Are there more inflationary headwinds in 2025?

Inflation spurred the “cost-of-living crisis” during 2022 and 2023. The pressure on household budgets from higher prices was exacerbated by the Reserve Bank’s necessary response of much higher interest rates, which dragged spending lower throughout 2023 and much of 2024. With inflation now under control and steady near the mid-point of the Reserve Bank’s 1-3%pa target range, and interest rates trending downwards, it feels like the economy is slowly turning. But are there new inflationary headwinds we need to watch out for?

In this article we look at how and why exchange rates have shifted over the past few months, the potential effects for tradable inflation, the role that higher oil prices could play, and what the Reserve Bank will be paying attention to over 2025.

The US dollar has strengthened against most major currencies over the last 4-5 months, as the world’s largest economy continues to show strength through job creation. The NZ dollar current sits at around US56c, down from as high as US64c at the end of September 2024 (see Chart 1).

Looking at the NZ dollar against other currencies, it’s clear that much of the apparent weakness is better viewed as a story of a strong US dollar. Chart 2 shows the AUD/NZD exchange rate has been largely stable, hovering around A90-91c in late 2024 and early 2025. NZ-dollar declines against the pound, yen and euro since the end of September have also only been between 4% and 5%, as opposed to the much larger 11% fall in the exchange rate against the greenback.

The US has been increasingly important to the NZ economy in recent years, becoming our second largest trading partner. With a lot of international trade also priced in US dollars, the strength of the greenback is critical for trade outcomes. Although a weaker NZ dollar is positive for export earnings, importers are forced to pay more in NZ dollar terms to acquire the same quantity of goods. Thus, recent exchange rate movements will result in higher costs of goods for importers, but to what extent are those costs passed on to the end consumer?

Research from the Reserve Bank shows that a downward shock to the exchange rate passes through to an increase in tradables prices. With tradables making up about 40% of the Consumers Price Index, exchange rate shocks are important for New Zealand’s inflation outlook.

There is little NZ-specific research measuring how much of a percentage change in the exchange rate is passed through to the end consumer, because it is likely to vary by good, and so the answer is not straightforward. But other Reserve Bank research shows that the change in tradable prices following an exchange rate movement is likely to be smaller than the change in the exchange rate, because New Zealand tradable goods prices have a large distribution cost component. In other words, the cost of purchasing the good internationally, which is directly influenced by the exchange rate, is only a portion of the cost to the end consumer.

Expanding upon the importance of distribution costs in tradable goods prices in New Zealand, another key factor in current potential inflation risks are oil prices. Oil prices have ticked higher in recent months, driven by trade policy and exchange rate movements – in a recent article we took a closer look at why prices at the pump have pushed up.

The importance of oil in the production of goods, along with the transportation of goods from the supplier to the consumer, drives prices of goods higher when oil prices rise. However, the inflationary relationship is slightly more nuanced when you consider the counteracting influence of reduced demand-side price pressures, because consumers have less money for discretionary spending when they face higher fuel costs.

As vehicles have become more fuel efficient and electric vehicles have become an important part of our national fleet, the effects of higher fuel prices on reductions in discretionary spending are likely to be less pronounced. For example, the international oil price surge of 2007/08 caused a 30% increase in petrol prices over the year to September 2008, and corresponded with a 2.8% fall in core retail sales volumes. A larger fuel price shock in 2022 saw a 32.5% increase in petrol prices over the year to June 2022, but it corresponded with a more muted fall in core retail sales volumes of 1.8%pa. Other economic factors will also have influenced the different retail spending outcomes in 2008 and 2022, but the negative effects on aggregate demand from higher fuel prices appear to be less acute now than they were 15-25 years ago.

With renewed inflationary risks appearing, consumers and businesses have expressed slight concerns about future costs and pricing. ANZ’s Business Outlook survey showed businesses’ expected inflation rate in 12 months’ time has ticked back up from 2.5% to 2.7%pa over the last two months (see Chart 3).

Rising inflation expectations could be related to the weakness of the NZ dollar. Reserve Bank research shows that the price response to an exchange rate shock is lagged, and it typically occurs a year after the initial exchange rate movement, which aligns with the timing of the rise in future inflation expectations.

It’s important to note that although inflation expectations have ticked up, they remain within the Reserve Bank’s target band of 1-3%pa. However, with trade tensions and geopolitical risks rising, the Bank will need to keep a close eye on developments over 2025.

The Reserve Bank has an important official cash rate decision on 19 February, and although some analysts are pushing for a 75 basis point cut given the weakness of the labour market, market sentiment has settled on a 50-point cut. We retain our view that the Bank will stick with the 50-point cut it signalled following November’s Monetary Policy Statement, which would bring the official cash rate down to 3.75%, its lowest level since November 2022.

Nevertheless, the Bank’s consideration of future inflation pressures will be a key factor to watch at next week’s Statement. That focus will be particularly important given the Bank had already been forecasting a blip up in inflation to 2.5%pa in the second half of this year, before many of the fresh inflation risks had really started to materialise. The Bank’s reaction to recent inflationary developments will be important in determining how many further interest rate cuts could take place at future monetary policy reviews later this year.