WELLINGTON: In early 2015 inflation fell to its lowest level in over 15 years, dropping to an annual rate of just 0.3%. Over the coming months, inflation is set to rebound and is expected to rise to 1.9% over 2016. There are two key developments underpinning this expected increase in inflation.
Petrol prices have risen sharply since the start of this year. In addition, the New Zealand dollar has fallen by around 15% on a trade weighted basis which will drive a generalised increase in the domestic prices of imported goods.
The decline in the New Zealand dollar is particularly notable. The Reserve Bank’s September policy statement highlighted this as a factor that would generate a significant and long lasting pick-up in inflation through until late 2018. Some of this pick-up reflects that the Reserve Bank is expecting the lower exchange rate to boost demand over the coming years.
“We agree with the Reserve Bank that the fall in the NZD will result in a sharp lift in inflation, we’re sceptical about how enduring the resulting pick-up will be”, says Westpac Research.
Changes in the exchange rate generate only a temporary lift in inflation, with the domestic prices of imported goods typically adjusting over a period of around 12 to 18 months. That’s a lot shorter than assumed in the Reserve Bank’s forecasts. In fact, the only time we’ve seen a pick-up in imported inflation that has been sustained for anything like what the Reserve Bank is projecting was in 2000-01. During that period the currency had fallen to a record low and oil prices had tripled over the previous three years, from $10 to $30 a barrel.
One could argue that the recent fall in the NZD will result in a slightly more persistent boost to inflation than usual as retailers may seize the opportunity to rebuild thin margins. In recent years, tough trading conditions and the lingering strength in the NZD resulted in retail margins shrinking.
Now, with the NZD having fallen, the domestic price of imports is set to rise. As retail prices rise in response to the increase in imported costs, we may see some retailers rebuilding margins at the same time.
However, the scope for retailers to claw back margins currently appears limited. Consumer confidence has fallen sharply and businesses have highlighted a limited ability to increase prices compared to average.
In addition, the increased prevalence of online purchases in recent years has resulted in a structural change in the retail environment, weighing on margins in some sectors. Furthermore, if retailers do increase margins, this adjustment is likely to occur when import prices rise. Consequently, even if margins do increase, it seems unlikely that this will result in a large sustained boost to inflation.
