Recessions kill inflation
- Prices are simply not rising as much as expected. Covid related caution has had an impact, and the outlook for inflation is weaker as a result.
- Prices rose just 0.7% (against consensus of 1%) in the September quarter, to ease to just 1.4% over the year, well below ours and the RBNZ’s expectations.
- The weaker starting point will only support the RBNZ’s resolve to do more, and do it early. We expect the FLP to begin before year end. And a negative cash rate is now highly likely as early as February.
Inflation bounced back in the September quarter, but by less than the we and the RBNZ had expected. Inflation came in at 0.7% in the quarter following the lockdown induced 0.5% fall in prices in the June quarter. Rather than rising, annual inflation eased a touch to 1.4%yoy. Smaller than the 1.7%yoy increase we had been expecting. Price rises from vegetables, rents, rates and public transport underpinned the rebound. There was plenty of noise in the data due to the April’s nationwide lockdown. Stats again noting that the price of tomatoes skyrocketed because growers, wary of a lack of future demand in lockdown, planted fewer crops.
The overall inflation picture in today’s report was weak. The third quarter release will also be of some concern for the RBNZ, who like us, is expecting to see inflation fade quickly from here. Core inflation measures were broadly weaker. For instance, annual CPI inflation less food, energy and fuel prices fell to 1.7%. It started the year at 2.3%yoy. The slow moving non-tradables, or domestic, inflation measure eased to 2.6%. The rise in the economy’s spare capacity from the recent recession will drive domestic inflation lower.
The recent domestic data flow has largely been one-way. Business confidence and housing activity are suggestive of a stronger demand picture. However, there is an element of noise here. Yes, activity has rebounded from the second quarter. But the hit to the economy from lockdown is a deep hole to fill. Our borders are closed, and the summer months will be challenging for businesses reliant on international arrivals. With inflation starting from a weaker position, and likely to weaken from here, the RBNZ will feel emboldened to act. And in conjunction with a bank funding for lending programme, we expect the RBNZ to move aggressively and cut the OCR by 75bp in February to take the cash rate to -0.5%.
Tradables vs non-tradables?
Driving the rebound in Q3 inflation, was housing, food and transport prices. The housing group posted another 0.6% rise in the quarter. The annual local-council rates rise was measure at 2.9% across the country. But this was the smallest annual rise in 20 years. Some councils held back from the usual annual hike in rates due to covid. Higher housing costs, including rents and home ownership featured in Q3. The Government’s rent freeze, that ended at the end of the quarter, held back some rent rises. But the rent freeze didn’t stop Wellington posting a 5.1%yoy jump. Further evidence that the Capital is suffering from a chronic housing shortage. The housing group contributed to the fall in annual non-tradables inflation to 2.6% from 3.1% in the previous quarter.
Tradables (or international) prices fall 0.1% in the quarter. We were expecting a modest 0.4% rise. With petrol prices remaining well behaved so far in Q4 and the NZ dollar showing relative strength, tradables inflation is unlikely to offset weakening domestic inflation pressure in the quarters ahead.
A cooling in the distance
Looking ahead, inflation is expected to fade. We’re picking annual inflation to ease further, falling near flat next year. Our economy is likely to run well below its potential while our borders remain closed. The rising unemployment rate signals growing spare capacity in the economy, which places downward pressure on prices and wage growth – our Economist Mary Jo Vergara covers the main forces behind weak inflation in a video here. Domestically generated inflation (non-tradables) will weaken. The current environment is just not conducive to price hikes.
Imported inflation (tradables) too will fall near-term. Because the covid crisis has sapped demand not just here, but also around the world. The 0.6%qoq jump in tradables is temporary and rather a consequence of countries re-opening their borders and re-starting machines. As explained in this week’s video, the outlook has improved slightly for the global economy, with the IMF forecasting an annual 4.4% contraction (previously -5.2%). However, that decline would still be the deepest since the 1930s Great Depression. And despite the upward revision, the IMF is projecting a longer and slower return to pre-Covid levels. The deflationary pressure on tradables of a more subdued recovery path also suggests that annual inflation will cool from here.
The RBNZ has a mandate to meet. But employment and inflation are clearly drifting further away from target. Indeed, the balance of risks remain skewed toward deflation, if no further policy action. With both employment and inflation drifting further away from target, more stimulus is needed and is expected to come. A Funding for Lending programme has been flagged and will likely be introduced at the November MPS. And while providing cheap funding to banks will successfully lower all retail rates (deposit and lending), we still believe the RBNZ will take the cash rate into negative territory.
Keeping the shopping basket relevant
StatsNZ has updated the CPI’s basket of goods and services and the weights within, as part of its triennial update. Regular updating and re-weighting of the CPI’s basket of goods and services ensures that the CPI’s remains consistent with Kiwis’ spending habits. The weights are largely based on the 2018/19 Household Economic Survey (HES). The latest exercise has thrown up some interesting changes in spending. We’re spending more, a lot more, on housing as the cost of putting a roof over our head takes an increasingly larger chunk of income. Housing and household utilities now makes up 28% of the CPI basket – up from 24.5% in 2017. NZers are spending less on transport and recreation. Covid has played a role here. Stats has had to acknowledge the inability/desire of Kiwis to travel overseas, by lowering the weights on international airfares and overseas accommodation booked in NZ by more than what might have been suggested by the HES. StatsNZ move is reasonable and justified. A possible risk is if somehow an effective vaccine is found and borders are reopened, transport will likely be underweighted in the CPI until the next reweight exercise.
The re-weighting exercise has also changed the shape of inflation. The split between non-tradables an tradables items has gone from a 56.5% and 43.5% to a 60:40 split respectively. Domestic inflation drivers will play a slightly larger role in price movements over the next three years.
Market Reaction
The financial market reaction to today’s report was swift. Immediately following the 10.45am release, the Kiwi fell ~15pts against the greenback, down to as low as 66.61c. The Kiwi has since recovered and is trading back at levels seen prior to the report. Wholesale interest rates however continue to trek lower. Kiwi interest rates flattened across the curve, led by the short-end. The pivotal 2-year swap fell from 0.0250% to 0.0172%. And the 5-year dropped, 0.1375% to 0.1275%. The descent in these short swaps continues, and may even trade negative today!
The unexpected weakness in the September inflation print points to a more sluggish start to our economic recovery. Market traders are expecting more stimulus from the RBNZ. A negative cash rate is now highly likely. And the cash rate cut could be delivered as early as February,