The Reserve Bank may be fixated on stubborn non-tradeable inflation but its monetary policy is unlikely to be able to get it down to 2% which may not be the optimal level anyway, BNZ Head of Research Stephen Toplis says.
Toplis makes these comments in a note on Tuesday morning's speech from Reserve Bank Chief Economist and Monetary Policy Committee member Paul Conway, the first public comments from a senior Reserve Bank figure this year.
Conway notes non-tradeable annual inflation, relating to inflation from domestic goods and services, in the December Consumers Price Index (CPI) weighed in at 5.9%, above the Reserve Bank's 5.7% expectation. In contrast tradeable inflation, which includes imported goods such as petrol, dropped to 3% from 4.7% as overall annual CPI inflation fell to 4.7%.
“To sum up, monetary policy is working, with the economy slowing and inflation falling. But we still have a way to go to get inflation back to the target midpoint [of 2%],” Conway said, reiterating the central bank's hawkish monetary policy bias.
The Reserve Bank's mandate is to; "achieve and maintain future annual inflation between 1% and 3% over the medium-term, with a focus on keeping future inflation near the 2% mid-point."
'Fixation with non-tradeable inflation'
Toplis reiterates his biggest concern is the Reserve Bank's "apparent fixation" with non-tradeable inflation.
"This was reinforced by Conway’s comment that 'non-tradables inflation is a long way from 2.0%.' It certainly is, at 5.9%, but non-tradables inflation is almost always higher than 2.0%. Since 2000 non-tradables inflation has averaged 3.3%. In the 95 quarters across this period annual non-tradables inflation has been 2.0% or below just six times. Four of those six quarters ended up sub 2.0% because of a big reduction in ACC levies that 'artificially' depressed the reading by around 0.6%," says Toplis.
"Given what is currently driving non-tradables inflation, it is highly unlikely monetary policy will be able to get it anywhere near 2.0% in the foreseeable future. In the last 12 months major contributions have come from: cigarettes and tobacco +11.5%, property rates and related services 9.6%, household energy +5.9%, out-patient services 5.8%, hospital services 12.9%, education 4.4% and insurance 11.9%."
"The Reserve Bank contests that its modelling shows non-tradables inflation is interest sensitive. This may well have been the case in the past but a significant proportion of today’s inflationary pressure will not be so. A substantial proportion of current non-tradables inflation can be attributed to four factors, which are in some cases inter-related: local and central government charges, the country’s infrastructure deficit, the impact of climate change and, increased insurance claims for natural disasters," says Toplis.
He goes on to say the other factor is population growth and its impact on housing and local government costs.
"The Reserve Bank’s actions can do little in this space but act as a barrier to second-round effects."
Although the Reserve Bank can warn government about its policy impacts on inflation it can’t direct policy.
"Monetary policy will not quickly address global warming issues - It won’t improve the weather. It won’t fix Wellington, or anyone else’s, water problems. It won’t curtail population growth," Toplis adds.
In an Of Interest podcast episode in December Toplis argued the Reserve Bank affects tradeable inflation more than it acknowledges, and a lot of the pressure on non-tradeable inflation comes from factors the Reserve Bank can do nothing about. (Listen from 14.55 minutes).
Toplis made similar comments in his CPI preview earlier this month.
'Simply be less dogmatic about getting inflation to the midpoint of the target band'
In Tuesday's note Toplis goes on to question the Reserve Bank's desire to get inflation to the mid-point of its 1% to 3% target band.
"In the recent past our get out of gaol free card has been that we have operated in a world where disinflationary pressures dominated in the tradables’ goods prices space. Tradables inflation over the last two decades has averaged 1.2%. The problem is, and Conway highlighted this, that those things that drove tradables inflation lower are now in reverse."
"The [Reserve] Bank’s view is that this means non-tradables will need to play a bigger role in getting headline inflation down. But given the headwinds to this over the next few years, we would like to think that a better approach would be to simply be less dogmatic about getting inflation to the midpoint of the target band. Alan Bollard, when he was central bank governor was much more relaxed about using the full width of the band. This didn’t seem to cause too much problem," says Toplis.
"And, anyway, even were we to be dogmatic about targeting a mid-point, we have yet to hear a good argument as to why we should be confident that 2.0% is the optimal number. As a point of contrast, if inflation was forecast to be 2.25% in both New Zealand and Australia the Reserve Bank of New Zealand would be running tight monetary policy and the Reserve Bank of Australia loose. Which [central] bank would be right?"
"All that said, it doesn’t really matter what we think about the appropriateness or otherwise of monetary policy settings. The best that we can do is read the Reserve Bank’s tea leaves and try to work out what it is going to do. With this in mind, and based on current information, it would seem to us that the [Reserve] Bank’s economics team will be strongly advising the Monetary Policy Committee, when it discusses its February Monetary Policy Statement, that it should maintain a very similar stance to that which it published when it produced its November instalment. That means limited inclination to cut rates until the second half of 2025 with an even to greater-than-even possibility of a further rate hike. This is a clear warning to financial markets that their pricing of at least three rate cuts this year is inappropriate," adds Toplis.
"Interestingly, financial markets completely ignored that warning today with pricing much the same after the speech as before. Hopefully, this does not act as a red rag to the Reserve Bank bull and tip the Bank into action just to make a point. This certainly cannot be ruled out. Indeed, while we are forecasting the Reserve Bank to stand pat in February you’d have to say that the chances of a hike are much greater than the zero chance of a February [Official Cash Rate] cut."
*Also see the latest Of Interest podcast with Kiwibank Chief Economist Jarrod Kerr including his views on how much the Reserve Bank can influence non-tradeable inflation, and whether its mandate may need changing.
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