Tuesday, February 27, 2024

Better get used to rising interest rates

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Can we get the inflation thief back in jail?
Simon Hegarty says an industry highlight is the agreement reached with both the UK and EU on separate Free Trade Agreements.
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Inflation remains public enemy number one. Living costs are rising rapidly and family budgets are stretched as inflation-adjusted incomes fall. Inflation creates uncertainty. It is hitting farm input costs and putting pressure on business margins. Asset prices are under pressure as interest rates rise.

For farmers, there have been some good aspects. A tough US Federal Reserve has sent the USD north and the NZD south, the latter accentuated by deteriorating fundamentals.  

The current account – our national chequebook with rest of the world – has widened to $27.8 billion. We deserve a lower currency.

Can we get the inflation thief back in jail? Yes, but the cost could be substantial, and we face many challenges. To appreciate these, we need to appreciate where we have been, relative to where we are likely going.

Many themes helped keep inflation low for decades, amid central banks taking interest rates lower and lower, and printing money (quantitative easing).

Key suppressants included:

• Technology driving down costs, increasing competition and pricing transparency, and globalisation, or the outsourcing of manufacturing production to Asia.

• In New Zealand, tradable or imported inflation averaged 1% per year for 30 years. Tradable inflation is about half of aggregate inflation.  If tradable inflation is only 1%, it is easier to hit a 2% target.

• Contained wage growth as globalisation, technology and the diminished wage bargaining power of unions combined.

• Demographics as people saved and abundant global savings was apparent. 

• It was self-reinforcing, with low inflation driving low inflation.  

Many other factors contributed too, including migration patterns. Lower inflation drove lower interest rates for fear of deflation taking hold.

Throw together low interest rates, massive quantitative easing, government spending largesse and supply shocks and you have an inflation problem.  

That was then. This is now.

The laws of economics have not disappeared. So interest rates are rising rapidly. 

A key problem for central banks is that getting inflation down now looks a lot harder.

Technology is still influential via the likes of Moore’s Law or the “law of exponential growth”. Moore’s Law is an expectation that the speed and capability of our computers increase rapidly every couple of years and we pay less for them. Think of the power of the iPhone today, or those cheap televisions. 

Globalisation faces challenges as the world becomes more fractured. Security looks to be trumping economics for trade direction. Security in food, energy and technology products such as micro-chips is paramount.  One of those is good for New Zealand. Onshoring is gathering pace.  Security over the supply chain is coming more to the fore. That does not look like an environment where tradable or imported inflation will average 1% per year for the next decade. 

Workers are flexing their muscle amid labour scarcity and low unemployment rates. Wages are moving up rapidly. Lacking productivity growth, that adds to unit labour costs and puts pressure on firms to rise prices. There are structural issues at play, too. They include an ageing population. We have under-invested in talent, relying too much on immigration. The race for global talent is here. Government policy is squarely aimed at raising workers’ share of the economic pie.

Demographics are shifting. A more aged population means people are spending more and saving less.

On top of that you can add other factors.  Climate change and the environmental, social, and governance movement add to costs.

Questionable government policy and covid have detracted from the economy’s capacity to operate. The economy does not appear to have the same productive base it had pre-covid. That has driven a bigger wedge between demand and the economy’s capacity to supply. Schooling outcomes today are a bad omen for the economy in a decade.

Can governments around the globe step back and deliver tight fiscal policy and spend less?  We seem to be in an era of populism and sugar candy-driven politicians.

All these factors add to the cyclical challenge of returning the inflationary thief to jail and suggest a larger economic adjustment.

Central banks remain strong in their resolve to get inflation down. Headline inflation is on the retreat, but core inflation is still stubbornly high.  That is where the war is set to be fought.

And so, interest rates will continue to rise and could remain elevated for some time.

When will central banks pause and watch? 

When you start seeing aggressive cost-cutting and layoffs, you can start to take comfort that the interest rate peak is in. The labour market needs to turn.  We do not appear to be there yet.

It is a battle of inflation versus jobs and that has politics written all over it.

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