As recently as May last year, the Reserve Bank was forecasting that inflation would peak at 2.6%pa, and that it would have settled back to 1.7%pa in the current (March 2022) quarter. But at last week’s Monetary Policy Statement, the Bank’s latest forecasts show that inflation is now estimated to be running at 6.6%pa, almost four times the rate that was anticipated 10 months ago. And given that the Reserve Bank’s estimate of current inflation over each of the last three quarters has been an average of 0.6 percentage points lower than the actual outcome, it’s not much of a stretch to see inflation topping 7%pa in the near term.

Chart 1 shows the evolution of the Bank’s inflation forecasts throughout the last year. To be fair to the Bank, nobody fully anticipated the tsunami of price rises that is currently washing over the economy. Nevertheless, given that the Bank’s primary mandate is to control inflation, one would hope that it gives more attention to, and is more accurate, than anyone else forecasting inflation.

Perhaps the most concerning aspect of the Reserve Bank’s communication over the last nine months has been its dogged emphasis of the one-off or temporary factors accentuating inflationary pressures. We recognise that the initial price increases were driven by unusual factors such as international shipping costs, other supply chain disruptions, and a post-lockdown rebound in some prices. Although the Bank has progressively talked more about capacity pressures and the challenge of “distinguishing between transitory price increases and underlying sustained inflation pressures”, its actions in tightening monetary conditions do not back up this rhetoric and do not align with the acceleration in inflation. So far, the Bank has moved in “considered” small steps of 25 basis points, even as inflation has surged. Chart 2 shows that the Bank’s “softly, softly” approach to raising the official cash rate means that, in real terms, interest rates are now at their most negative (and therefore most stimulatory, relative to inflation) since the early 1980s, when Muldoon’s questionable economic management was in full swing. 1

The feature that should be of most concern for the Bank is that inflation expectations have risen across the board and, for one-year and two-year expectations, they are at their highest levels since 1990 or 1991 (see Chart 3). In one sense, this lift can be expected given the pick-up in headline inflation, which tends to influence short-term inflation expectations more significantly. In the Bank’s own words, the “much smaller movement in longer-term expectations is consistent with inflation expectations remaining anchored at the [Monetary Policy Committee’s] target.”

Throughout the 2010s, well-anchored inflation expectations were a key explanation from the Reserve Bank about why inflation was persistently below economists’ forecasts and the mid-point of the Bank’s target band. Basically, businesses were seen to be reluctant to put up prices, worried that they would lose market share if their competitors didn’t follow suit.

The difference now is that everybody knows their competitors are in the same situation as them in terms of cost pressures. The pricing behaviour and competitive disciplines that have served the Reserve Bank so well since the 1990s have evaporated, and firms have little hesitation in passing on any cost increases they are currently experiencing.

Our discussions with clients over recent weeks suggest that there is still a lot more inflation to filter through the system yet.

• International shipping costs are still about seven times their pre-pandemic levels, and there is little relief in sight, as port space remains a key constraint globally. Concerningly for New Zealand firms, Trans-Tasman shipping costs are increasing sharply and the availability of shipping to New Zealand remains patchy. It is unlikely that all the cost increases associated with this disruption have flowed through into New Zealand retail prices yet.
• Diesel prices have climbed 18% since the start of 2022 and are now 58% higher than a year ago. Fuel Adjustment Factors put in place by transport companies mean that domestic freight costs are rising in line with this surge. However, the recent nature of the fuel price increases suggests there will be more to come in terms of retail prices for goods and services with a transport component. Furthermore, the uncertainty caused by the conflict in Ukraine means there must be considerable upside risks to international oil prices yet.
• The pick-up in labour cost inflation has been surprisingly modest to date, especially in comparison to the growth rates recorded in 2008 (see Chart 4) – when consumer price inflation was weaker than it is now and the unemployment rate was slightly higher. Some commentators have suggested that the current outcomes mean that labour cost pressures are not an issue, thereby justifying the Reserve Bank’s cautious approach to raising interest rates. However, we believe that labour costs are a lagging indicator and that wage growth will accelerate considerably during 2022. Workers will demand larger wage increases to make up for the increased cost of living, and firms will also be forced to pay more to attract and retain staff. Add in the effects of a 6% increase in the minimum wage next month, requirements for an extra week’s sick leave and a new public holiday for Matariki, and the looming shadow of a 1.4% cost increase for businesses due to the government’s proposed unemployment insurance scheme, and there is only one way that labour cost growth is heading this year.

Amid this range of specific inflationary pressures, anecdotal evidence suggests that inflation is going to stick around for longer. Instead of price reviews for product lines being undertaken annually (and those prices then often being held unchanged), price changes are coming through with increasing frequency – twice, three times, or even four times in the last year. Those price increases have also been larger than we have typically seen throughout the last decade.

Sentiments such as the Reserve Bank has lost credibility, that inflation is running out of control, or that we are risking the emergence of a wage-price spiral are becoming more common among businesses we talk to. The latter remark encapsulates the idea that this year’s wage increases will flow through into further price rises for business, pushing up the cost of living further, and thereby feeding through into further wage demands in 2023. At this stage, with the unemployment rate forecast to be still around 3.5% next year, employers would have little choice but to meet those wage demands. And so, without some sort of circuit breaker, the upward pressure on wages and prices would continue.

In response to the overwhelming feedback we have received about the cost pressures still to flow through the economy this year, we will be revising up our outlooks for inflation, labour cost growth, and interest rates in our next set of forecasts published in April. Furthermore, the Reserve Bank’s own forecasts imply that the Bank will need to do more tightening later to make up for its lack of action now. The Bank’s latest prediction for the official cash rate sees it reaching 3.3% at the end of 2023, which is about 70 basis points above the Bank’s forecast published in November last year. Getting inflation back to 2%pa is looking like an increasingly big challenge for the Reserve Bank given how slow it has been to react to outcomes over the last six months.