Despite low inflation, OCR cuts are unlikely. Economic growth prospects look quite good, aided by falling fixed mortgage rates. This implies the best indicator of mediumterm inflation prospects will head into the danger zone this year. Inflation has fallen below the bottom of the Reserve Bank’s 1-3% target range, sparking some speculation that the OCR may be cut. However, the indicator most relevant to mediumterm inflation prospects may start to justify OCR hikes later this year.
Inflation is extremely volatile in NZ because it is impacted hugely by movements in the exchange rate, while petrol and primary product prices can also have significant impacts. All three have contributed to what is likely to be temporarily low inflation. The single largest cost of production in modern economies is labour costs. This puts the labour market at the heart of medium-term inflation prospects. The unemployment rate is the best measure of whether the labour market poses a threat to medium-term inflation prospects. The historical experience points to approximately 5.5% being the unemployment rate that is consistent with keeping inflation at around the midpoint of the Reserve Bank’s 1-3% target range on average over the medium-term. Governor Wheeler has stated he is targeting the midpoint. If the unemployment rate is above the level consistent with keeping inflation low, on average over the medium-term, the Reserve Bank can promote growth with below average interest rates. This has been the case for most of the period since the financial crisis struck in 2008 (see the chart). At 5.7% in the December quarter the unemployment rate suggests there is little spare capacity in the labour market.
Economic growth prospects look quite good for this year, so I expect the unemployment rate to fall below 5% by early-2016. To put this in context, Governor Bollard made the mistake of allowing the unemployment rate to fall to a low of 3.5% in the mid-2000s, which fuelled a wage-price spiral that required 13 OCR hikes to tame. OCR hikes seem unlikely this year, but if the unemployment rate continues to fall, there is a risk of hikes in 2016.
Written by Rodney Dickens.
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