Falling fuel prices could drive inflation, not ease it, economist warns

Falling oil and fuel prices may not deliver the inflation relief many households and businesses are hoping for, with Bank of New Zealand (BNZ) warning they could instead add to medium-term inflation pressures, keeping upward pressure on interest rates.

BNZ head of research Stephen Toplis said it would be a mistake to assume that lower oil prices would automatically mean lower inflation and the Reserve Bank would not have to raise rates.

"It misses the point that if oil prices fall, it puts money back into the pockets of New Zealanders, which gives them the ability to increase spending," Toplis said. "And that increases domestic demand."

New Zealand was already facing demand-driven inflation pressures before the recent Middle East conflict began, with confidence improving and the Reserve Bank signalling further interest rate hikes, Toplis said.

"If we return to that state of affairs, then there are still inflationary forces at work, particularly if the Reserve Bank leaves monetary policy settings at stimulatory levels," he said.

BNZ pointed to rising consumer confidence as an early sign of that dynamic. The latest ANZ-Roy Morgan Consumer Confidence survey showed a sharp lift following easing fuel prices in May.

The bank noted that in the quarter before the Middle East conflict started, oil prices were lower, confidence was improving, and the Reserve Bank was already signalling interest rate hikes.

BNZ said a similar dynamic could now re-emerge if falling fuel prices help revive confidence and demand.

While cheaper petrol would likely lead to lower near-term inflation, BNZ warned the bigger risk would be medium-term inflation expectations - what the Reserve Bank focuses on when setting monetary policy.

If demand rebounded and became a key driver of inflation, medium-term inflation forecasts could rise, even if headline inflation fell in the short term.

BNZ said markets may be underestimating that risk by focusing too heavily on the immediate impact of lower prices at the pump, noting that lower energy prices did not feature in the Reserve Bank's forecasts in its May Monetary Policy Statement.

Supply-driven inflation would require a more nuanced response by the central bank, but dealing with demand-driven inflation would not, Toplis said.

"The Reserve Bank knows how to deal with demand-driven inflation," he said. "They raise interest rates."

He said the Reserve Bank would want to ensure monetary policy settings were no longer stimulatory before pausing its tightening cycle.

Although the ultimate peak in rates would depend on how global and domestic conditions evolved, Toplis said "three or four rate increases by the end of the year would probably do the trick".