Missed targets — do they matter?

There’s little sign that NZ is drifting into deflation

The Reserve Bank has some explaining to do. The annual inflation rate has fallen to 0.2 per cent. It has been below the bottom of the bank’s 1 to 3 per cent target band for two straight years now.

And apart from the spike from the 2010 GST increase, it has been below the mid-point of the band, on which monetary policy is supposed to focus, for six-and-a-half years.

No wonder the bank frets that inflation expectations will get into a self-fulfilling decline.

But while the bank’s critics see this track record as prima facie evidence that it has run policy too tight, it does have a case to make in its defence.

Its assistant governor and chief economist, John McDermott, put the case in a recent speech.

First, we need to remember that nearly half of the consumers price index, weighted by what the average household spends money on, consists of tradables — goods whose prices are influenced by international competition.

And the rest of the world has been a disinflationary influence for more than four years now, reflecting such factors as industrial overcapacity and weakness in commodity markets.

In the year ended September, tradables inflation was minus 2.1 per cent, which offset almost all of the 2.1 per cent rise in domestic or nontradables prices.

True, tradables prices are also affected by currency movements, but exchange rates depend more on what is happening in the economies of New Zealand’s trading partners, than anything in the Reserve Bank’s control.

It is easy when you live in New Zealand to underestimate how much impact the other 99.8 per cent of the world has on us.

The recovery from the global financial crisis has been pretty weak and has depended on extraordinarily loose monetary policy. We experience the effects of that in low import prices and a high kiwi dollar.

Over the past 10 years, the cumulative rise in non-tradables prices has been around 35 per cent; in tradables prices, just 5 per cent.

As far as non-tradables prices are concerned, McDermott says a key structural development which has led to persistent weakness in inflation has been stronger growth in New Zealand’s potential output. That is, growth in the supply side of the economy.

That determines how much demand the economy can handle on a sustained basis before spare capacity is taken up and inflationary bottlenecks become problematic.

Back in the first half of the 2000s, the bank estimated potential growth to be around 3.5 per cent. By the depths of the recession in 2009 it had fallen to around 1.25 per cent but since then it has recovered, the bank reckons, to around 2.5 per cent.

The potential growth rate boils down to growth in the labour supply and in labour productivity.

Productivity growth is nothing to write home about; the increase in potential in recent years has largely been about high net immigration boosting the labour supply.

Immigration also boosts the demand side of the economy, and in previous cycles that effect has been larger and sooner than the boost to supply.

But this time, the Reserve Bank reckons, is different.

One reason is the age composition of the net inflow of migrants.

In the latest cycle a much higher proportion — in fact a majority — are younger, aged 15 to 29.

They tend to have a more muted impact on domestic demand compared to people in their 30s or 40s, McDermott said.

The other factor is that higher net immigration — remember, this includes the coming and going of New Zealanders — which is driven by a weaker Australian economy, tends to result in a higher unemployment rate, all else being equal, while inward migration driven by other factors has the opposite effect.

“People who move to New Zealand because their job prospects in Australia have deteriorated are likely to spend less once here,” McDermott said.

After seven years of a negative output gap — the difference between potential and actual growth — the bank reckons it has now crossed into positive territory and will put upward pressure on inflation.

But it does not expect to see 2 per cent inflation again until the second half of 2018.

On the non-tradables side, it is not just the output gap and prices set by businesses that matter. Statistics New Zealand says that excluding central and local government charges, inflation in the September year would have been 0.4 per cent, not the 0.2 per cent the overall CPI recorded.

The big downward influence there was in ACC motor vehicle levies. Together with lower petrol prices,

that has seen transport costs, which make up 15 per cent of the CPI, fall 6.7 per cent over the year.

On the other hand, political decisions push up tobacco and local body rates, which together make up 5.5 per cent of the CPI.

The Reserve Bank expects the annual inflation rate to jump to 1 per cent when the December quarter numbers are released in the new year.

Not because it thinks inflation is running hot, but because the weak December 2015 quarter, when the CPI fell 0.5 per cent, will move from the current year’s tally to the prior year.

If it is right, that should help to stabilise inflation expectations, which have been trending lower, influenced by the string of low inflation outcomes.

In ANZ’s business outlook survey, firms’ expectations for inflation over the year ahead, which were running around 2.5 per cent back in 2014, have been below 1.5 per cent this year. To be fair, that has still generally been higher than the Reserve Bank’s own forecasts for inflation a year ahead.

But reassuringly for a central bank whose stock in trade is credibility, longer-term expectations, as captured by Consensus Economics, are more securely anchored to the 2 per cent target.

So the risk that the country is drifting across some imperceptible event horizon around a black hole of deflation seems negligible.