Is Inflation Already Beaten?

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The recent CPI release of 4.0% for the year ended 31 March 2024 was a step in the right direction, falling further again from the December number of 4.7%. It arrived in line with economists’ consensus levels and slightly higher than what the RBNZ thought (3.8%).

But it was still noticeably above the ‘accepted’ 1-3% target range.  

Consequently, the RBNZ let all parties know it, with a brief statement noting that the “OCR needed to remain at restrictive levels for a sustained period”. Also unhelpful was that despite ’tradable inflation’ printing at 1.6% p.a., non-tradable inflation was 5.8% p.a. (more on this at the end of the article) leading most economists to say “we need to be here longer” and pushing out rate cut forecasts further into 2025.

But are we yet again being over obsessed with looking backwards rather than looking at what’s happening right now?

Let us explain. The latest CPI print of 4.0% is made up of 4 quarters - and they look like this:

Quarter ending June 2023:                         1.1%

Quarter ending September 2023:           1.8%

Quarter ending December 2023:             0.5%

Quarter ending March 202424:                0.6%

Total equals                                                           4.0% for the year

So, what if we extrapolated forward the last six months of CPI change and annualised this to the rest of the year?

Well, we would get a 2.2% inflation rate, being (0.5%+0.6%) x 2 which is smack bang in the middle of our target range.

The graph below shows it best by plotting the six-month annualised figure against the annual figure since 2017.

Put another way, the first six months of the latest annual CPI figure showed annualised inflation of 5.8%, and the last six months showed 2.2%.   That’s an almost unprecedented drop in inflation.

Why shouldn’t we put a lot more focus on the last 6 months rather than the prior 6 months - surely that’s a better gauge of where things are heading?

Most people would then rightly ask about seasonal/intra-year fluctuations - in other words, what if we typically see more inflation in the June and September quarters due to seasonal shifts?

So, let’s a take look at the data table below which shows all quarters going back to 2017.

The data shows that the averages for the June and September periods (the periods that aren’t covered by our “annualised” figure) aren’t that dissimilar to the December and March period.

Furthermore, if we add on the average pre-COVID inflation rates for the next two periods of June and September, that would take total annual inflation for this year to 2% (0.5% + 0.6% + 0.35% + 0.6%), further validating the possibility of a 2% inflation rate. Even if we used the average including the COVID years, this would take it to 2.89% (0.5% + 0.6% + 0.63% + 1.16).

If you stand back and think about it, why does the first 6 months of this year have any greater relevance than the average data - both are historical numbers aren’t they?

But all this seems a bit risky and too early to say that the battle against inflation has been won - don’t we want to be absolutely certain?  

And herein lies the point, we have the RBNZ who wants to be certain that inflation is squashed. Not just certain, but absolutely dead and buried.  

A grim analogy might be a boxing match where the opponent has been knocked down, but the fight continues even though the downed fighter is flat on the canvas. After all, we don’t want that opponent to get up again, do we?

The fear from the RBNZ of inflation getting off the canvas seems to be twofold. 

Firstly, inflation is a terrible thing and once it’s embedded in the economy it is notoriously difficult to remove. It goes without saying that you simply don’t want it in your economy. Plenty of research has proven that a little bit of inflation is good (hence the 1-3% band), but you have to keep it there otherwise instability creeps in and a vicious circle of increasing prices, wages and eventual distrust in money ensues. So fair call, it needs to be managed carefully.

But secondly, it’s clear that the RBNZ is desperately worried about being wrong again. Inflation is the one thing that they tie their colours to. Regardless of who created it or what the ultimate underlying drivers of the massive increase in inflation we suffered in 2022 and 2023, the RBNZ had a significant hand in both the oversupply of money at a time when the supply of goods was tightest and also was too slow to raise interest rates when confidence returned.  

On the back of that there seems to be an almost outlandish preoccupation with ’not being wrong’. Commentators often say that the RBNZ “wouldn’t want to ease up (or cut early) and later be found that they hadn’t quite stamped out inflation and reverse tack”.

In other words, the RBNZ doesn’t want to be wrong twice.

But what about the opposite? What if the medicine is actually poisoning us?

The thing about lag data and setting interest rates by it, is that it also works the other way around .  

Given that the OCR level is the de-facto market signal to interest rates, and most of NZ lending is on fixed rate home loan rates* (fortunately now on shorter terms than historical, but still around 1-2 years) then once a cut is signaled, it will take at least a year after that before there is any material stimulation to actually turn the economy back around.

Added to that, not all the interest rate pain is being felt yet. At that time of writing this, the average yield (interest rate) on all home loans in NZ is still 5.98%. The re-fix rate is still around 7%.

58% of fixed home loans will roll this year and if the re-fix rate is still higher than that average of 5.98% when they roll (like it is now), this will add even more drag to the economy. 33% of those loans are set to roll within the next 6 months. With current signalling from RBNZ and economists suggesting rate cuts will be into FY 2025, this will lock in that economic ’drag’ until at least mid to late 2025 at best, and probably into 2026.

Doesn’t that seem crazy?

(*Business and farm loans typically have a greater component on floating loans but make up only 35% of all NZ lending)

Put another way - RBNZ are setting NZ interest rates (and by default the state of the NZ economy) based on conditions that occurred almost 12 months ago, and locking in that setting for potentially the next 2 years. 

That makes the Titanic look agile.

And this is on top of the fact that the NZ economy is already in recession. Despite having interest rate settings that are causing the economy to be in recession, we are still potentially locking in those settings for a long time yet.

None of this is conducive to investment and business confidence which is already appallingly low despite a dead cat bounce after the change in government.

None of this makes NZ competitive on the world stage, nor encourages businesses to invest in new technology, gain better efficiencies, expand their operations, or build new businesses. Given the already significant regulatory impost on business and particularly farmers, can’t we do better than this?

It’s hard not to see this approach by the RBNZ as terribly old fashioned - a bit like parenting your teenager by never letting them go out to a party - it might feel safer right now, but more often than not, that tight boundary setting doesn’t do anything for preparing them for the real world.

And the decision-making feels like the earliest border-dyke irrigation systems that existed over 50 years ago. With this system, farmers would get (and use) 30+ days of water in one hit, and would have to apply it, not knowing if it was going to rain or not and knowing that you wouldn’t get water again for another long period leading to a significant waster of water.   With modern irrigation systems based on better data, continuous availability and precise placement, the ’fear’ driving putting all that water on has gone.      

Gosh, wouldn't it be good to say that we were that dynamic with our interest rate settings too?

What’s a better way?

None of this is suggesting that we should cut rates right now (although that could be argued), but there are some easy wins here:

1. More emphasis could be placed on current CPI pricing conditions with decisioning. More advanced countries now have monthly CPI releases and are released very soon after the period end. In NZ, we are in 3 monthly cycles and the summary isn’t released until 10 days later. That said, Stats NZ (who measures CPI), is putting out more regular updates to some of the components of the CPI bundle. But we need to go further and faster. Why wouldn’t we put the required investment into getting the most up to date and dynamic data possible? 
   
   
2. Better signalling from the RBNZ to the market as to ’current’ CPI numbers and what they might mean for rates cuts. At the moment, there seems to be an abject fear of even breathing the statement “interest rates cuts” for fear of the market getting ahead of itself. Other countries’ Reserve Bank heads, like those from the US and the Eurozone, openly talk about the potential of rate cuts allowing businesses to better plan. RBNZ market based signalling gives greater confidence for businesses to invest and would also prevent some of the wayward guessing we’ve been seeing from some bank economists causing sharp changes in the wholesale swap curve.
   
   
3. Competitive pricing from banks for floating home loans. This is less of an issue for business and farm loans whose floating loan margins are similar to fixed margins, but the home loan market makes up 65% of all lending. So, what happens to the whole economy, happens first in the home lending sector. In the home loan market, floating rates are very non-competitively priced with banks preferring to push fixed rate loans to “lock in” customers. They do this by pricing standard home loan floating rates at levels that are not economic to use. Even with a typical discount attached, a floating home loan would be 8%, whereas a 1-year rate might be 7% even though the underlying cost of funding is broadly the same. If floating rates were priced on the same lower margin, then more people would use them, and when rate cuts did occur, the economy would shift more quickly to the change in OCR. At the time of writing, only 11% of NZ home loans are floating. This is not because kiwis don’t like them, it’s simply because banks don’t price them fairly.
   
   
4. Take a closer look at the drivers of non-tradable inflation and apply a “look through” approach, otherwise it may make the problem worse (* to explain this, see afterword below on tradable vs non tradable inflation).

There will be other ideas that we could implement to make the NZ economy a more dynamic and world leading place to do business. As always, we would love to hear your feedback.

Afterword: Tradable vs Non-Tradable inflation

By definition (and courtesy of the RBNZ), tradable inflation covers goods and services that are imported or in competition with foreign goods, either in domestic or foreign markets. Movements in these prices demonstrate how international price movements and exchange rates are affecting consumer prices.

Major items in here are fuel, most food groups, and imported goods.

Conversely, non-tradable inflation covers goods and services that do not face foreign competition, for example, government charges. It shows how domestic demand and supply conditions are affecting consumer prices.

A major group of non-tradable inflation is housing and household utilities such as rent or the price of new houses, rates or the cost of electricity.

It’s evident that non-tradable inflation remains sticky, and with ongoing increases in things like household and business rates, it may remain sticky for a bit.  

But it’s worth acknowledging that non-tradable inflation is always much higher than tradable inflation - see table below for the split of each since 2016, including the average of all data and pre-COVID data.

But here’s the rub with non-tradables - and why high interest rates might actually make the problem worse.

Given so much of non-tradable inflation is based on housing (change in; rents + new house costs + rates + insurance = 42% of all non-tradable inflation), what do you think high interest rates are going to do to that category, particularly in the context of high net immigration rates?

• Rates bills continue to increase at double digit rates on the back of much higher interest servicing costs and infrastructure works coming due.
  
  
• Rents continue to rise as landlords (already a scarce activity) look to offset higher interest rates and can do so as the population is growing and not enough new houses are being built.
  
  
• And new houses aren’t being built again at the required rates, because of a lack of confidence to invest with high interest rates.

So, if we apply the ethos of “high interest rates are needed to change behaviours to rein in inflation”, apart from outright revolt, how does the average NZ individual or business influence the above categories so “capacity” can build up and therefore supply might drop?

Seems all a bit flawed, doesn’t it?

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