Inflation gets a haircut
01 April, 2016
Former baseball player Sam Ewing once said "Inflation is when you pay fifteen dollars for the ten dollar haircut you used to get for five dollars when you had hair." Many of our investors, regardless of how much hair they have, will know that inflation has been trending downwards for a long time and inflation rates now sit just above or below zero in many countries, including New Zealand. Expectations about future inflation have also fallen.
Managing inflation is a tricky task for central banks. There is a "Goldilocks" level — not too high and not too low as either can be harmful — but that level is not defined, it can change, and it depends on inflation expectations.
The Reserve Bank of New Zealand's March Bulletin concluded that low inflation expectations are "contributing to the current need for low interest rate settings". This suggests that investors should get used to low term deposit rates for a while to come. The paper also hinted that low interest rates themselves may help keep inflation expectations low. This seems to point to a virtuous circle — as long as inflation expectations remain low, interest rates will follow suit, making it hard for savers to achieve decent returns.
In contrast, officials of the U.S. Federal Reserve think inflation expectations are now too low. They believe that inflation will be higher than the public and markets expect, and are preparing to raise interest rates over the next year or two.
The one similarity between the two central banks is that both consider the impact of a low oil price on inflation will be temporary. Time will tell whether they are correct in their assumptions and which of the two approaches — raising interest rates to manage inflation or lowering interest rates to manage inflation expectations — proves most successful.
One thing is certain — inflation will continue to be the most followed, most discussed, and most challenging economic metric for markets to consider in the year ahead.