Roger J Kerr says the the reality is that the New Zealand economy still has a major problem with sticky/high non-tradable inflation from the public sector and non-competitive sectors of the economy

Summary of key points: -

• Kiwi dollar falls three cents in ten days
• Lower New Zealand inflation – good luck, or good management?
• Aussie economy and currency show their resilience

Kiwi dollar falls three cents in ten days

The Kiwi dollar has reversed dramatically downwards over the last two weeks, from a high of 0.6360 on 30^th September to a low of 0.6055 on 10^th October.

The first two cents of the sharp decline were directly related to a stronger US dollar on the world stage, initially an escalation in the Middle-East war and then a blockbuster jobs number for September in the US economy which pulled back the speed/extent of US interest rate cuts over coming months. The last once cent drop in the Kiwi over this last week from 0.6160 to the 0.6055 low, stemmed from the Reserve Bank of New Zealand’s (“RBNZ”) 0.50% OCR cut and accompanying dovish tone in the statement on Wednesday 9^th October. The 0.50% cut was widely expected and fully priced-in to both interest rate and FX markets ahead of the RBNZ decision, so it was a little surprising to see the NZ dollar sold down one cent in response. It has since recovered to 0.6120 by Friday 11^th October. The New Zealand specific related selling of the Kiwi dollar ahead of, and after the OCR cut was evidenced by the NZD/AUD cross-rate falling away from above 0.9200 on 30 September to below 0.9020 on 9^th October. The Kiwi significantly underperforming the Aussie dollar against the USD. No surprises there, as we are aggressively cutting interest rates, and the Aussies are holding their rates stable. Local AUD exporters with orders for new hedging placed at 0.9050 and 0.9025 spot entry levels have been rewarded for their patience.

There was no forward guidance from the RBNZ on further interest rate reductions, however many are expecting another 0.50% reduction in the OCR to 4.25% at the 27 November RBNZ Monetary Policy Statement. The RBNZ see the New Zealand economy as weak with spare capacity and the global economy not much better. Their commentary on the US and Chinese economies appeared somewhat out of date. We have seen a massive Chinese monetary stimulus in recent weeks and therefore the comment “economic growth in the United States and China is expected to slow” may prove to be wide of the mark with both the US and China slashing interest rates.

The question for local interest rate markets and the Kiwi dollar is whether the RBNZ will deliver future OCR interest rate cuts in accordance with the current forward pricing which has the OCR reducing to below 3.00% over coming months? As always, that depends on the upcoming economic data. Will the New Zealand economy continue to weaken, which appears to be where the RBNZ are coming from? Or will the prospect of lower interest rates and improving export commodity prices lift activity levels in the final months of 2024 and into 2025? Continuing weaker data results will see earlier and larger cuts by the RBNZ and therefore individual NZD depreciation over and above what the USD is doing against the major currencies. Some improvement in the data may lead to NZ interest rates reducing at a slower pace than US interest rates, and therefore neutral to positive for the Kiwi dollar on its own account.

Evidence so far is that the Kiwi dollar is holding above 0.6000 on this latest bout of US dollar strength from the Middle East and a rouge-looking jobs number. A return to the NZD uptrend (based on USD selling) is expected as the Fed will still be sticking to their plan of progressively cutting their interest rates. The surprise to everyone is that Israel has not yet retaliated to the Iranian missile attack. Rest assured, the reprisals will come, so further bouts of USD strength cannot be ruled out over coming weeks/months.

Lower New Zealand inflation – good luck, or good management?

The first piece of economic data to answer the question on the Kiwi’s future direction from local factors will be this week’s CPI inflation figures for the September quarter. Consensus forecasts range from +0.70% to +1.00% for the quarter, the likely outcome is +0.90%. The annual rate for tradable inflation is likely to decrease to below 0.00%, aided by a 20% drop in crude oil prices over the quarter. It is always tradable inflation (imported goods) moving up and down that drives the overall inflation rate in New Zealand. As the chart below confirms, over the last 20 years domestic/non-tradable inflation has been remarkably stable, averaging at over 3.00% per annum increases. Low overall inflation rates from 2013 to 2019 were achieved by low or negative tradable inflation, which in turn, was caused by importing deflation on goods from China and technology/communication prices tumbling. Covid-related supply disruptions and strong consumer demand from 0.00% interest rates in 2020 and 2021 were behind the spike higher in tradable inflation in 2022. Likewise, it is again cheaper product prices out of China and lower oil prices that have sent tradable inflation to 0.00% in 2024. Inflation is falling rapidly, however it seems to be due to more good luck from offshore developments, than good monetary management here in New Zealand. Consumer demand has off course weakened off this year due to the higher interest rates, however the majority of the reduction in tradable inflation comes from supply side changes, not the demand side.

The continuing volatility in imported tradable inflation (up and down) causes monetary policy to swing from loose to tight to loosen again, causing more volatility in economic growth than would otherwise be the case if domestic/non-tradable inflation was more under control at lower levels. It also causes more volatility in interest rates and exchange rates, contributing to the boom/bust mentality and patterns that has become a feature of the New Zealand economy for many years.

Whilst there was a lot of hoopla and self-congratulatory back-slapping last week with the 0.50% OCR cut implemented on the success of reducing overall inflation much earlier than everyone thought, the reality is that the New Zealand economy still has a major problem with sticky/high non-tradable inflation from the public sector and non-competitive sectors of the economy. The September quarter’s non-tradable inflation increases for rents, house build costs, rates, electricity, medical costs, telecommunications and insurance will be a salient reminder that we do not have appropriate control over inflation as many would like us to believe. We just got lucky!

Looking ahead, there is a real risk that the offshore forces on inflation could turn against us again with increasing oil prices and commodity prices. As the Chinese Yuan strengthens against the weaker USD, Chinese manufacturing goods exporters will not be in the same position to discount their USD selling prices to our importers. In this situation tradable inflation starts to move up again and overall inflation increases. Without addressing and rectifying the underlying root causes of the consistent domestic/non-tradable price increases, New Zealand will always have a higher vulnerability and volatility with inflation control within the 1.00% to 3.00% limits.

The chart below aptly displays the larger volatile swings in tradable inflation compared to the consistent and stubbornly high non-tradable inflation over a 20-year period.

Aussie economy and currency show their resilience

Whilst the Kiwi dollar tumbled three cents in ten days, the Australian dollar was more resilient against the bout of recent USD gains. The AUD/USD exchange rate pulled back from 0.6900 to 0.6700, however has since regained some composure to 0.6750. The clear difference between NZ and Aussie is that the market sentiment has firmed up in Australia that they will not be cutting interest rates until well into 2025. Only two weeks ago, both the interest rate markets, and the Aussie economist fraternity were convinced the Reserve Bank of Australia (“RBA”) would be forced to U-turn and cut interest rates before Christmas. The view on that has changed abruptly.

Over recent weeks, the economic data releases in Australia have not exactly supported a weaker economy and less pressure on inflation: -

• The Westpac-Melbourne Institute Consumer Sentiment index jumped 6.20% month-on-month to a 2-1/2 year high of 89.8 in October, a sharp turnaround from a 0.5% fall in the previous month.
• The ANZ-Indeed Australian Job Ads rose by 1.6% month-on-month in September, reversing a downwardly revised 1.8% fall a month earlier and marking the first rise in eight months.
• Retail sales were stronger than expected for August, a 0.70% lift compared to prior consensus forecasts of no change.

Another strong employment increase for the month of September (released Thursday 17^th October), on top of five consecutive months of increases between 35,000 and 47,000 new jobs, will be another good reason why the RBA cannot cut interest rates anytime soon. 

On top of the more positive domestic economic data, the Chinese monetary stimulus has reversed the trend of iron ore prices (Australia’s largest export). Iron ore prices have moved up from a low of US$91.30/tonne in early September to US$106.40/tonne today. Copper commodity prices have also reversed out of their previous downtrend. The Chinese are even buying Australian lobsters again after a prolonged trade ban.

The recent closing up of the interest rate differential between the USD and the AUD has negated the rationale for currency speculators to short-sell the AUD and pick up the free forward points advantage. AUD short-sold speculative positions have reduced dramatically, paving the way for further Australian dollar gains against the USD. The gap in the two-year interest rate between the AUD and USD has closed from Australian rates being 1.00% below US rates just six months ago to near zero today.

All the economic and commodity price signs point to a quick recovery of the recent Aussie dollar losses and further appreciation of the AUD to above 0.7000 against the USD.

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.