Inflation, interest rates, Covid surprise economists

Economists spend their days pondering what will happen, but last year they were taken by surprise by how strong inflation was, how well the economy withstood Covid and Reserve Bank interest rate hikes.

At the start of 2021, few forecasters predicted the strength of annual consumers price inflation (CPI), ASB economist Nathaniel Keall said in a research note yesterday.

The year began with annual inflation of 1.5 per cent, but by June it hit a nearly 10-year high of 3.3 per cent, rising to 4.9 per cent three months later.

There are signs inflation was at least 6 per cent in the December quarter, Keall said. Stats NZ will release that data on January 27.

‘‘Inflation proved much stronger than even the most hawkish forecasters predicted.

‘‘Inflationary pressures started to rear their head in early 2021, but few forecasters (including us) predicted annual CPI growth would reach the lofty heights its looks to have,’’ Keall said.

Instead of the temporary Coviddriven disruption, supply chain problems were proving hard to solve. It would take significant investment in shipping to restore the flow of goods and raw materials, he said.

Also surprising was the New Zealand economy’s resilience in the face of Covid restrictions.

The June quarter’s 2.8 per cent jump in gross domestic product (GDP) beat economists’ forecasts of up to 1.5 per cent quarterly growth. GDP had been expected to plunge 8 per cent the following quarter after the time spent in alert levels 3 and 4 last year. The quarterly drop of just 3.7 per cent was reason to celebrate despite being the secondlargest decline on record.

Keall said businesses had adapted to the Covid era, and strong household balance sheets meant there were spending splurges when restrictions eased.

Economists got it wrong with the Reserve Bank’s changes to its official cash rate (OCR). At the start of 2021, forecasts had the central bank holding interest rate hikes until mid-2022 or early 2023.

‘‘Market pricing began the year actually pegging further cuts,’’ he said.

In October, the bank raised its benchmark rate, by 25 basis points, after 18 months at the record-low rate of 0.25 per cent. That was followed by another 25-point hike in November, to 0.75 per cent.

Despite the arrival of the Delta variant, pushing the country into level 4 lockdown, the central bank’s hand was forced by job market resilience and inflationary pressures, Keall said.

The market now expects the Reserve Bank to hike the OCR over the year by about 150 basis points, to 2.25 per cent.

‘‘We’re a bit more cautious and think there’s a lesson here around the tendency for markets to overcorrect in response to shifts in tone. While some of those inflation indicators are looking lofty, there are other clouds on the horizon that could yet derail the RBNZ – a dip in house prices being our chief candidate,’’ he said.

This year would throw some curve balls to economists. ‘‘Above all, the golden rule for forecasters is to stay humble, and not to be afraid to shift your view as new information comes to light.’’

Independent economist Benje Patterson said forecasters’ models predicted the future using historical statistical relationships.

‘‘These models work well when we are confronted with a crisis that resembles something we have seen in some shape or form before, for example, a sharemarket crash or a major earthquake.’’

However, those models broke down when confronted with an unfamiliar scenario, such as a pandemic. Forecasters’ static models made fixed behavioural assumptions that did not take into account how resilient people were.

In uncertain times it was better for businesses to scan the environment, read widely, and think about potential scenarios that affected their operations, rather than pin their fortunes on the forecasts of one economist. ‘‘Businesses that are nimble and can adjust their behaviour to unexpected events will be those that are more competitive relative to others.’’