December inflation data is expected to show annual headline inflation back inside the Reserve Bank of New Zealand’s (RBNZ’s) 1-3% target band, the first time in it will have been inside the band since September 2014. Such an outcome will more than likely see the RBNZ confirm the easing cycle is over when it releases its next Monetary Policy Statement on February 9th. The big question for markets now is how long will it be before we see an interest rate increase? The best answer to that right now is “it depends”.
Headline inflation is heading higher in many countries. We have been at pains to point out that this is in large part due to ‘base effects’, that is low numbers from last year capturing sharp falls in commodity prices are now dropping out of the annual calculation. In New Zealand’s case, we expect a 0.4% increase in December 2016 to replace a decrease of -0.5% from December 2015. That will see the annual rate of increase ‘surge’ from 0.4% to 1.3%, yet without any sign of broad-based inflation pressure.
The RBNZ will obviously be happy to see inflation back within its mandated range as it will help solidify inflation expectations. One of the chief worries for the RBNZ over the last two years was that a perennial undershooting of its inflation target could become entrenched through its impact on inflation expectations, the primary influence on which is the current inflation rate. We have therefore more than likely seen the lows in inflation expectations.
Around the world ‘reflation’ sentiment is also being helped by currency depreciation (in Europe and Japan) and higher (in some cases) commodity prices. But while headline inflation is up, outside the United States core inflation pressure remains subdued – and it’s changes in core inflation that will ultimately determine the timing and quantum of responses to higher inflation from central banks.
In New Zealand, measures of core inflation have remained at more robust levels than headline inflation with the more important of those, from the RBNZ’s sectoral factor model, sitting at 1.5% in the year to September. That measure has remained within the target range throughout the recent period of weak headline inflation and is now trending higher, though remains short of the 2% mid-point of the target band.
While higher than headline inflation, core inflation has itself remained relatively subdued given the strong growth in the economy and employment. High levels of net inward migration and a high participation rate have conspired, in large part, to keep growth in the supply of labour up with growth in labour demand, with the end result being subdued wage inflation.
But capacity constraints are undeniably increasing. GDP growth looks set to remain ahead of potential and the output gap is closing, if not already closed. The most visible sign of that is the unemployment rate which continues to nudge lower, currently sitting just under 5% and getting closer to full-employment. That should have an upward influence on wage inflation, but progress towards this could be further delayed given that migration inflows seemed to be getting a second wind with the annual net total making fresh highs towards the end of 2016.
It also remains to be seen whether standard business cycle theory still holds and to what extent countries that are close to full employment (New Zealand, United States) turn to business investment to increase the capacity of the economy to grow, solve the ‘productivity paradox’, and keep wage inflation in check.
On balance, while headline inflation looks set to head back into the bottom end of the target band when December quarter data is released next week, we think the next leg of the journey to the 2% mid-point of the target band will be harder work.
Furthermore, given the persistence of lower than desirable inflation and the amount of ammunition central banks around the world have thrown at the problem, we expect a level of patience in removing that policy accommodation. Central banks will want to ensure that core inflation is heading sustainably back to target before acting. Indeed, many have signalled a willingness to allow a period of over-shooting of the target band to ensure the sustainability of higher inflation and a return to more solid levels of inflation expectations.
At this point, we expect the RBNZ will be able to delay interest rate increases until early 2018. Also counting against an early rise in the Official Cash Rate is the fact that (fixed) mortgage rates are already rising as bank funding costs rise and the yield curve steepens. And the RBNZ will remain conscious of the impact interest rate increases will have on the exchange rate.
That said, the balance of risks is biased towards earlier rather than later hikes. Factors that could see us bring interest rate hikes into 2017 would be faster than expected wage inflation, sharply higher commodity prices spilling over into generalised inflationary pressure, stronger than expected pricing power in the economy that allows firms to act on recently elevated pricing intentions, or simply an inflation surprise that suggests a broadening of nascent inflationary pressures.
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