KEY POINTS:
The latest quarterly inflation figures, which are arguably the country's most important economic statistics, sent shivers through financial markets on Tuesday.
This is because Reserve Bank Governor Alan Bollard has been given a nuclear warhead that enables him to scorch the economy if inflation goes above the "1
to 3 per cent target range on average over the medium term".
There are no targets for the current account deficit, for productivity, for unemployment, for immigration, for GDP growth or for any other economic indicator.
The sole focus on the inflation target - which is unique to New Zealand and is a legacy of the Robert Muldoon and Roger Douglas eras - makes the quarterly Consumer Price Index (CPI) announcement particularly important for home owners, businesses and investors.
The good news from the June quarter CPI is that Bollard can justify taking his finger off the nuclear trigger. The bad news is that the inflation figures were bad enough for him to move more slowly than most of us had hoped.
The CPI rose 1.6 per cent in the June quarter and 4.0 per cent on an annual basis. These rises were above Reserve Bank and market consensus forecasts of 1.4 per cent and 3.8 per cent respectively.
The biggest contributors to the 1.6 per cent quarter increase were transport, chiefly petrol, (0.9 per cent); food (0.4 per cent); and housing and household utilities (0.2 per cent).
The latter was primarily because of a sharp hike in electricity charges.
The annual headline inflation rate is now 4.0 per cent, well above the 1 to 3 per cent target range.
But the issue is more complicated than this because the CPI is divided into two main sub-sections, tradeable and non-tradeable inflation.
Tradeable inflation comprises all goods and services in the CPI that are imported or in competition with foreign goods in domestic or foreign markets. Dairy prices are included in tradeable inflation because prices are determined on world markets.
Non-tradeable inflation includes all goods and services that do not include foreign competition, for example government charges.
According to the May 2007 agreement between Finance Minister Michael Cullen and Bollard, the latter has the ability to focus on non-trading inflation when considering the most appropriate rate of inflation and implementing monetary policy.
As the accompanying table shows, there has been a big difference between tradeable and non-tradeable inflation over the past two years.
Annual tradeable inflation was negative a year ago because of the high New Zealand dollar and relatively benign commodity prices. That has changed dramatically in the past year as petrol and dairy prices have risen sharply. Non-tradeable inflation is now well below tradeable inflation and is at its lowest level, on an annualised basis, for a number of years.
The big question is when will Bollard start reducing interest rates. Will it be on Thursday or on September 11, October 23 or December 4, the remaining dates for interest rate announcements this year?
A number of high-profile economists, including Bank of New Zealand chief economist Tony Alexander, want Bollard to keep his finger on the nuclear trigger. Alexander believes that annual inflation will rise to 5 per cent by the September 2008 quarter, and it is only "left-wing economists who want higher inflation".
Inflation is a problem but, unfortunately, we take a strict religious approach to the issue, particularly as we are not facing the hyperinflation experienced by Germany in the early 1920s, Yugoslavia in 1993-94 and Zimbabwe today. These are quoted as examples of the damage caused by high inflation in a recent Reserve Bank publication. It is also incorrect to state, as Alexander does, that New Zealand's sharp drop in the OECD's GDP per capita rankings has been primarily because of our high inflation in the 1970s.
Fortunately, Bollard has to adopt a rational approach and in doing so he will take into consideration two major issues, namely the influence of imported or tradeable inflation and the state of the domestic economy.
Imported or tradeable inflation is difficult to forecast because it is heavily dependent on commodity prices, particularly petrol.
Assuming the petrol prices either stabilise or ease, then tradeable inflation should peak in the current quarter and ease after that.
The outlook for domestic, or non-tradeable inflation, is highly dependent on consumer spending and the state of the economy.
The June quarter CPI figure showed early signs of the economic downturn, with electrical goods, recreational equipment and motor vehicle prices all falling.
Economic activity has deteriorated since the June quarter CPI data was collected in mid-May, with many listed retailers reporting extremely depressed trading conditions over the past six to seven weeks. This should help keep a lid on non-tradeable inflation.
If the Reserve Bank maintains its hawkish monetary stance next Thursday, and through to the end of the year, the New Zealand economy could fall into a deep recession with inflation being a minor problem in 2009.
But is this what we want? Do we want Bollard to crush inflation, much of which is imported, at the expense of businesses, jobs and the overall wellbeing of the economy?
Most business people and investors believe that the clear answer to this question is no.
The Reserve Bank started raising interest rates in January 2004, and since then the overnight cash rate (OCR) has increased from 5.0 per cent to 8.25 per cent.
Given the state of the economy, there is a strong argument that interest rates should be cut three times - each time by 0.25 per cent - before the end of the year, starting next Thursday. The OCR would then be 7.5 per cent by the end of the year and another two cuts in the first half of 2009 would bring it down to 7.0 per cent.
There is a precedent for this as the Reserve Bank cut the OCR on three successive occasions in the first half of 2001 and had two further cuts in the second half of the year.
New Zealand's current OCR of 8.25 per cent compares with 7.25 per cent in Australia and 2.25 per cent in the United States. Headline inflation in the three countries is 4.0 per cent, 4.2 per cent and 5.0 per cent respectively.
New Zealand's inflation rate is below the OECD average, yet our interest rates are amongst the highest in the 30-country group.
The expected drop in interest rates will not be a quick fix for the economy but it could help start a slow recovery process. Reserve Bank interest-rate cuts are not an instant solution because a large number of fixed-term mortgage borrowers will have to roll over to higher interest rates over the next few months, and the banks will be slow to cut their rates because of high borrowing costs.
Unfortunately there is no quick fix for a credit fuelled economic expansion, but a meaningful reduction in interest rates over the next six to 12 months will take some pressure off beleaguered households and shouldn't stimulate inflation, particularly the domestic or non-tradeable component.
Disclosure of interest: Brian Gaynor is an executive director of Milford Asset Management.
