Is inflation dead?
In a recent economic speech on the 12th of July, The Reserve Bank of New Zealand expressed they were ’’perplexed’’ by the low inflation numbers undershooting expectations in the last six years, and that ‘‘short term inflation expectations remain low’’.
The previous inflation data printed below the RBNZ’s target of 2 per cent per year at 0.4 per cent for the quarter (1.6 per cent annualised). It is notable that on a long-term basis, inflation may have bottomed out and looks to be heading higher.
But there is a growing difference in perception versus reality between what most households across the country are experiencing and the inflation data being reported.
This difference between what is being experienced in the real world versus central bank models can primarily be attributed to the changes in how the consumer price index (CPI) is calculated.
Measurement of consumer inflation traditionally reflected assessing the cost of maintaining a constant standard of living, as measured by a fixed-basket of goods and services, as well as measuring that cost of living in terms of out-of-pocket expenses.
The changing costs of maintaining a constant standard of living were measured by pricing out a fixed-basket of goods and services—same components, same weighting—period after period.
Whatever the percentage change in the cost of that basket, that is how much income would have to rise in order for someone to maintain a fixed- or constantstandard of living over the given period.
Maintaining a constant standard of living means being able to consume the same goods in the same quantity, without having to trade-off your living quality. A practical example of this is being able to buy fuel for your car, without having to cut back on food quality.
We have since moved to a more substitution based model in calculating CPI where weightings are far more frequently changed. Some observers note that the current models also do not accurately account for changes in housing costs experienced by those who own or rent.
The public has relied on CPI as an important component of their financial decision making. Planning appropriately for retirement, targeting returns that stay ahead of inflation, and ensuring wages or income growth keeps pace.
In hindsight, perhaps confining the estimate of price inflation to selected goods and services may be a myopic mistake and may be in need of review in terms of total inflation movements both in asset and consumer prices.
The Reserve Bank, as with many other central banks around the world, may run the risk that they have made so many changes to their traditional models that it may be producing a less accurate reading of the economic reality.
As a result their monetary policies may be ineffective or have unintended consequences, resulting in the booms and busts we have seen with growing frequency over the last few decades.
In the meantime, as the current economic conditions continue, the strategic priority of the RBNZ is to increase its understanding of low inflation, in order to ensure financial stability, which is one of their core responsibilities as an organisation.