Westpac economists say the Reserve Bank will have its work cut out to try to get inflation back to the targeted 2%

Westpac economists are predicting that annual inflation will be just 1% for the year to September 2016, which is well below what the Reserve Bank is forecasting and aiming to achieve.

The RBNZ has an official target of keeping inflation within a 1%-3% range, with an explicit target of 2%, but it has been falling well short of these targets for a long time now. The central bank will be releasing updated economic forecasts next week with its December Monetary Policy Statement. But in the September MPS it had forecast that inflation would get back to the mid-point of its 1%-3% targeted range by the September quarter next year.

However, Westpac economists, in their weekly commentary, say the RBNZ is facing an uphill battle.

“Inflation has been below the RBNZ’s target band for a year now. And although the fall in the exchange rate since mid-2015 will result in some lift in prices, a sustained pick-up in inflation back to 2% still looks elusive. The main reason for this is that domestic growth is set to slow, which will result in continued downwards pressure on prices.”

The economists said that looking to the year ahead, they do expect some pick-up in inflation in the early part of 2016, with earlier weakness in petrol prices set to soon drop out of annual figures. In addition, the exchange rate has fallen by more than 10% since mid-2015, which will gradually pass through to higher prices for many imported goods.

“Nevertheless, we are sceptical that this pick-up in inflation will be sufficient to meet the RBNZ’s 2% inflation target. In fact, we’re forecasting that inflation in the year to September 2016 will be just 1% – right at the bottom of the RBNZ’s target band.”

The economists said the key reason they expected inflation to remain so stubbornly low is the strength of domestic demand.

“Over the coming year, GDP growth is set to slow as the economy confronts a number of significant headwinds. These include drought, lower dairy prices, a softening in the housing market, and the plateauing of reconstruction activity in Canterbury. These conditions will result in unemployment rising and consumption spending growth easing back. Such an environment will make it hard for retailers to push through price increases.

“At the same time, we’re seeing downward pressure in terms of some key operating costs for business. Lingering weakness in the global economy is weighing on the prices of many internationally traded goods. This includes industrial commodities that are used in the production of other goods, such as fuels and metals. It also includes consumer goods that New Zealand imports, such as clothing and electronics.”

The Westpac economists said there has been strong growth in New Zealand’s productive capacity in recent years. This has meant that the economy has been able to grow without generating significant cost pressures.

“One area where this can be seen particularly clearly is the labour market, where record high net immigration has resulted in a significant boost to the size of the labour force. This has helped to address specific skill shortages, such as the need for specialist labour for the Canterbury rebuild. However, the large increase in the labour force over the past year has also had a dampening effect on wages. And even though the current strength in migration will eventually turn, wage inflation is still likely to remain low for some time.

“On top of this softness in demand and subdued cost pressures, there are some ‘special’ factors that are weighing on inflation. First, the coming years will see lower rates of increase for some government charges, such as the tobacco excise tax and ACC levies. Second, the continuing shift to online retailing and the related increase in import competition are likely to keep pressure on margins for some time.”

The economists said that when all these things are put together, the RBNZ “is going to have its work cut out for it” in terms of generating a sustained increase in inflation back to levels close to its 2% medium-term target.

They reiterated that they are expecting the RBNZ will cut the Official Cash Rate at its upcoming December decision and that the OCR will continue to fall over the coming year down to a record low of 2%. It currently stands at 2.75%.

The Westpac economists have for some time now been forecasting a low point of 2% of the OCR and were officially joined in this belief by ASB economists last week. The RBNZ has indicated – though not explicitly – that it sees a likely low point of 2.5% for the RBNZ.