NZ Q2 CPI Review: Cost Push Inflation

Q2 CPI 1.6% q/q, 4.0% y/y

• CPI pushes further above RBNZ target band.
• Food and energy the major drivers.
• Non-tradable inflation still high.
• Inflation outlook remains worrisome.

New Zealand's inflation problem is getting worse. The 1.6% increase in the CPI in Q2 was on our expectation but higher than the 1.4% expected by the market and RBNZ. The quarterly rise in prices lifted annual inflation to 4.0% in Q2 2008 from 3.4% in Q1.

The main drivers of inflation in Q2 should have surprised few: food, fuel, electricity and housing construction costs. Despite a very high probability the economy is in recession, inflation is high and accelerating. The two are related – rising prices are hurting consumers and contributing to recession. These pressures are not expected to abate anytime soon. The economy is operating under immense cost pressure. In fact, NZIER's Quarterly Survey of Business Opinion released last week showed that firms' cost expectations are at their worst in more than 20 years.

Cost pressures were evident in many parts of today's CPI data. The most obvious is fuel costs with the hefty 12.8% quarterly rise in petrol prices (not to mention the massive 29.0% increase in diesel prices). Even if petrol prices had remained constant in the quarter, the CPI would have increased a chunky 1.0%. Higher fuel costs are flowing through to other goods and services like airfares – domestic airfares rose 3.9% and international airfares rose 1.7% in Q2. Rising electricity costs are also squeezing household and business budgets alike. Consumer electricity prices rose 3.6% in Q2.

Housing construction and maintenance costs continue to rise despite a slump in residential building activity. This reflects rising raw material prices. Moreover, the usual downward pressure that comes on construction wages when activity slows is being somewhat dampened by the Australasian construction market remaining relative strong.

It is always tempting to remove some items like petrol from headline inflation to get at the underlying picture. But how do you decide what to take out and what to leave in? Should we remove the jump in electricity prices this quarter, or remove the downward effect on annual inflation from the government subsidy changes on health and education last year?

For policy, the current rate of inflation is mostly of concern in so far as it pollutes inflation expectations. Headline inflation accelerating northward is worrisome in this regard. The medium term inflation outlook is more important than current inflation. Respite appears limited on this front, despite our forecast of a dip in annual inflation below 2% by the end of 2009. This dip will be short lived. We forecast average inflation of 3.3% over 2010 and 2011 following an expected economic growth recovery in 2009 and with still high inflation expectations. It is this medium term inflation outlook that should be of most concern to the RBNZ.

Non-tradeable inflation remained high at 0.9% in Q2. Annual non-tradeable inflation came in at 3.4%, matching RBNZ and our forecasts. This, in its own right, is still too high for the RBNZ to be comfortable. Remember too, that the government subsidy changes from last year that will start dropping out of the annual calculations next quarter. Add in the second round effects of recent costs increases along with alcohol price increases (among other factors) and annual non-tradeable inflation will likely leap to around 4.5% in short order.

On an annual basis, price increases for basic items make some scary reading: groceries up 11.4%, petrol up 25.9%, electricity up 6.6%, and rents up 3.1%. These increases are putting considerable strain on the weekly household budget.

Annual inflation in Q3 is shaping up even worse than the 4.0% recorded in Q2. We think it will hit 5.5% next quarter and average 4.7% over the next 12 months. Annual inflation pushing further above the top of the target band and set to breach 5% for the first time in 18 years (when GST was increased) suggests a cautious approach to easing monetary conditions should be taken.

Increasing costs and prices are hurting businesses and consumers. An aggressive easing in monetary conditions could unleash even more inflation – hardly the tonic required. Consider a 100+ basis point easing by December with the NZD falling 10 big figures. Few would welcome the resulting $2.45 per litre at the petrol pump let alone higher prices for food and other traded goods. Annual tradeable inflation has already hit 4.8% without a major fall in the NZD.

Implications

We think the RBNZ remains on track to cut interest rates in September, closer to the point when annual inflation is set to peak. However, a cut in July remains a close call given the sharp slowing in economic growth and continuing jitters on world financial markets reflecting economic conditions in the US.

The tick down in annual non-tradeables inflation on its own leans towards a July cut. But the outlook for Q3 leans back towards a September cut. The mild pick up in annual services inflation will not have gone unnoticed by the RBNZ. This is another measure of the persistence in domestic related inflation providing enough discomfort to prevent an early interest rate cut.

Westpac Institutional Bank

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