Challenges for the RBNZ as inflation heads upwards

By Roger J Kerr

Inflation figures released this morning (+0.8% for the quarter and +4.5% for the year) confirm some of the challenges ahead this year for households, business firms and our managers of monetary policy, the RBNZ.

There is no doubt that the elevated financial pressures on your average household from sharply higher fuel, transport and food prices is going to lead to higher wage increase claims this year.

Some industries are in a position to pay higher wages; other industries such as the retail sector have compressed profit margins already and will resist trade union demands.

All this adds up to these supply-side price increases having a potentially higher risk of feeding into wider/general inflation later on.

For this reason the RBNZ are too light on their current 2012 inflation forecasts and when they realise they have to increase these to nearer 3.00% they really have to return monetary policy settings to 'neutral' - that is, a 4.50% OCR - with some urgency in early 2012.

The moneymarkets and swaps markets are already starting to price in this scenario.

Had the Christchurch 22 February earthquake not happened, we would have been witnessing embarrassing U-turns by many gurus as to their timing of OCR increases in 2011. The markets would have shifted from October increases to June increases about now in response to the higher inflation outlook.

It is not just higher food and petrol prices pushing inflation higher than expected this year, add in electricity, gas, insurance premiums, building costs and the perennial local Government rates increases.

The RBNZ do not just look at the headline and core inflation forecasts in isolation. The overall demand and strength of the economy is assessed and analysed constantly as lead indicators that raise and lower the risks around the inflation forecast.

Standing in January 2012, Alan Bollard will potentially be looking into 2012 with an inflation forecast above his 3.00% limit and a GDP growth forecast above +4.00%.

All this is predicated on our export commodity prices staying up near their record high levels.

According to the recent RBNZ research paper on commodity price increases - as mentioned in Mr Bollard’s speech to Ashburton farmers last week - our commodity prices are set to stay high due to global supply/demand imbalances.

Unfortunately, that research paper omitted two additional key determinants of global commodity prices; artificially low US interest rates rendering holding costs of virtually zero and the weight of money from pensions/superannuation managed funds being allocated to commodities as a separate asset class over recent years.

If commodity prices correct downwards due to increasing US interest rates, the pressure comes off food price inflation and NZ GDP growth will not be as impressive in 2012. Hopefully the RBNZ are comprehending and monitoring some of these global inter-relationships that directly impact on the NZ economy.

The NZD/USD exchange rate almost at 0.8000 will reduce retail selling prices on imported product, however a lower NZD/USD rate due to an expected USD recovery against all currencies over coming months could change that off-setting factor again.

The pressure is certainly on the RBNZ as they deal with the extraordinary circumstances of the earthquake and booming agriculture export prices on the economy.

Corporate borrowers need to be looking forward and taking pre-emptive interest rate hedging action today for what their hedging policies will be requiring them to do in nine to 12 months hence. The two to five year fixed rate swap rates are likely to be over 1.00% higher by the end of the year.

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 * Roger J Kerr runs Asia Pacific Risk Management. He specialises in fixed interest securities and is a commentator on economics and markets. More commentary and useful information on fixed interest investing can be found at rogeradvice.com