What happened to the inflation we keep being promised?

Core non-tradable inflation, which is the type watched closely by the Reserve Bank, appears to have lost its correlation with output gap since 2010. Chart by BNZ

Yet again, inflation is failing to fire this year and interest rates are staying lower for longer. Bernard Hickey looks at why prices, wages and interest rates just won't, or can't, get up off the floor.

It's been almost a decade since the Global Financial Crisis and the economy has been growing solidly for nearly seven years. Time and again since 2010, central bankers and economists have warned everyone that wage inflation and higher interest rates are just around the corner. Yet time and again, they have had to reverse their initial interest rate hikes or wind back their forecasts of higher inflation and interest rates. It is a mystery that is forcing some to wonder if 'this time is different' and something structural is going on that is breaking all the rules about full employment, skills shortages and inflation.

The mystery deepened again this week after another weaker than expected inflation result on Tuesday, which forced economists and financial markets to recalibrate their expectations for the umpteenth time. Many now don't expect interest rates to rise until late into next year or maybe not until 2019. Some expect headline inflation to fall back to one percent, the bottom of the Reserve Bank's one to three percent target range by early next year.

Inflation was surprisingly flat in the June quarter, which means financial markets and economists now see the Reserve Bank as more likely to keep the Official Cash Rate on hold for longer.

Statistics New Zealand reported Consumer Price Index inflation fell to 0.0 percent in the June quarter from 1.0 percent in the March quarter as domestic airfares fell 15 percent and petrol prices fell 2.9 percent in Wellington and the South Island, and 1.7 percent in Auckland. Annual inflation fell to 1.7 percent from 2.2 percent in the March quarter.

Economists had expected quarterly inflation of around 0.2 percent and annual inflation of 2.0 percent so the result lowered expectations about an early start to rate hikes by the Reserve Bank. The central bank itself had forecast in May that there would be quarterly inflation of 0.3 percent and annual inflation of 2.1 percent. Before the release of the figures, economists had expected the Reserve Bank to begin hiking the OCR from its current 1.75 percent level in the second half of 2018, although the Reserve Bank itself forecast in May that it would not start increasing the official rate until the second half of 2019.

The Tradables index of the CPI fell 0.2 percent in the June quarter and was up just 0.9 percent from a year ago as fuel and other import costs were weak, in part due to a strong currency. The New Zealand dollar initially fell more than half a cent to 72.7 USc after the result, although it remains more than two percent higher on a Trade Weighted Index basis than the Reserve Bank's May forecast, effectively tightening monetary conditions. The currency bounced back by late on Tuesday.

Part of the surprise was that petrol prices in Wellington and the South Island fell more than expected. There has been a widening divergence (around seven percent) between Auckland and the upper North Island (where Gull stations are present) and the rest of the country (Wellington and South Island) over the last six years. However, petrol prices in the non-Gull regions fell more sharply in late June in the lead up to the release of a Government analysis of petrol prices, which found the petrol market in those regions may not be fully competitive. Many suspect the petrol companies cut prices to reduce political pressure ahead of the report's release.

Non-tradables prices, which are the domestically influenced prices most closely watched by the Reserve Bank, rose just 0.2 percent in the June quarter (the lowest quarterly inflation in two years) and annual inflation fell to 2.4 percent from 2.5 percent in the March quarter. Strong inflation in housing construction costs and rents was more than offset by cheaper hotel and motel rates and airfare price. This was also lower than the 0.3 percent and 0.5 percent rises expected for the quarter by economists and the Reserve Bank respectively.

Perhaps surprisingly during a quarter that included most of the Lions tour, accommodation prices fell 8.1 percent in the June quarter and domestic airfares fell 15 percent.

"We continue to expect the RBNZ will not lift the OCR until late 2018 – certainly there is no hurry for the RBNZ to act any earlier based off the June quarter CPI," ASB's Chief Economist Nick Tuffley said.

Short term wholesale interest rates fell around three basis points.

"While the RBNZ has already been on the side of arguing that OCR hikes are a long way off, today’s result should put a severe dent in market expectations that the RBNZ will be hiking rates by mid-2018," said Westpac Acting Chief Economist Michael Gordon.

So why won't inflation get going?

Employers have been reporting rising skill shortages and business confidence surveys have found capacity constraints for years, but still the inflation won't come.

The missing link is wage inflation, which remains stuck below two percent on measures that adjust for skill levels and promotions.

"A breakdown in the usual relationship between tight labour markets and wages is a current global phenomenon, not confined to NZ," said BNZ economist Jason Wong.

"Global structural forces, demographics and technology have all been pointed as possible factors behind this trend," he said.

"In New Zealand’s case we can add strong net immigration as a possible factor weighing on wage inflation."

Those wondering what the economists are talking about when they talk about technology and demographics need look no further than their smart phones and bond yields.

Globally available apps such as Airbnb, Whatsapp, Uber and Facebook have vastly increased supply of services such as accommodation, text messaging, taxi transport and advertising at much lower costs. They are effectively evaporating previously domestic and non-tradable sectors into the cloud and are globalising services in the same way that manufacturing was globalised in the 20 years before the Global Financial Crisis.

The advent of new technology is also making it much easier for employers to outsource work and to slice and dice it up into small chunks that can be done in multiple locations and time periods. The likes of Freelancer, Etsy and Taskrabbit have created platforms for the 'gig economy' to flourish, effectively opening up labour markets to a globalised pool and driving down wages in services sectors.

Low headline inflation last year has also chilled employer and employee expectations for wage hikes, particularly for those that link their pay increases to CPI inflation.

So no rate hikes til 2019?

Despite the years of surprisingly weak figures, most economists still see the wage inflation eventually kicking in. They point to the Government's $2 billion pay equity settlement for aged care workers as one catalyst for a ripple effect on wages through the health care and education sectors.

"Certainly, we are hearing anecdotal evidence of higher wage inflation that various businesses are facing. The recent significant government settlement for rest home workers should ultimately feed into higher wage inflation elsewhere," Wong said.

Economists now see the Reserve Bank's own forecast of a flat OCR until 2019 as more realistic.

"Together with the recent soft GDP figures, today’s data and the mixed forward-looking inflation signals will leave the RBNZ fully vindicated in its ultra-cautious stance and no doubt the market will shift more towards its view," ANZ's Philip Borkin said.

"While our own view is that domestic inflation pressures will eventually rise and broaden, that hinges heavily on the labour market (and wage growth specifically). The RBNZ is not going to react until it sees actual evidence of this and the risks are clearly building that this theme will not only be delayed, but will be surmounted by growing evidence of structural disinflationary forces," he said.

And there we have it.

'It's different this time'

Something structural is going on in the economy that is continually surprising central banks in ways that mean they have keep interest rates too high for too long in the expectation that inflation would eventually come. It begs the question of whether the Reserve Bank and other central banks are tweaking their models of the economy to adjust for the supply shocks from the 'gig economy.'

They have over-forecast inflation and under-estimated the productive capacity of the economy for more than five years, which has meant they have effectively kept interest rates too high to achieve their inflation targets. That, in turn, has kept unemployment higher than it should have been.

Our Reserve Bank has argued it could not have forecast the currency's surprising strength or the unusually high growth in the working age labour force because of record high net migration over the last two years, both of which have suppressed inflation. But it is adjusting. It has certainly been more cautious this year about predicting a rapid rise in inflation and interest rates, which has meant it has looked more in tune with the weak inflation results than many others in the market.

The big question is how long before the usual rules about strong economic growth turning into inflation apply again. Anyone trying to answer that should take a good look at the apps on their phone's home screen and ask how much their prices and wages have fallen because of them.

Statistics New Zealand is certainly taking these changes into account. Earlier this month it announced it was rebasing the Consumer Price Indices because of massive falls in the prices of new technology. It said the improving quality of many products, particularly electronics and digital devices, had meant some of the indices were approaching zero and needed rebasing.

But aren't the banks putting up mortgage rates anyway?

One argument put forward by those seeing higher interest rates is that banks are putting up mortgage rates and term deposit rates even though the OCR is unchanged. That is because banks are restricted from using the pre-GFC tactics of borrowing on 'hot' short-term money markets overseas and have to use more expensive local term deposit and long term funding. Also, banks are being forced by regulators to hold more capital, which is more expensive for banks and forces them to increase their profit margins.

However, those mortgage rate hikes happened mostly between September and March, and have actually been nudging lower in recent weeks as the big four banks poke their heads above the parapets again now their funding gaps are narrowing.

ANZ Chief Economist Cameron Bagrie pointed out this week that the gap between term deposits and lending growth had narrowed, which was taking the pressure off mortgage and deposit rates.

"A gap remains when comparing annual household credit and deposit growth, but over the past three months credit and deposit growth have actually run at a very similar pace. So much of the hard work appears to have been done," Bagrie said.

With core inflation subdued and banks suspending their rate hikes, the outlook for interest rates remains flat into the foreseeable future.

The Reserve Bank's own preferred measure of core inflation, the sectoral factoral model, reflected that flat outlook. Annual inflation of this measure fell in the June quarter to 1.4 percent from 1.5 percent in the March. This was the first fall since March 2015 and took the rate back to the level it was at in September 2015. Back then the OCR was at 2.75 percent.