Expectations for New Zealand interest rates continue to increase, with inflation remaining persistent and requiring tighter monetary policy to address sticky pricing pressures. Economic activity remains unbalanced, with demand outstripping supply. Our latest assessment of conditions means we have raised our expectations for interest rates, given it is unlikely there will be firm evidence of slowing price rises before the first quarter of 2023.

In preparation for our next quarterly economic forecasts (scheduled for Friday 14 October), we are lifting our expectation for the peak official cash rate (OCR) to 4.50%, with flow-on effects for retail mortgage rates.

We’re increasingly of the view that risks of more persistently high inflation are on the upside and, because of this risk, that the OCR might need to go higher still.

Changing to a 4.50% call represents an entire percentage point increase in just two months. Our last published forecasts in July 2022 had a peak OCR of 3.50%, and at the time we noted that “there is now a general belief that the projected increases are sufficient to bring things back under control. In fact, most forecasters (including ourselves) expect the OCR to peak at around 3.5%.”

The broader rise in inflation in the June 2022 quarter, and other economic indicators, meant that we raised our peak OCR call to 4.00% in August, with two more 50 basis points expected at the last two reviews by the Reserve Bank in 2022.

We now expect two further 25 basis point increases in the first half of 2023.

Concerningly, inflationary pressures continue to not only hold at high levels, but in some areas are still accelerating.

• Food price growth accelerated to 8.3%pa in the August month, the fastest rate in 13 years.
• The Infometrics Foodstuffs NZ Grocery Supplier Cost Index rose 8.7%pa in August, a further acceleration from the 7.9%pa recorded in July.
• Recent producer prices and capital goods prices rose at an accelerating clip and outpaced our forecasts.
• Stats NZ’s farm expenses price index rose at its fastest pace on record, going back to 1993.
• Import costs continue to rise in the June 2022 quarter, including imported food price growth being at its highest since 1985.
• International shipping prices remain around three times their pre-pandemic average.
• International energy prices continue to affect global manufacturing output and manufacturing costs, limiting supply and pushing up production costs.
• The strong US dollar is pushing up the cost of imported goods in New Zealand even further.
• Labour cost increases are at decade-highs, and with the labour market remaining tight, these higher costs are likely to be passed on into consumer prices.

Thankfully, some reversal in petrol and diesel prices has recently provided some relief for households. Fuel prices remain uncomfortably high, but they have at least retreated from the highs reached in June and early July.

Even so, the breadth of inflationary pressures facing the economy is immense. In the US, the CPI 0.1% between July and August, despite a fall of nearly 11% in fuel prices.

Having considered the sustained inflationary pressures and increasingly fragile economic growth outlook both domestically and overseas, the question we continue to ask ourselves is as follows: when will the Reserve Bank have sufficient evidence to be confident it has done enough to pull inflation back towards its 1-3%pa target band?

Despite recent falls in retail spending and overall private consumption, pricing pressures are showing no signs yet of letting up . We are worried that inflation might remain higher even as economic activity retreats.

We currently expect two more 50-point OCR increases in October and November. We’re unconvinced that pricing indicators will show enough improvement by the end of 2022 to change this outlook. There is then a three-month gap over summer before February’s Monetary Policy Statement. By then, the Reserve Bank will have both the inflation and labour market figures for the December 2022 quarter. Given the current strength in inflation that is still evident at the end of the September quarter, just one more quarter of data is unlikely to convince the Reserve Bank that pricing pressures have subsided enough that it can stop raising the OCR.

We therefore expect a further 25 basis point increase in February 2022, and another in April or May. Inflation doesn’t need to be fully under control before the Reserve Bank pauses or stops tightening, but it does need to be headed in the right direction. However, at present, apart from fuel, pricing pressures are still firmly heading higher.

Effectively, the Reserve Bank should be cautious of stopping its attack on inflation too early, particularly in light of its reluctance to tighten quickly enough during late 2021 and early 2022. Having lost some of its inflation-fighting credibility, the Bank effectively needs to overcook its response to get on top of sustained price rises and bury inflation. That approach will likely mean more interest rate hikes, until actual, observed, price growth starts to moderate. By the time the Bank sees that price growth moderation, it will already have done too much. But the risk of easing off too soon, and letting inflation become further embedded and remain higher for longer, is a greater risk than engineering a short-term hit, and possible recession, for the economy.