Opinion: The producer price spike is not a big worry

By BNZ Markets Senior Markets Economist Craig Ebert This morning's economy-wide producer price data looked highly inflationary. However, because it mainly reflected transitory spikes in isolated areas, we wouldn't read too much into it. Sure, the very high headline PPI inflation, and the stubborn pace under the surface, is a rude reminder of the need for the economy to keep slowing down. But it doesn't change our macro view to any material degree. Most notably, the 3.5% increase in Q2 output prices and 5.6% for inputs were further inflamed by approximate 50% spikes in wholesale electricity spot prices. This was a direct consequence of the drought, as generation companies rationed supply amid hydro lakes dropping to crisis levels. These were extreme times, with the rationing working through extreme prices. Better that than directly enforced rationing of electricity, as tended to be the case during lake level crises in years past. Oil prices also featured very strongly, yet again, in the Q2 PPI results – directly visible through the wholesale trade category (which includes oil companies) and indirectly by way of transport costs and the like. Since the June quarter, of course, oil prices have fallen quite a bit (for a change) amid a broader correction in international commodity prices, and spot electricity prices have almost halved. Such things should remove as much from the Q3/Q4 PPI as they added over the first half of 2008. The other area where headline gains were overstating the fundamental story was in agriculture. To be sure, price increases for sheep and beef during Q2 started to pick up on a good news story that has only become stronger in Q3. However, there is an offset here in that meat prices are bound to be supported by the lower supply forecast for the coming season, especially as a consequence of the sizable culling of the breeding ewe stock over the first half of 2008. Dairy producers are looking at even more robust revenue. From prices holding at strong levels in Q2 (in line with the $7.90 dairy payout announced for the 2007/08 season), the indicated payout for the coming season of $7.00 has upside, in our estimation, and production will rebound noticeably increasing following last season’s drought. However, it is true for the dairy sector, as it is for most every other farming enterprise, that farm input costs, in general, have been clawing back a big chunk of the top-line revenue gains. The Farm Expenses Price Index, published as part of the PPI these days, highlighted this. It swelled nearly 8% y/y. This included a 15% increase in feed and grazing costs, a 37% jump in fertilizer prices and a 40% surge in fuel. The big question is: to what extent might these costs pressures abate over the coming year, especially if the recent drop in global commodity prices is sustained and better grass growth takes pressure off feed costs? What is apparent already is the economy as a whole is seeing input cost inflation outpacing output price increases, implying downward pressure on margins. Producer input prices surged 11.8% in the year to 2008 Q2, while output prices rose 8.5% y/y. This gels with the many other signs that firms' profitability is under severe duress and reaching unsustainable points in many cases. As this partly reflects the stalling economy (so not just input price pressure), it's likely to reinforce a period of business sector consolidation in activity, costs and employment rather than spill over into more generalised selling price inflation, in our view. So, overall, we're left with the impression of an economy, at heart, continuing to struggle this year, with severe input cost inflation intensifying the distress. The end point to this process is a moderation in(presently firm) core inflation, with the recent stalling of world commodity prices a sign that headline inflation indexes will soon look much less problematic, and especially so in respect of the NZ PPI. Also worth noting from this morning was the June quarter Capital Goods Price Index (CGPI). Not normally of much interest, it did highlight a couple of themes. The first was that housing inflation is clearly waning. The price of a new residential building rose 0.8% in the Q2 CGPI (the slowest since September 2002), which lessened annual inflation to 4.4%, from 5.0%. A similar deceleration was evident in the Q2 CPI, wherein the cost of building a new home slowed to 5.2% y/y, from 5.7% in Q1 and 6.1% in Q4. We believe housing inflation will slump more noticeably over the next few quarters – with a risk it might even turn negative – which will help take steam out of domestic (non-tradables) CPI inflation, as needs to happen. This would be a source of significant relief for the RBNZ, as it continues to lessen the degree of monetary restraint. Conversely, prices for plant machinery and equipment were picking up the pace. They rose 1.5% in Q2, which was actually quite a big deal for a price series that has typically been flat to declining for many years now. This is a warning that the cost of investment spending is now on the up, with further increases likely as the exchange rate keeps slipping. This will be problematic for firms still needing to invest, while profitability is crimped and interest rates remain relatively high. As much as this will choke aggregate demand it will at the same time constrain the supply side of the economy. The latter effect will keep the Reserve Bank a little edgy about the extent of capacity constraints and core inflation relief it can bank on. This recommends a steady, rather than aggressive, easing cycle. * This economic review was written by BNZ’s Senior Markets Economist Craig Ebert. A full version of this report with charts can be found here. All of the research from the BNZ Markets team of economists is available here.