If there is anything that might derail the Reserve Bank's efforts to rein in inflation, it is the strength of the labour market.
I've said for a little while that at the moment it's the labour market figures - both the unemployment rate and pay rates - that are the vital statistics to be watched, more so than actual inflation itself. And that's because we are very much on the cusp of the dreaded wage and price spiral.
The situation we are in at the moment is extremely unusual. Normally when you see the kind of economic turmoil we've had, unemployment goes up. Our unemployment rate has gone DOWN to super-low levels. And that's creating pressure.
The Reserve Bank (RBNZ) actually needs to see unemployment rise and for the pressure for higher wages to ease in order to successfully begin to control inflation.
Right at the moment, there's no guarantee at all that the RBNZ will be able to get the labour market to do what it wants. If it can't it may be forced to push interest rates higher than it currently intends.
I think the risk here is that our inflation is going to become 'baked in'. The fact that people have been able to use such a super-tight jobs market to engineer for themselves meaningful pay rises means they can go a fair way towards making up for the higher cost of living we've seen developing over the past year.
That means they will keep spending, business in the economy will remain brisk enough, and companies will be able to keep putting up their prices. And so it goes on. People will expect inflation and so we will have inflation.
The RBNZ is desperate right now to get on top of this as soon as possible so that those inflation expectations are not allowed to develop. But whether it will be able to do that remains very much in question.
The risk is that we are now moving into a period in which inflation is with us on an ongoing basis in a way in which we've not seen for decades.
Inflation, lest we forget, came in at a chunky 7.3% (annual rate) as of the June quarter. More recently we've seen food price inflation hit a high of 8.3% as of August.
The next Consumers Price Index (inflation) figures for the September quarter are set to be released by Statistics New Zealand on October 18.
It's worth pointing out that inflation for the September 2021 quarter was a truly momentous 2.2%. It's the September 2021 quarter that has really been pushing up the annual inflation rate this year. Now of course that 2.2% figure is going to come out. So, the annual figure is going to drop, probably by a reasonable amount.
The RBNZ is forecasting inflation for the September 2022 quarter of 1.4%, which will give an annual rate of 6.4%.
So, inflation is going to start coming down. That's generally accepted and expected. But how fast and how far will if come down? That's the real issue.
The RBNZ's forecasts for inflation as shown in the central bank's August Monetary Policy Statement (see table below) have the 'headline' CPI figure falling back into the bank's targeted 1% to 3% range by June 2024.
But of course there's two specific parts to inflation - the domestically generated 'non-tradeable' inflation and the overseas generated (think things like oil prices) 'tradeable' inflation.
The RBNZ's forecasting our imported inflation will drop sharply. It hit 8.7% for the June quarter. But the RBNZ reckons it will be down to just 2.3% by June 2023.
However, domestic inflation's a different story. It was 6.3% as of June this year - but it's forecast to fall only slowly to 5.4% by June 2023. In fact the RBNZ doesn't forecast domestic inflation alone to drop under 3% till June 2025.
So, here's where the labour market comes in.
Make a note of November 2, 2022 in your diaries. That's when the next labour market figures, for the September quarter - including unemployment and pay rates - are released.
Unemployment as of June was just 3.3%.
The RBNZ is forecasting that the unemployment rate will again be 3.3% for the latest quarter, but then blip up to 3.5% by December, over 4% by June 2023 and 5% by early 2025.
So, they ain't going to say it, but the RBNZ folk actually want and need some, ahem, slack to develop in the labour market. People need to lose their jobs in other words.
The tight as a drum labour market we have at the moment is seeing workers able to push up pay rates.
Average hourly rates, according to Stats NZ, rose 7% in the year to June.
The RBNZ is conceding that there's more to come on this. It's forecasting that average hourly rates will see an annual rise of 8.3% as of the September quarter, and there will also be an 8.3% rise in the year to December too.
After that pay rises are forecast to slow only gradually, with the annual rate dropping back to 7.3% by June 2023, 6.4% by June 2024 and 5.2% by June 2025.
As you can see, the RBNZ is not expecting pay rises to magically dwindle to nothing. But it is expecting them to reduce. And for that to happen it needs to see headline inflation falling and the extreme tightness in the labour market easing.
These forecasts I've described from the RBNZ all feed into its current forecast of the Official Cash Rate peaking just above 4% by the middle of next year - but then holding at around that level till late 2024. So, by implication, if the RBNZ's wrong about the unemployment rate and pay rise levels, this will change what it needs to do with the OCR.
And there's plenty that could go wrong with how the RBNZ sees things at the moment.
First up the global situation is so volatile that there's plenty of room for upward surprises in the amount of imported inflation we get in the months and years ahead.
And then what about the anticipation from the RBNZ that some slack will start to develop in the labour market? What if it doesn't? There's plenty that could go wrong in this area too, not least the possibility that increasing numbers of people that might get attracted to Australia - which also has a labour market as tight as a drum.
So, if the labour market remains as tight as it is and pay rises remain elevated then there is the risk the RBNZ has to do more with the OCR than it currently intends.
The RBNZ seems at this stage very confident than an OCR of around 4% for a reasonably extended period will do the trick.
It will be forced to change its mind if the labour market doesn't start to cool down and those pay rises don't moderate. This is going to be the big issue to follow next year.
The worst case scenario might be if we see the RBNZ being forced to keep gradually increasing the OCR over an extended period of time - and therefore for mortgage burdens to keep increasing.
The dreaded 'Stagflation' remains a very live possibility.
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