More than a spike on the inflation horizon?
NZ Monetary Policy
More than a spike on the inflation horizon?
Don Brash issues a warning against potential second-round inflation effects
RBNZ Governor Brash confirmed in a speech today that inflation is likely to head higher over the second half of this year. We expect the 3% mark to be reached by December. That outcome is a function of high oil and other commodity prices, a significant increase in tobacco taxes, as well as the pass-through of exchange rate related pressure on import prices. The RBNZ is likely to project that inflation will retreat again in 2001, based on the assumption of non-repetition or reversal of those influences. The purpose of Dr Brash's speech was to emphasise that the RBNZ is willing to `look through' an inflation spike created mainly by one-offs, including a step adjustment in the NZD. However, the Bank's tolerance would end if evidence emerged of the inflation spike causing a lift in inflation expectations and more generalised inflation pressure. Dr Brash made it clear that the RBNZ would respond to the collective attempt by households and businesses to claw back the reduction in real incomes caused by higher taxes and a lower exchange rate. Higher wage increases appear to be the RBNZ's key concern, particularly considering the forthcoming changes to the industrial relations framework.
Higher interest rates required to offset stimulatory NZD effects on growth Dr Brash also mentioned that, while he can ignore the direct price effects of a downward shock in the exchange rate, he cannot ignore the influence of the weak NZD on growth. With the TWI trading about 8% below the level assumed by the RBNZ in its May forecast, the Bank is likely to revise up its medium-term growth profile. In terms of the medium-term track for the output gap, that will offset the effect of the current and near-term weakness in activity. In terms of monetary conditions, Dr Brash noted that `...we have to set overnight interest rates in recognition of these medium-term effects of the exchange rate on total demand. If the export sectors, and the sectors supplying import substitutes, were demanding more resources than the domestic sector of the economy were willing to release, then interest rates would need to rise somewhat to avoid that conflict generating on-going inflation.' With the exchange rate undoubtedly more stimulatory than expected in the last RBNZ forecasts, that suggests that the Bank will see no room to move away from its foreshadowed interest rate profile, i.e. the 90 day rate reaching 7.50% by mid-2001. In fact, Dr Brash's comments could be read as a warning that the RBNZ may, over time, revise up its interest profile.
OCR increase or not, the RBNZ is likely to send a hawkish message on 16 August With the speech addressing mainly medium-term considerations, there was little information about the likely course of RBNZ action on 16 August. Medium-term fundamentals argue for a continued increase in the OCR over time and the issue becomes one of tactics and appropriate timing of further rate hikes. We continue to believe that the RBNZ will raise rates by 25 bps on 16 August, although it is a very close call. Even if the cash rate is left unchanged, the Bank is likely to be reasonably hawkish with respect to future rate hikes. That may trigger a significant market correction, particularly considering the fact that the market interpreted Dr Brash's comments today as relatively soft.
There may be a more immediate risk than `second-round effects' While we agree that second round effects pose a significant upside risk to the medium-term inflation outlook, the Bank may face a more immediate problem. Part of the RBNZ's central scenario of a mere spike in inflation is the assumption of a recovery of the NZD, which will help to reduce price pressure in 2001. While the starting point assumption for the NZ dollar in the forecast update will be lower than in the last set of projections, we expect the same assumed rate of appreciation going forward - around 3% over the next year. Based on the RBNZ's model, that implies that medium-term CPI inflation could be around 0.8% higher than projected by the Bank if the NZ dollar fails to appreciate. That number could even be higher if one considers the dampening effect of a rising NZD on activity, as well as lags in price adjustments. Businesses may not have raised prices in response higher import prices in the expectation that the currency weakness is only temporary. If that expectation proves to be wrong, pent-up cost pressure may be passed through. Non-oil import prices have risen in excess of 10% over the past year, with very little evidence of that in the CPI so far. A weak NZ dollar could potentially keep inflation in a 2.5-3.0% range for longer than expected, which would significantly heighten the risk of second-round effects. It may be possible to encourage discipline on the wage and price-setting front in the case of a one-off increase in inflation. However, expecting such behaviour over an extended period does not appear realistic, particularly considering a healthy medium-term outlook for growth, the labour market and capacity utilisation. While a stagnant NZ dollar over the next year may be not be the central forecasting scenario, it is clearly within the range of plausible outcomes. The NZ currency has continually surprised on the downside over the past year and recent trade data suggests that any current account improvement may be painfully slow. That reinforces the upside risks to the RBNZ's inflation outlook - regardless of any subsequent second-round effects.
Ulf Schoefisch, Chief Economist, New Zealand
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