Thursday, February 22, 2024

Can we declare the war on inflation won?

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We have seen lots of battle wins, with headline rates receding around the globe, says Cameron Bagrie.
The market is betting that, if global rates are moving down, there is little reason to think NZ will be an exception.
Reading Time: 3 minutes

Financial markets are taking a different view to that of central banks. Place your bets on who is right.

The former are taking the view that interest rates are set to come down over 2024 and 2025, providing much-needed interest rate relief. Market expectations are that the Reserve Bank of New Zealand is set to lower the Official Cash Rate (OCR) 100 basis points in the coming 18 months.

The yield on a NZ 10-year bond, after rising to 5.5% has, at the time of writing, receded to below 5%.

Contrast that with the Reserve Bank’s November Policy Statement, where it discussed raising the OCR and the prospect of it falling was a 2025 story. Other central banks, including the United States Federal Reserve, continue to express a willingness to raise interest rates further if needed.

The market is not buying into it. Central banks are done raising rates, and the more those expectations have firmed, it’s helped push up the NZ dollar versus the US dollar.

The drivers include favourable global inflation figures, which continue to nudge lower; and more signs of weaker global demand, and we can see evidence of that with oil prices dropping sharply over the past few weeks. 

Concerns towards China continue to linger, with Moody’s putting China’s credit rating on a negative outlook. Bad (economic) news has become good news for interest rates and borrowers.

NZ interest rate markets have become the two-bit player at the international roulette table and the bet is that if global rates are moving down, there is little reason to think NZ will be an exception.

Can we declare the war on inflation won?

We have seen lots of battle wins. Headline rates are receding around the globe. Recent falls in oil prices will help further, and some food items have fallen sharply in price of late. Slower global growth is helping dampen the ability to raise prices and open the prospect of discounting. Global supply chains have somewhat reconnected, freight rates fallen and geopolitical hot-spots that added to inflation, such as the Ukraine-Russia situation, have receded.

Wage inflation has started to moderate as unemployment rates have started to nudge higher. Inflation expectations – where people think inflation could be in a few years – have remained low, a sign central bank credibility is intact.

Central banks are more guarded. Some of that is tactical. As soon as you declare victory, markets will price in aggressive rate cuts, and central banks still need monetary policy to be restrictive to keep growth subdued to deliver low inflation.

While both underlying and headline inflation rates have decreased around the globe, they remain uncomfortably high.

The real inflation battle is not getting it from 7% to 4%; it is getting it from 4% to 2%.

Does it matter? With inflation at 2%, the price of an item will double in 35 years and price rises are barely noticeable. Inflation of 4% means prices double in 18 years and price rises feed on themselves with regularity.

With tight labour markets, wage inflation – while easing – is still inconsistent with low inflation, and adverse energy price developments are just one geopolitical shock away. The finger is being pointed at greedflation – firms expanding margins in some sectors.

Globally, central banks have had to face a rolling maul of supply shock after supply shock, which adds to the persistence of inflation. Powerful forces are seeing the global economy fracture as a rules-based trading environment is being challenged by exercising power, and security is now more important driving trade. NZ needs to redefine its trade strategy.

The latest International Monetary Fund’s economic assessment included a chapter on geopolitics and commodity prices.

Individual countries will have their own set of inflation circumstances that need to be wound into central bank expectations.  The first for NZ is migration, which is now adding to demand, rents and inflation. The second is the new government’s fiscal strategy. The Reserve Bank does not want to see demand stimulated further by more money being poured into the economy.

A key factor that will determine which nations navigate the tricky path towards getting rid of inflation is productivity.

It is the key to the holy grail. Less inflation without beating up the economy too much, prospective lower interest rates, and a big driver of profitability. ANZ’s Business Outlook Survey is hinting at it. Pricing gauges are inching slower, and growth expectations are up. Whether that is hope or substance is not clear.

Productivity is not one of those variables you can turn quickly, though. Education, infrastructure, skills, innovation, compliance costs, investment in the right assets, effective pricing and taking of risk, along with a host of other variables, are influential.

It will be up to firms and farmers to drive the first impetus to productivity via removing costs and, if possible, investing in technology. Consolidation is needed where good businesses take over weak businesses. This is not a cycle where bad businesses can expect to be bailed out by interest rate relief.

NZ is likely to lag countries such as the US, though, meaning we do the same on the inflation and interest rate front. 

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