David Hargreaves says with key economic data starting to turn out softer than expected, crunch time is looming for the Reserve Bank in its inflation battle and in how far it wants to drive up interest rates

The Reserve Bank's tough job in the battle against inflation just got a little trickier. 

Clear signs are now emerging that the economic tide is turning. That means the RBNZ is approaching the time when it has to be less aggressive in its fight with inflation and switch to what it terms the 'watch, worry and wait' phase.

However, that time may be coming upon the RBNZ faster than it anticipated. And how it reacts now is crucial. I think this is now the time when the central bank is at serious risk of overcooking it with the interest rate hikes. 

For the RBNZ, pushing down hard on interest rates in the inflation fight is actually the easy bit. The really, really hard bit is deciding when to back off. But I think the 'back-off' point is now much closer than the RBNZ anticipated at the end of last year. And I have to say it is much closer than I thought at the same time as well.

Since inflation started to seriously raise its ugly head in 2021, one of the common factors has been that key economic data releases - such as CPI inflation, unemployment and GDP - have continually come in stronger than forecast. Often, the data has been WAY STRONGER than forecast - and this had included  some of the inflation releases.

There've been abundant shocks.

The Reserve Bank has conceded it could have reacted faster to the emergence of inflation. It like other central banks around the world miscalculated that the rising wave of inflationary pressures would be transitory. Not so. These transitory pressures, such as from supply chain bottlenecks, made their way into the domestic economy and started to fuel that most dreaded of things - inflationary expectations.

Once you have inflationary expectations in your midst you've got a population with one eye all the time on what they think things are going to cost in future and so they react in pre-emptive fashion by putting their costs up. And so up inflation goes, and that's where we are now.

The RBNZ decided to start pushing up interest rates in August 2021, but in the event that became a false start because Auckland chose that very moment to have its Covid Delta outbreak. So, the RBNZ held fire through the August 2021 Official Cash Rate review decision and then, once there was greater clarity around the Delta outbreak, it started the OCR hiking 'cycle' with a 25-basis-point rise in October, lifting it from the emergency setting (since March 2020) of 0.25% to 0.5%.

There was a bit of speculation about how quickly the RBNZ might look to 'normalise' the interest rates and so the RBNZ itself, in September 2021, before the first OCR move had in the end been made, came out with a "considered steps" mantra. This told the marketplace that the interest rate moves upward would therefore be gradual, IE in 25 point moves.

Well, that didn't last, as the economic data - and particularly the inflation figures - continued to run just so much hotter than anybody expected. And so it was that after a total of three 25 point hikes taking the OCR up to 1% by February of 2022 in a suitably considered-step manner, the RBNZ went for its guns and hiked the OCR by 50 points in April 2022. 

Another four 50 point rises followed between May and October, taking the OCR to 3.5%. At about this time the RBNZ was thinking it had matters in hand and that it was on the right path to checking inflation.

Then came the September quarter inflation figures, which were an almighty shock and clearly rattled the RBNZ. Annual inflation actually fell, from 7.3% to 7.2% - but this was a much smaller fall than expected. And the devil was in the detail, with domestically generated inflation increasing from 6.3% to 6.6%. It is the domestic inflation that the RBNZ can do something about - with its OCR hikes, so if that's rising it knows it has more to do.

Therefore, come the November OCR review and we had the big bang 75 point OCR hike and some very hawkish language from the RBNZ. It even candidly conceded that it was now looking to engineer a recession.  

The clear inference to be drawn from the RBNZ was that after the 75-pointer in November it would follow this up with another one at the next review - some three months later - on February 22, 2023.

Ah, but three months is a long time and the tide appears to have turned over the summer.

Amidst some of the frightening language the RBNZ was brandishing in November, was a pick for the next inflation figures for the December quarter 2022 to come in with an annual rate of 7.5%.

In the event, the figures released in January 2023 showed inflation stayed static at 7.2%, but again it was all about the detail and those figures gave a clear indication that inflation may be at last slowing, that the constant blasting away on the OCR by the RBNZ was starting to gain traction.

Already after those inflation figures, there were several economists that came out and suggested the RBNZ should be looking at a smaller rise to the OCR in February, of 50, rather than 75, points.

Then we came to the labour market figures for the December quarter. My view of these was that if they came in as super strong as, certainly I was expecting, then the RBNZ would still go ahead with a 75 point rise.

However, they did not at all. They showed a rise in unemployment, massively contrary to what I thought when I was walking around during the holidays looking at signs everywhere on the pavement urgently seeking staff.

One thing though: I have to disclose at this point that I am a long time sceptic of unemployment data as I think they can throw up rogue results, as is the risk from any sampling survey. I would not rule out revisions to this week's employment data when the next quarter's figures are released.

But if we take that 3.4% unemployment figure as read, a figure taken just before the summer holidays, when our tourism industry was cranking up for the first 'real' tourism season since the start of Covid, then it is to be assumed that things are already cooling much more than anybody thought and therefore unemployment could start to rise quite quickly this year once the 'summer' (I use the term loosely in consideration of what the weather has been) is over.

So, the pressure is back on the RBNZ. More economists are now saying it should rein back its OCR hike in February to a 50-pointer and not 75. I would actually go further than that and say right now could be the time to go back to a 25-pointer, with future rises 'data dependent'. IE more of a watching and waiting role.

The RBNZ's got another key indicator (too often overlooked in the marketplace) coming out before February 22 and that is its own Survey of Expectations on February 14. This is where a relatively small group of business leaders and professional forecasters give their views on where inflation is headed in future. This is important for the RBNZ, since it tackles that whole 'inflation expectation' ogre. If the inflation expectations fall in the next survey - and I'm going to say I think they will - then I think that will put paid to any talk of a 75 point OCR rise.

We really don't want or need the RBNZ to overcook the inflation response. The time is fast approaching when the central bank, in card-playing terms, needs to change its approach from 'twist' to 'stick'.

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