The highest inflation in a generation over the past year has caused great pain for households and policymakers alike. The recent release of the March 2023 quarter Consumers Price Index (CPI) showed a moderation in the headline inflation rate to 6.7%pa, the slowest increase in over a year. However, a rate of 6.7%pa, compared to a target of 1-3%pa, suggests that although inflation is beginning to decelerate, it is not yet under control.

Our analysis shows that overseas-based inflationary pressures have moderated, which drove the headline rate lower. However, concerns remain for domestically-based inflation, particularly given recent analysis showing that New Zealand inflation is still been driven by demand-side pressures. We have also calculated the broad dollar cost of inflation to the average household, to turn intangible percentages into more tangible costs to households.

Consumer prices rose 1.2% from the December 2022 quarter, the smallest quarterly increase since the beginning of 2021, bringing headline annual inflation down to 6.7%pa. This result was considerably lower than anticipated, with a market expectation of 7.1%pa, the Infometrics pick of 7.2%pa, and the Reserve Bank’s forecast of 7.3%pa.

A decline in fuel prices helped to drive down inflation, with the cost of petrol down 8.3%pa. Airfares have fallen recently, with domestic and international airfares declining 3.7% and 4.3% respectively from the December 2022 quarter. Household utility costs are continuing to rise, but the pace of price rises did at least ease from 7.6%pa in March last year to 4.1%pa in the March 2023 quarter. This softening in the pace of price rises is especially welcome news for households given the 11%pa increase in food costs this March quarter. This result is the highest annual inflation rate for food on record.

The tradables component, which reflects price changes from imported products, slowed to 6.4%pa, having been at 8.5%pa in March last year (see Chart 1). However, non-tradable (domestic) inflation rose to from 6.0%pa in March last year to 6.8%pa. This rate is the fastest domestic-focused inflation rate on record. Non-tradable inflation is now more rapid than tradable inflation for the first time since March 2021, illustrating how items whose prices are driven by conditions overseas are moderating more quickly than domestic based inflation.

As we noted in our analysis at the time of the release, several core measures of inflation are showing improved signs of price increases decelerating. The ‘All groups less food, household energy, and vehicle fuels’ inflation measure showed a 0.9% increase in the March 2023 quarter, the slowest since the March 2021 quarter. The number of items rising in price pulled back from 72% last quarter (the second highest on record) to just under 63%. The goods component of inflation has eased to 7.0%pa, from 8.7%pa in March 2022.

Inflation across all levels of trim (where the more volatile price changes are stripped out to provide a better read on core inflation) slowed back further in the March 2023 quarter. The 30% trim measure showed a 1.1% quarterly increase, the smallest rise since mid-2021. The weighted median inflation rate was 1.1% in the March quarter, higher than in December but broadly in line with the weighted median over the last year or so. Taken together, these core measures show that underlying inflation has stopped accelerating to an even faster pace. But the core measures also show too much pressure in the system. Annualising those core measures would produce annual inflation of above 4.4%pa, and there’s likely still further large increases to come in 2023.

The government recently confirmed, again, that it would end the fuel tax subsidy at the end of June 2023. This time, we believe them, given the teaser that the government will also introduce more targeted support at the Budget. That end to the subsidy will add around another 0.5 percentage points to inflation in the September quarter. Higher inputs costs are also set to see local government rates rise substantially in the September quarter too. All of these factors reinforce that the recent moderation in headline inflation is positive news, but that there are still concerns around the persistence of inflation and the pathway down from here. The moderation does also affirm that the peak of the Reserve Bank’s tightening cycle is not too far away. We remain concerned that the largest downward driver on inflation came from fuel, the price of which is volatile and could rise in the near-term if global conditions warrant it, even as non-tradeable cost increases in construction, rents, and food prices decelerate much more slowly.

Debate has continued to rage over what has caused the high inflation environment that we are currently enduring. Recent analysis by Treasury staff has provided a more data-driven answer, finding that inflation has been driven by both demand- and supply- side factors. This analysis by Treasury staff found that although supply-side factors made a larger contribution to inflation over the second half of 2021, driven by supply-chain bottlenecks and labour shortages, both supply and demand have made roughly equal contributions over 2022.

Adverse weather, labour shortages, and strong wage pressures are continuing to weigh on supply-side inflation, even as worldwide supply constrains recover substantially from the pandemic. Food inflation, which has been the key driver of New Zealand’s rising prices in recent quarters, will likely remain elevated for the next few months as a result of supply constraints caused by Cyclone Gabrielle. However, the Cyclone effects are expected to be temporary.

More interesting is the level of demand-side pressure on prices. Demand pressure has increased over the last two years, particularly in the services sector, as the easing of pandemic restrictions allowed households to diversify their spending away from only goods. Services inflation is in fact continuing to rise, reaching 6.1%pa in the March quarter compared to 4.1%pa in March last year.

The level of demand-driven inflation is challenging. Similar analysis of US and Australian inflation data shows that 60-66% of explained inflation is driven by supply factors, compared to 50% in New Zealand. The results highlight the importance of demand in keeping inflation at a persistently higher level.

Although demand-side pressures have been more persistent than supply-side, recent retail data suggests that sales volumes are beginning to turn around, and we expect consumer demand to ease further as the delayed effect of interest rate hikes take hold. Our latest forecasts indicate that household spending growth will decelerate over the year and dip negative, briefly, in the December 2023 quarter, as monetary tightening reaches its peak.

The double pronged hit of high inflation and high interest rates is massively squeezing household budgets. Unfortunately, these issues reinforce each other – in the short term – in the sense that persistently high inflation requires persistently high interest rates to subdue.

Even with headline inflation in the March 2023 softer than expected, the burden that these cost increases place on households remains huge. Infometrics analysis shows that inflation is now costing households an additional $5,100 a year on average compared to March last year. Average annual household spending on food has increased by $1,000.

In addition, rising mortgage rates mean that the median annual house repayment for a home bought in March 2022 has lifted by $12,900pa. Data from Centrix Credit Bureau suggests that the proportion of consumer accounts in arrears reached 11.5% in February 2023, the highest share since 2019. A substantial enough increase to debt-servicing costs such that households change their spending behaviour is an inherent and unfortunate part of the inflation battle. It’s also exactly this change in spending behaviour that will arrest the demand drivers of inflation.

The latest inflation release tells us that the Reserve Bank’s tighter monetary settings are starting to have the desired effect, but it is not yet clear whether enough has been done. Given that annual inflation remains more than double the target rate of 1-3%pa, and that non-tradable inflation is yet to abate, there is still considerable work to do until the Bank can lay down its sword. Although retail interest rates, and the OCR, are likely close to a peak, we don’t see the Reserve Bank wanting to move quickly to cut rates before its abundantly clear that inflation is back under control.