Inside Economics: Goodbye inflation, hello deflation (already?!)

What do the terms “soft” and “hard landing” actually mean?

(T. Wood)

A: I'm glad you mentioned the US because that's where the debate is still going on. New Zealand has had a hard landing because when economists talk about hard and soft landings, they mean, in simple terms, a recession.

Specifically, it is about whether policy makers will succeed in reducing inflation by raising interest rates without plunging the economy into recession.

No recession = soft landing. Recession = hard landing.

In his eagerly awaited speech to central bankers in Jackson Hole last weekend, Federal Reserve Chairman Jerome Powell almost declared victory in the fight against inflation.

“It is time to adjust policy,” Powell said during the Kansas City Fed's annual meeting in Wyoming. “The direction is clear, and the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the allocation of risks.”

You can't say it more clearly from a central banker outside of an interest rate decision. The US will soon begin cutting interest rates, and the first cut will come at the next Fed meeting on September 18th.

The markets were pleased and recovered immediately, but the news that the battle against inflation had been won (at least for this cycle) meant that the focus in Jackson Hole immediately shifted to the question of whether or not the US could achieve a soft landing.

So far, the US economy has proven extremely resilient to rising interest rates, and a soft landing is in sight.

It would be a rare achievement to avoid a recession at this stage of the cycle. The United States has only managed to do so once, twice, or maybe even three times.

This should give you an idea of ​​how widely this concept is being discussed. As a reminder, candidates for a soft landing are the 1965-67, 1984-87 and 1994 cycles.

From Jackson Hole, the Financial Times notes that there is a lot of optimism about the outlook this time around.

“Bank of England Governor Andrew Bailey and his Fed counterpart Jay Powell pushed back against fears that growth would have to be sacrificed to meet their inflation targets. As they began to cut borrowing costs, both men signaled they were still on track to avoid a recession. Economists in the audience echoed their optimism.”

That gives hope. When it comes to US cycles, Wall Street has a lot of power. Usually, it's big stock market crashes that derail efforts at soft landings. That seemed to be the case a few weeks ago when the Fed failed to push through a rate cut for August and Wall Street threw a tantrum.

But investors seem to have calmed down for now. Call me superstitious, but I always get a little nervous as we head into autumn (or fall, as it's called) in the US.

The Wall Street Crash of 1929 and Black Monday of 1987 both occurred in October. The global financial crisis of 2008 peaked in September and October.

Local landing

It would be an exaggeration by any measure to say that New Zealand has achieved a soft landing. The economy has slipped into recession twice since the Reserve Bank began raising interest rates and is probably currently in a third recession (based on the Bank's own forecasts).

In addition, GDP per capita has been declining for two years.

But compared to the economic cycles of the past decades, the landing was not (yet) particularly hard.

Recessions so far have been superficial (albeit supported by high net migration). Unemployment is still below 5%, which is a historic low. And despite some grim headlines and high-profile corporate bankruptcies, loan delinquencies, mortgage sales and corporate liquidations remain much lower than during the global financial crisis and the years since.

The question now is how bad the situation will get before the favorable wind in the form of lower interest rates prevails.

Much will depend on sentiment and how much optimism lower interest rates trigger among consumers and businesses.

We get the ANZ business outlook and consumer confidence numbers on Thursday and Friday this week.

Nick Tuffley, chief economist at ASB, expects the main reaction to be relief.

“Informal sentiment surveys (i.e. conversations with people) suggest that there is a general mood of relief, although there is understandably less joy among savers,” he wrote on Monday.

“Households, which will bear the brunt of higher debt service costs on $360 billion of debt, or 65 percent of all private sector debt, will feel a weight lifted from their shoulders. The good news is that we believe the effective mortgage rate has now peaked.”

Tuffley notes that there will still be some homeowners who cancel their low fixed rates and take a hit, but that number should gradually decline in favor of those who cancel shorter terms and take advantage of the new lower rates.

“The more popular fixed-rate contracts with a term of up to two years are now at their lowest levels since October-November 2022,” he says.

Deflation shock (what, again?)

The gloomiest analysis I have seen so far comes from economists at UBS, who warn that the Reserve Bank (RBNZ) is already in danger of overshooting its targets and must worry about deflation if it does not cut interest rates quickly.

This assessment by the Sydney-based economists was based on retail data released on Friday. And it was pretty bleak.

Seasonally adjusted retail sales fell 1.2 per cent in the June quarter compared with the March quarter. This was the eighth consecutive quarter of decline, according to Stats NZ, reflecting the continued cost of living pressures on customers.

“The last time we saw multiple quarters of continuous declines was between 2007 and 2009, which coincided with the global financial crisis,” said Ricky Ho, manager of economic finance statistics at Stats NZ.

Eleven of the 15 industries reported lower sales in June compared to March of the quarter.

This highlighted “a further significant deterioration in the pricing power of New Zealand retailers in [the second quarter]”, UBS wrote in its commentary.

“The change in the retail price deflator was negative and amounted to -0.1%. [in the second quarter]a further slowdown of +0.1% [in the first quarter] and +0.4% [in the last quarter of 2023].”

In other words, the situation was not only disinflationary, but deflationary!

“In contrast to the consumer price index, this dataset is seasonally adjusted. It therefore implies that retail prices have increased by [approx] -0.3%,” said UBS.

Remember deflation? We were worried about that before the pandemic, when inflation was so low that the economy was in constant danger of stalling. Back then, the Reserve Bank was considering whether it could cut interest rates below 0% if necessary.

If the retail deflator remains stagnant or even negative, New Zealand's consumer price index (CPI) is likely to fall below 2 percent in the final quarter of this year, UBS said.

The current forecast for the fourth quarter is 2.1%, while the RBNZ expects 2.3%.

“If the consumer price index falls below the RBNZ’s target average of 2 percent, New Zealand would be a global outlier,” UBS said.

And if that were to happen, the RBNZ would have to start cutting interest rates in 50 basis point increments.

For clarification, UBS’s base case assumes that the RBNZ cuts the OCR in a “relatively rapid” series of consecutive cuts of 25 basis points each, from 5.25% to 3% by the end of 2025.

Bonds

Q: What I still don't understand is government bonds. Who buys them? Are they international banks? How are they repaid? Does the government sell them? And what if nobody wants them? Is it basically a contract that says, “You give us money and we promise to pay it back at this interest rate”? Are they really just paper?

M. Heide

A: All good questions. Broadly speaking, yes, buyers are international banks and large pension funds. Most people probably have some bonds in their KiwiSaver account, depending on how aggressive their settings are.

The idea is that sovereign governments provide a very stable economic platform on which they can generate investment returns and which they can use to borrow relatively cheaply.

Of course, this is not always the case. Countries with an unstable political environment are significantly riskier for investors.

But countries like New Zealand can in principle sell bonds to raise money. For investors, the payout is a guaranteed return, insulated from the ups and downs of the stock market. The downside is that returns are generally lower than those from investing in the stock market.

The Treasury Department has a debt management agency that places the bonds on the market. They are bought by registered “primary dealers” who then sell them in secondary bond markets.

The primary dealers are the institutional arms of all major banks operating in New Zealand. According to the Treasury website, the primary dealers currently registered are: ANZ, BNZ, Westpac, CBA (the parent company of ASB), JP Morgan Australia, UBS Australia and Citigroup Global Markets.

They bid on the bonds issued, thereby setting their price. If no one wants them, the price goes down. However, if the government really can't find buyers for all of its bonds, it generally means the economy is in trouble and will likely have to offer higher interest rates.

This is one of the reasons why we are so concerned about our international creditworthiness.

Occasionally, the Treasury fails to sell off all the bonds it has issued. This has happened more frequently in recent years as the government issued more bonds to cover spending during the Covid era.

After all, bonds are now electronic, but they used to be paper certificates. In fact, British bonds used to have elaborate gold leaf edges, which is why you sometimes hear bonds referred to as gilts.

Liam Dann is business editor of New Zealand Herald. He is an experienced author and columnist and also presents and produces videos and podcasts. He joined the Herald in 2003. To subscribe to his weekly newsletter, click on your user profile under nzherald.co.nz and select “My Newsletters”. For step-by-step instructions, see Click hereIf you have a burning question about the idiosyncrasies or intricacies of economics, send it to [email protected] or leave a message in the comments section.