How far will central banks be prepared, or need to go, to tame inflation?

Businesses should be mindful that central banks are now on the warpath against inflation with the rhetoric and expectations towards higher interest rates ramping up.  Businesses need to be thinking about what it means for them as the economy moves from the boom into reset mode.  Many business people have not seen the destructive impact of inflation.

Inflation is surging, driven by COVID, logistical challenges, supply chain problems, higher energy costs, the situation in Ukraine, but primarily an economy that has insufficient capacity to meet demand. Talk to any firm about finding staff – the unemployment rate is 3.2% and 2% for full-time employees.  Email or written notifications of cost increases are frequent.

Inflation is hitting both the economy and the social ledger.  The cost of living is now issue 1# for households according to the IPSOS issues monitor, displacing housing from top spot.  Inflation is now appearing regularly in the political arena as middle- and low-income households feel the impact.

Central banks are talking in sterner tones as inflation rises and interest rates are rising as a result.  Rising inflation risks seeping into more generalised price rises, especially with the economy facing capacity constraints. The tough talk is required to cement their credibility to get on top of inflation.  Credibility once lost is hard to retain.

For now, the reaction function needs to be skewed that way.  Economies are still basking in the glow of low unemployment, elevated asset prices, and strong growth, albeit with persistent COVID challenges intermixed for some sectors.

That reaction function is likely to be tested as 2022 progresses.  Taming inflation is not growth, or asset price friendly.  When you have a lot of inflation, the necessary action is even more unfriendly.  And central banks inflation challenges are being driven by some factors they have no influence over such as the situation in the Ukraine and the ever present COVID.  They can only ignore them for so long though if they start generating second round inflation effects.

Financial markets anticipate the Reserve Bank of New Zealand will raise the Official Cash Rate (OCR) to around 3.7%, a whooping 3.5 percentage points from the 0.25% low. Fixed mortgage rates have gone from less than 3% to 4-6% and are still rising. Many borrowers are facing a doubling in their mortgage costs, and fixed rates are still rising. House prices have started to decline in recent months.

The OECD described the economy as overheating which is too much growth, resulting in pressure on resources and rising inflation. The economic cycle needs to turn, and particularly pro-cyclical areas such as housing and construction. 

Housing and household utilities has a weight of 28.3% in the consumer price index.  When those costs rise, they add a lot to inflation. The flipside also applies. The BIG ones are rents and construction costs.  House prices lead construction costs. You need the housing market to pull-back to dampen construction cost inflation. House prices have started to decline in NZ, easing 2.3% in the past quarter.  That is still early days and a blip following gains of 40% in two years.  The Reserve Bank is expecting house prices to ease 5% over 2022.  Auckland house prices are down that much already. Some are talking of house prices declining 10% given the trajectory for interest rates, tighter credit conditions and a big slowdown in population growth. That is feasible, particularly given valuations and the 40% prior 2-year surge.

Those sorts of movements potentially get into the uncomfortable zone.  Housing has a big impact across the economy.  It drives confidence, and spending.  Lots of businesses use the house as the working capital facility.  Construction is a big sector directly and indirectly and construction cycles are large from top to bottom and bottom to top.

Central banks will be prepared to instigate a light recession / big slowdown in growth to tame inflation.  That is the cost of getting inflation back down. The piper will be paid. It might be a different story if the signals start pointing to a hard landing and large falls in asset prices start to occur. 

Higher interest rates have only just begun, but when they start rising from basically zero, the economic consequences can be sharp as it does not take much for borrowing costs to double.  Central banks have blunt instruments at their disposal and uncertainty is high both locally and globally over how asset prices and consumers are going to react to higher interest rates.  History can be a guide, but economies are being buffeted by so many different things at present, isolating one economic effect from another is nigh on impossible. 

For now, central banks can talk tough.  Their real challenge could be in the back half of the year when inflation could still be elevated but the wheels are starting to come off the economy a bit. Older business heads will remember the economic adjustments required to get inflation down.  They know the importance of good business relationships when the business cycle turns.  Younger heads might want to go back and look at some pre 1992 history.   

*While Bagrie Economics uses all reasonable endeavours in producing reports to ensure the information is as accurate as practicable, Bagrie Economics shall not be liable for any loss or damage sustained by any person relying on such work whatever the cause of such loss or damage. The content does not constitute advice. 

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