By Rodney Dickens*
"By increasing the OCR as needed to keep future average inflation near the 2 percent target mid-point, the Bank is seeking to ensure that the economic expansion can be sustained."
Governor Wheeler is tasked with keeping annual CPI inflation within a 1-3% target range on average over the medium-term.
He plans to target the mid-point of this range; hence the reference to 2% in the sentence quoted above from the March Monetary Policy Statement.
The CPI measures the prices of the broad range of goods and services consumers buy.
For those interested the appendix shows the main spending categories included in the CPI.
It is useful to consider separately two groups of goods and services in the CPI that are termed "tradable" and "non-tradable".
Tradable refers to internationally traded goods and services for which the local prices are impacted by international prices and the exchange rate.
This includes imported goods and services, and exported goods and services that are also consumed locally (e.g. dairy products, lamb chops, etc.).
Non-tradable refers to goods and services that are largely produced and consumed locally, which means local demand-supply conditions determine prices.
The tradable and non-tradable components make up around half of the CPI each.
The top chart shows annual inflation in these two components and the Reserve Bank's March predictions for both. I will come back to the fact that non-tradable inflation is already 3% and predicted by the Reserve Bank to reach 4% in 2015 (green line in top chart).
The exchange rate plays a major part in driving the extreme volatility in tradable inflation shown in the top chart.
The TWI measures the behaviour of the NZD relative to the currencies of most of NZ's major trading partners.
The second chart shows that when the TWI increases it results in import prices measured in NZ dollar terms falling and when the TWI falls it results in import prices increasing.
The second chart shows the annual % changes in the TWI and the import price index compiled by Statistics NZ.
For the statistically minded I have shown the correlation that at -0.83 is close to the maximum possible negative correlation of -1.0 (i.e. the exchange rate plays the major part in driving the short-term cycles in import price inflation).
In terms of export prices what happens to international prices can have a larger impact than the exchange rate, but the exchange rate can still play a significant part in determining the local prices of exported goods like dairy products and lamb chops faced by NZ consumers.
The short-term spikesand tumbles in import price and tradable inflation have little bearing on the medium-term inflation prospects the governor is supposed to target, but successive governors seem unable to look-through them in assessing the appropriate level of the OCR to keep inflation low on average over the medium-term.
In the second to last paragraph of the Policy Assessment in the March Monetary Policy Statement Graeme said: "The speed and extent to which the OCR will be raised will depend on economic data and our continuing assessment of emerging inflationary pressures, including the extent to which the high exchange rate leads to lower inflationary pressure."
Governor Wheeler clearly does not intend to look-through any temporary weakness in inflation caused by further upside in the exchange rate.
In the last three Monetary Policy Statements the Reserve Bank has predicted that the NZD TWI would fall (see the three coloured lines in the adjacent chart), but it has instead appreciated as we have predicted in the monthly Forex Prospects reports (for info on these visit http://www.sra.co.nz/index.php/forex-prospects).
The forex market is quicker and smarter than central bankers in assessing the outlook for economic growth, with the relative performance of economic growth between NZ and NZ's major trading partners and especially between NZ and the US being the major fundamental drivers of cycles in the NZD TWI and NZD/USD.
Just as we have been advising clients of our monthly economic reports that economic growth would be stronger than the Reserve Bank and economic forecasters in general have been predicting, the forex market has been pricing the stronger growth into the exchange rate.
As covered in our latest economic report (visit http://www.sra.co.nz/index.php/interesting-times for info on these), three key drivers will mean economic growth will run quite a bit above what the Reserve Bank is predicting over the next year, which should mean more upside in the exchange rate, albeit with mini-cycles along the way caused by a range of factors.
If the exchange rate heads higher as I expect and Governor Wheeler acts as he has suggested (i.e. moderates OCR hikes because "the high exchange rate leads to lower inflationary pressure") he will increase the risk that even higher interest rates and a recession will ultimately be required to fix the resulting inflation problem.
Non- tradable inflation has already reached 3% and will head higher as a result of economic growth being allowed to continue at a faster pace than is consistent with the governor's 2% inflation target and this will be revealed when the exchange rate eventually falls and means overall CPI inflation heads well above 3%.
At this point Governor Wheeler is likely to follow in the footsteps of his predecessors and battle the persistent inflation problem with even more OCR hikes than would have been required if he had acted in advance of non-tradable inflation reaching 3%.
I have recommended in the past the Reserve Bank should focus on non-tradable inflation and if it did it would ensure more proactive or early adjustments in the OCR that reduced the risk of eventually larger increases.
I don't expect my advice to be taken any more now than it has in the past, which means the Reserve Bank will continue to play a major part in driving periods of excessively strong economic growth, like the one currently underway, to be followed by large interest rates increases, an excessively high exchange rate and eventually a recession.
The forex market is smarter than central bank governors
The chart is useful for reviewing past monetary policy follies that have culminated in recessions.
Governor Wheeler isn't exactly following in the footsteps of his two predecessors, but if he moderates OCR hikes in response to a higher exchange rate he will be doing so sufficiently to make these examples of relevance.
In 1993 the forex market responded to clear signs that NZ economic growth was accelerating by driving the NZD TWI up, but Governor Brash was concerned the appreciating exchange rate would unnecessarily depress inflation and hurt growth so he acted to bring about a significant fall in the 90-day bank bill yield (see the left red boxed area in the chart).
The OCR didn't exist then and the 90-day bank bill yield was the key interest rate the Reserve Bank focused on.
The result was that economic growth accelerated to almost 7% during 1994.
Governor Brash realised his mistake and more than reversed the 1993 fall in the 90-day bank bill yield falling, despite non-tradable inflation already being above 3%.
His action was partly motivated by the earlier appreciation in the exchange rate (right hand red box in the chart above).
This fuelled excessively strong economic growth, meant non-tradable inflation remained well above 3% and contributed to further appreciation in the exchange rate.
When the exchange rate eventually depreciated tradable inflation spiked and overall CPI inflation headed well above 3%.
The governor's go-for-growth experiment was successful in generating a period of strong economic growth, but it also resulted in persistent period of higher non-tradable inflation and a large appreciation in the exchange rate.
And to fix the resulting inflation problem Governor Bollard was forced to deliver 13 OCR hikes between January 2004 and July 2007.
The recession that was required to fix the inflation problem was already in the pipeline before the financial crisis arrived, but the crisis speed up the process of fixing the inflation problem.
The table shows the percentage weights the eleven major groups in the CPI have and the weights for the larger subgroups/spending categories.
These weights are update every few years based on surveys of actual spending behaviour. For example, based on the latest sample, 2.48% of the average household’s spending is on fruit and vegetables.
House prices are not included in the CPI, but spending on rent is the single largest subgroup (8.78% of total spending), while spending on the purchase of new dwellings is also included (4.01%), which means increases in rents and building costs are picked up in the CPI.
*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.