Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Brian Fallow: Inflation threatens to bite into recovery

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In the past year, householders have faced a rise in the price of milk on supermarket shelves of 9.3 per cent.  Photo / Greg Bowker
In the past year, householders have faced a rise in the price of milk on supermarket shelves of 9.3 per cent. Photo / Greg Bowker

While more than 1000 businesses gather at Mystery Creek in hopes of selling things to newly flush farmers, the downside of the same commodity boom is apparent to consumers facing a 7.4 per cent rise in food prices over the year to May.

In the supermarkets beef has risen 16.5 per cent, lamb 20.7 per cent and fresh milk 9.3 per cent in the past year.

Parliament's question time on Tuesday saw Labour's deputy leader Annette King brandishing reports of increasing child poverty at the Government.

Thousands of children were going hungry, she said, and charitable organisations were struggling to cope with the demand.

Finance Minster Bill English responded by saying that the average wage had risen 2.5 per cent, after tax and inflation, over the past year.

Benefits have to increase every year at the same rate as prices, he said, and superannuation by at least the same rate and usually more.

Well, what's past is prologue, as the bard said.

Looking ahead what are the economic soothsayers forecasting for wage growth on the one hand and inflation on the other?

The overarching view is upbeat.

Last month's Budget and last week's monetary policy statement from the Reserve Bank are predicated on the conviction that the economy is coming right.

A decent recovery is at hand, allowing the Government to concentrate on the state of its own books and on such structural issues as the appropriate level of government spending as a share of GDP, and allowing the bank to focus on the risk of inflation.

The Treasury forecasts wages to rise by an average 4.1 per cent a year over the next four years or 1.5 per cent a year in real terms.

That is slightly weaker than the 4.4 per cent average increase over the five years to March 2008.

But that was a period when the unemployment rate averaged just 4 per cent, compared with the average 5 per cent the Treasury expects for the next four years.

It has drawn some unreasonable scorn for forecasting a cumulative increase in employment of 173,000 over the five years to March 2015.

In fact the economy added jobs at a faster rate than that for years following both the early 1990s recession and the Asian crisis in the late 1990s.

But the population keeps growing too. Five out of every six of those 170,000 jobs would be required to keep up with projected growth of 143,000 in the labour force over the same period. That would leave only 27,000 jobs to whittle down the ranks of the unemployed, currently 155,000.

The unemployment rate is 6.6 per cent now and has zigzagged around that level for the past 18 months.

However, the Bank of New Zealand's head of research, Stephen Toplis, argues that the labour market is in fact tighter than the headline unemployment rate would suggest.

It was mainly the young who took the hit in 2009 when the number of people employed fell 54,000.

Unemployment among 15 to 19-year-olds is 27.5 per cent and among 20 to 24-year-olds 13.5 per cent.

The unemployment rate among those 25 and over is just 4.6 per cent.

This the age group from which most skilled labour comes, Toplis says. "It is stretched already so we believe the risk of wage inflation is probably higher than the Reserve Bank expects."

This may explain what the Reserve Bank called the surprisingly high proportion of firms reporting difficulty in finding staff in the New Zealand Institute of Economic Research's quarterly survey of business opinion.

Economist Rodney Dickens accuses Governor Alan Bollard of the major responsibility for the boom/bust cycle of the past decade.

A crucial error the bank made, Dickens says, was to take too sanguine a view of how low the unemployment rate can go before it drives inflation relentlessly higher.

Dickens estimates that anything below 5.5 per cent is asking for that sort of trouble. Certainly 4 per cent is.

At this point the short-term indicators are mixed, but generally positive.

The Labour Department monitors job advertisements online. It found a pick-up of 2.3 per cent in total vacancies between February and May and 1.9 per cent rise in skilled vacancies.

But the latter was boosted by strong demand in quake-ravaged Christchurch, where skilled vacancies rose 12.6 per cent especially in the construction and engineering trades, as you would expect.

By contrast skilled vacancies in Auckland were flat (up 0.1 per cent) and slipped 0.4 per cent in Wellington.

Another job ads indicator, compiled by ANZ, which includes newspaper advertisements and is a good fit historically to changes in the unemployment rate suggests, says that "the labour market is slowly recovering and we can expect further falls in the unemployment rate".

And Work and Income New Zealand reports a drop in the number of people drawing the unemployment benefit: 59,000 last month, down 2900 on March.

All in all, there is probably enough promise in those indicators to spare the official forecasts of employment and wage growth from "yeah, right" treatment.

The question is how much of the projected wage growth of 4 per cent will be gobbled up by inflation?

Last week's monetary policy statement forecasts inflation to swiftly fall back to around the middle of the Reserve Bank's 1 to 3 per cent target range, as soon as the increase in GST and other Government policy-related price rises drop out of the annual rate in the December quarter.

But that depends on three key assumptions, none of which is particularly secure.

One is that construction costs - a hotbed of inflation during the mid-2000s construction boom - will not rise as much as they did then once the rebuilding of Christchurch gets under way.

Another is that households will continue to focus on reducing debt, which built up to historically very high levels relative to incomes during the last housing boom. If they do it will keep consumption growth weak and make it hard for firms to pass on higher costs.

And finally the bank is counting on recent increases in inflation expectations proving short-lived.

With inflation about to hit 5 per cent for the second time in three years it is not surprising if confidence that we live in a low-inflation economy is under strain.

That confidence was hard-won and no inflation-targeting central bank can stand by and see it frittered away.

Even with these optimistic assumptions the Reserve Bank has pencilled in a fairly swift "normalisation" of interest rates - rises totalling 2 percentage points by the end of next year, most likely starting before this year is out.

At the moment the high dollar is keeping a lid on imported inflation, while weak demand and a lack of pricing power do the same in those parts of the domestic economy where competition reigns.

But the pressure is mounting.

Households are therefore at risk of the unpleasant combination of sluggish wage growth - always the last cab off the cyclical rank - outstripped by rising prices and rising mortgage rates.

- NZ Herald

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