Hibernating bear set to topple the honey pot

By Brian Fallow

Between the lines

Inflation has been a hibernating bear but as the economy warms up the beast is starting to stir.

For the past two years annual inflation rates have been around, and latterly below, the middle of the Reserve Bank's 0 to 3 per cent target range.

But a combination of one-off factors and core inflation pressures are forecast to push the rate to around 2.7 per cent by March next year.

Friday's September quarter CPI figures will give us a taste of what is to come. The market is expecting a 0.7 per cent rise for the quarter, which was also the Reserve Bank's forecast back in August.

Petrol prices, up 14 per cent over the past three months, will do the most damage, explaining perhaps two-thirds of the increase. Other contributors will be local body rates and car registration fees.

In theory the Reserve Bank should disregard such one-off factors which cause a spike in inflation that will have come and gone before the period which monetary policy can influence - the year after next.

Provided, that is, they not only come but go. That's the catch. In effect the bank is saying, "We will ignore these price rises if you do, when you set your prices."

To the extent that the surge in inflation will raise inflationary expectations and trigger second-round price rises, Dr Brash will not be able to ignore it.

As ANZ Bank's economists point out, the ability of businesses to absorb higher fuel prices has been eroded by the squeeze on margins over the past couple of years.

Many distributors and retailers have found themselves caught between the rock of higher import prices (as the New Zealand dollar depreciated sharply) and the hard place of competitive pressures in a subdued domestic market. Over the past seven weeks alone the kiwi has fallen 7 per cent against the yen, the currency in which a lot of big-ticket consumer goods, including cars, are denominated.

One of the most difficult judgements the Reserve Bank has to make is how much that margin squeeze will be unwound as the economy strengthens.

Business confidence surveys have been showing both inflation expectations and firms' own pricing intentions on the rise.

Even the Treasury, in its latest forecasts, expects inflation after the bulget early next year to subside to around 2 per cent for the following two years.

That implies they expect their counterparts over the road at the Reserve Bank to err on the high side of the mid-point of the target range.

The converse of rising inflation expectations is a declining confidence that the bank will contain inflation. The likely way for the Reserve Bank to douse those undesirable trends is a bucket of cold water in the form of higher interest rates.