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Rodney Dickens says analysis doesn’t support the RBNZ embarking on a go-for-growth experiment in the hope there won't be inflationary consequences

Rodney Dickens says analysis doesn’t support the RBNZ embarking on a go-for-growth experiment in the hope there won't be inflationary consequences
Graeme Wheeler

By Rodney Dickens*

Annual CPI inflation fell to 1% in the September quarter, which puts it at the bottom of the 1-3% inflation target range; noting Governor Wheeler has stated he is targeting the mid-point (i.e. 2%).

Are structural factors at work that mean inflation will remain low even if the Reserve Bank (RB) allows economic growth to run above the rate it estimates to be consistent with low inflation (i.e. the RB's 2.75% estimate of the "sustainable" growth rate)?

The factors include:

(1) low global inflation or possibly deflation (i.e. falling global prices);

(2) downward pressure on local retail prices because of increased competition from online shopping; and

(3) developments that mean labour cost inflation will be lower than normal.

This Raving investigates these three issues and concludes that we haven't yet, at least, entered a new inflation paradigm.

The implication is that if Governor Wheeler allows economic growth to run above the current estimate of the sustainable rate for much longer an inflation problem will develop in time.

If the governor waits for signs an inflation problem has developed before hiking again he risks repeating a watered-down version of Governor Alan Bollard's boom-bust experiment that ultimately resulted in 13 OCR hikes (i.e. timely hikes reduce the ultimate need for hikes).

Have we entered a new inflation paradigm?

The 1% annual inflation rate for the year ended September was well below what the RB predicted (left chart), with inflation in both the domestic/non-tradable component of the CPI and the tradable component coming in below the RB's forecasts (right chart).

This appears to have played a significant part in the more dovish stance adopted by Governor Wheeler last week.

It raises the question of whether local and/or international factors have resulted in a new inflation paradigm that mean GDP growth can run above the RB's 2.75% estimate of the sustainable rate without it fuelling an inflation problem.

The counter view is that a range of one-offs resulted in a temporary dip in inflation, while it could be a bit of both.

One possibility is that low global inflation or even deflation is at work (i.e. a range of developments, including the impact of technology, resulting in downward rather than upward pressure on the global prices of goods and services).

If this was the case NZ import price inflation should be running lower than would be expected just on the basis of what changes in the exchange rate suggest should be occurring.

The left chart below shows that annual import price inflation has been behaving much as would be expected given the appreciation in the NZD TWI (the right hand TWI scale is inverted).

Falling oil prices should contribute to lower import price inflation, but the fall in the NZD TWI is starting to point to the risk that annual import price inflation will turn positive again.

See below for a survey that points to retailers planning on putting up prices, which is most likely in response to the fall in the NZD. This suggests there isn't yet at least a global deflation at work resulting in lower NZ inflation than would be otherwise expected.

The next possibility is slippage between import and export price inflation on the one hand and inflation in the tradable component of the CPI on the other hand.

The tradable component of the CPI measures the local prices of internationally traded goods and services (i.e. exports and imports).

The right chart shows that tradable inflation is running reasonably closely in line with what would be expected based on annual inflation in import and export prices combined. We used a 70% weight for import prices because imports are largely consumed and a 30% weight for the export price index because exported goods make up a smaller share of local consumption.

The fall in tradable inflation in the September quarter fits with what is likely to have occurred with import and export prices in the September quarter.

The next possibility is that online retailing and especially local consumers purchasing items from overseas websites is putting local retailers under pressure to cut prices to compete (i.e. the technological revolution is resulting in at least a transitory reduction in local retail price inflation).

Anecdotes we have heard suggest this is happening to various degrees, but it is somewhat hard to measure. We have used the ANZ monthly business survey to shed some light on this issue.

We conclude that this issue could be of some significance (i.e. online retailing depressing prices), although this should be largely a transitory effect that ends when local retailers have fully adjusted to the challenge posed by increased online purchasing.

If this was a major issue we would expect retailers to report poorer profit expectations than firms in general (adjacent chart).

Retailers are a bit less positive about profits than all firms, but no more than has been the case at times in the past. If retailers were under major pressure to cut prices in response to increased competition from online shopping we would expect retailers' price intentions to be weaker than all firm intentions, which isn't the case.

The left chart below shows periods when retailers' price intentions have deviated significantly from all firm price intentions.

The right chart below compares the gap between retailers' and all firm price intentions (left hand scale) and the annual % change in the NZD TWI (right hand scale, inverted).

The exchange rate has played a major part in driving the divergences in retailers' and all firm price intentions. There have been two periods since early-2013 when the gap between retailers' and all industry intentions was negative and not justified by changes in the exchange rate. So there is some evidence suggesting retailers have had to cut/curtail pricing potentially in response to increased competition from online retailing.

But most recently there are signs retailers are responding to the fall in the exchange rate in a pretty normal manner (i.e. the adjustment phase may be over, at least for now).

If this is the case it should be a warning sign for Governor Wheeler.

The next question is whether structural changes in the labour market mean the unemployment rate can run at lower levels than in the past without fuelling an inflation problem, which would mean economic growth could run above the RB's 2.75% estimate of the sustainable rate without causing an inflation problem.

The left chart below shows a high negative correlation between the unemployment rate and the productivity-adjusted measure of labour cost inflation the RB focuses on most. The peak correlation is with the unemployment rate advanced or leading by three quarters. The chart also includes the RB's September predictions for both.

The productivity-adjusted measure of labour cost inflation measures the pure inflationary component of labour cost increases (i.e. increases not justified by increased productivity). Increases in productivity-adjusted labour costs mean labours costs per unit of production increases, which firms will respond to by putting up prices and the end result will be a self-defeating wage-price spiral. This is distinct from "good" labour cost increases that are justified by improvements in productivity (i.e. increased output per hour worked) that don't result in a wage-price spiral developing.

Recently labour cost inflation hasn't increased in response to the initial fall in the unemployment rate (adjacent chart). The unemployment line has been advanced or shifted to the right by three quarters to allow for how long it takes on average for changes in the unemployment rate to be reflected in the productivity-adjusted measure of labour cost inflation.

The fall in the unemployment rate over the last three quarters points to potential upside in productivity-adjusted labour cost inflation over the next three quarters.

But there is nothing new in this. The same thing has occurred twice in the past, with labour cost inflation not responding to the initial falls in the unemployment rate (see the green boxed areas in the chart above).

In the previous two cases labour cost inflation did start to increase after the unemployment rate had fallen below "threshold" levels.

The unemployment rate has this year fallen to levels that in the past have started to fuel labour cost inflation.

Consequently, I believe it is too early for the governor to conclude the lack of upside in labour cost inflation so far means we have entered a new inflation paradigm in the labour market.

In the September Monetary Policy Briefing report we discussed in detail whether a structural increase in the participation rate was underway that would result in lower labour cost inflation for any given level of economic growth.

We concluded that the structural increase in the participation rate was probably over (i.e. the percentage of the working age population working or seeking work).

The big story has been the increase in the female participation rate, but the third order polynomial trend line in the left chart below suggests the trend increase in the female participation may have ended for now at least. In the case of the male participation rate we showed in the Monetary Policy Briefing reports that it has largely responded to cycles in the labour market with no clear increase in recent years. There is even the suggestion of a trend fall by the third order polynomial trend line (right chart below).

If the structural increase in the participation rate is over it means future increases in employment will largely result in a lower unemployment rate that with around the normal lag will drive up productivity-adjusted labour cost inflation.

The question of whether we have entered a new inflation paradigm is still open to debate.

But the analysis above doesn’t support Governor Wheeler embarking on a go-for-growth experiment in the hope there won't be inflationary consequences.


*Rodney Dickens is the managing director and chief research officer of Strategic Risk Analysis Limited.

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When Govenor Wheeler was first appointed, i said, on this site, the best thing the government could do was to give him his salary and send him on a long holiday as he wont be needed.
Unfortunately they did not take my advice. Instead he has sat around, with other supposedly clever people. All doing their heads in trying to work out something that didnt exist.
Finaly they felt they had to do something to justify that salary and started to meddle where it was not needed. Now they have to backtract.
Is the RBNZ just another incompitent government department or what?

Well, Well, Well an economy with NO consumers.
Not once did i see a single mention of "peoples ability to pay"
Workers exist (unemployment) but consumers dont. And they wonder why they cant get it right. Tut, Tut, Tut

People wedded to the demand side take no account of ability to pay. They assume that no matter the price consumers will pay, ergo the cost of inputs doesnt matter. Oil and teh collapse of demand I think has proved that wrong.  The Q is what happens when the businesses sandwiched between rising costs and consumers inability to pay more find there is no margin for them, why then they close their doors.  After the paradgym shift of peak oil the effects of raising the OCR to dampen costs simply wont work it will instead will hasen that door closing.
Sadly indeed he wasnt sent on Holiday, complete with all of Treasury as they will stuff us up IMHO.

I though i heard recently that Walmart made its first loss ever. Also i have seen videos of rows of shops boarded up.
Just think what would happen if the government took away the wage subsidey (working for families).
So we see rents and wages being propped up by the government while the RBNZ and other twits talk about inflation.
How do these idiots justify there salaries?

Good point (rents and wages), actually an extremly good one.
Take those away and what happens?
Tenants have to move to cheaper accomodation (assuming they can find it) or the landlaord drops the rent...
going to end well, yes it is.

We need more banks. No consumers needed.
Banks are making record profits, Wheeler is making record salary, all is write with the deals.
Though pay-back may be coming, in spades.
No need for ability to pay, just go for broke, let the poor workers suffer, just print, borrow and be damned.
Paper profits, papering over the cracks, the tax revenue will help, the rates revenue will even up the score.
Though how Mortgagee Sales can still exist in this haven of liquidity, with ever escalating house prices and decelerating interest rates is beyond me.
They should just re-mortgage with any other bank or perhaps borrow straight from the horses mouth, the poor old pensioners, whose savings have been plundered to even up the excessive need to have excessive Inflation, over excessive debt.
We can all spend our way to success, if given the chance.
I plan on coming back to work as a Melbourne Cup jockey,riding my own horse, though a dead cert, might be a bit of a giveaway, if backing a loser at the tote.
Still we do need our distractions, so I had better get back to planning which flag we will be flying, next year.
Smile and Wave is all very well, but I need to know the design well in advance, is it a black flag with Q.E. emblem, or not,or a rising sun, with chequered history.
If you could indicate well in advance, I could make a killing, before that eventuality.
Thanks, your pal...nudge nudge, wink wink...the Friday Funny, but true.

Of course we have inflation - if Auckland house prices have increased 50% and the stock market is at a record high those increases are were inflation has registered. The fact the manipulated CPI shows 1% inflation when most consumers know their discretionaery spendable income has diminshed due to cost increases in Energy/Govt Charges GST/Duty/ACC on rego's, and food exposes the manipulation of the CPI add in wages increases of 2% Gross - 1.5% net of tax and much less net of other expenditure taxes and its not difficult to work out the causes of reduced tax revenue and "low CPI inflation). I doubt Wheeler is incapable of seeing this so I assume he is complicit in the attempted deceit.

Precisely Rumpole, Joyce (no. 2 Amigo) let the cat out the bag the other day admitting that Area Health Boards (foolish inventions that should be shot - but that's another story) have had to deal with 70% inflation over the last ten years.

Rumpole we have "Mixflation" which is a mixture of inflation and deflation.
Firstly - inflation
We have inflation in all of those things you mention Energy/Govt Charges GST/Duty/ACC on rego's and so on. And you can add Rates.
The reason for this is because they are in the unique position in that you cannot escape them. Government and Rates are enforced on you so they can charge what they like. Inflation or deflation does not matter to them.
As for Energy, Telecoms, Insurance, Bank fees and the like. They can also get away with upping charges because they are Monopolies and Duopolies, and can get away with it.
As for house prices and the sharemarket. Well what percentage of the population can aford to buy a house or invest in shares. I think this has a lot to do with global super funds pumping up prices. They are all bragging how well they are doing.
Now - deflation
The shopkeeper is very vunerable and in a competative market, so much more difficult to pass on costs. They have to compete for consumers ever diminishing spare cash and increasing Internet sales. Inequality also plays a part.
Why is nobody giving us graphs showing the widening gap between these two groups? Now that would tell a story.

Hang on a sec Mike B, that is what the tradeable / non-tradeables CPI separation is all about, and the RBNZ bang on about those differences all the time.
You can see those charts here.

Not strictly true on a few things here.  NB To make it easier to understand consider that there is pull inflation and push inflation.
We measure overall inflation. so it is always a mixture of different sectors with a differing level of change.  What is "new" here is wage inflation is pretty much flat and hence the mixture is more severe. 
Also when you say energy can always get away with upping you are on a demand side model which in the last 6 years or so has clearly been shown to be broken. 
Tradeable and non-tradable graphs are well commented on IMHO.
"Internet sales" well wow that's mostly GST, lets can GST, what a great idea.  though note that I buy overseas because a) its a lot cheaper but b) because it is my only option.  eg I have small feet, no one now its seems holds adult shoe sizes below 8, so I have no choice.
You are right on how vunerabe the shopkeeper is and behind them commercial property investment and behind that investors and pension is going to get ugly IMHO.
"inequality" yes and its looking like quite a big part btw.

House prices are not included in the CPI - only rents!

Yep as its an investment, and not an expense though maintenance is I think.

Wheeler needs to slash the OCR and man up to his mistake in rushing to increase the OCR as he got it wrong re inflation

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See Party Policies here. Party Lists here.