased that they will boost their cash rate 0.5% in at least one of the two rate reviews in April and late-May. And they are also likely to issue some warning words.

But it pays to note that their aim is suppressing inflation in 2023, not this year.

There is very little they can do to affect how fast prices rise this calendar year. And when we look ahead to 2023 it is highly reasonable to expect that oil prices will be falling again, supply chains improving, shipping costs coming down, and global growth perhaps 1% weaker than thought three weeks back. In other words, oil price hikes are likely to cause lower inflation next year than we were recently projecting.

The argument is made for interest rates for a very brief period potentially rising faster than we were all recently thinking. But the case is not made for the peak in interest rates to be higher than before. That will only happen if wage earners ignore the warnings and strike for much faster wages growth, or if businesses ignore the warnings, give those high wage rises, then increase their selling prices substantially.

We can see prices rising strongly in residential construction because demand for new houses is the strongest in half a century. But in other areas of the economy demand is either weak (hospitality for example) or set to get weaker. I can tell this from my monthly survey of people’s spending intentions which has fallen away sharply over the past two months.

What the survey tells us is that the crunching of household spending which the Reserve Bank is aiming to achieve through higher interest rates is already happening. Add in high awareness now that house prices are falling and that buyers have withdrawn from the market and the chances are my peak pick for the official cash rate of 3.0% could be 0.25% too high.

For floating mortgage rates, rises up to 1.75% from current levels are possible. But increases will get smaller the longer the lending term and for the five year rate which currently sits near 5%, the peak may only be another 0.5% from here.

We shall see. Uncertainty is high and who knows what shock next week will bring.

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