Understanding Low Inflation in New
Zealand
A speech delivered to the Bay of Plenty Employers and Manufacturers
Association (EMA) in Rotorua
On 11 October 2016
By Dr John McDermott, Assistant Governor and Head of Economics
2 The Terrace, PO Box 2498, Wellington 6140, New Zealand
Telephone 64 4 472 2029 Online at www.rbnz.govt.nz
Low inflation in New Zealand
It is a pleasure to be here today to address the Bay of Plenty EMA. My job is all
about trying to take the pulse of the economy, but you are some of the people that
actually make it beat.
In recent years, inflation has been low - and below the rate targeted - in many
advanced countries around the world. The possible reasons for this are a focus of
discussion for central bankers, financial market participants, politicians, academics
and journalists, both here and abroad. Low inflation in New Zealand is what I want to
talk to you about today.
The consumer price index (CPI) for the September quarter will be released next
Tuesday, and it is widely expected to reveal continued low inflation. The Bank's goal
is to keep future annual CPI inflation outcomes between 1 percent and 3 percent on
average over the medium term, with a focus on keeping future average inflation near
the 2 percent target midpoint. As described in the September Official Cash Rate
(OCR) review, monetary policy will continue to be accommodative. Interest rates are
at multi-decade lows, and our current projections and assumptions indicate that
further policy easing will be required to ensure that future inflation settles near the
middle of the target range.
The Reserve Bank's forecast in the August Monetary Policy Statement was for
annual headline CPI inflation to be 0.2 percent in the September quarter. More
recent information, including movements in petrol and food prices, remains
consistent with this low number. Our typical margin of error in forecasting near-term
annual CPI inflation is about 0.2 percentage points. So, while we have no prior
knowledge, next week's outturn could be between zero and half a percent.
Actual inflation has been low, despite robust growth in the New Zealand economy.
Looking at individual items in the CPI basket, low annual inflation in the September
quarter is expected to result from: falling prices for petrol; further reductions in ACC
vehicle levies (resulting in cheaper car licensing fees); cheaper and better quality
audio-visual and computing equipment; and reductions in domestic and international
airfares. These lower prices are expected to be only partially offset by increases in
the prices of housing-related goods and services - things like construction costs,
rents, property maintenance, and local authority rates - and increases in cigarette
and tobacco prices. In annual terms, these large negative and positive factors have
been at play for at least the past year (figure 1).
Figure 1: Contributions to annual CPI inflation over the past year
Ppts
Other
1.5
Cigarettes & tobacco
1.0
Housing & household-related
goods & services
0.5
Audio-visual & computing
equipment
Communications
0.0
Air transport
-0.5
Other transport services
(includes ACC vehicle levy)
-1.0
Petrol
Total annual CPI
-1.5
Sep 2015 Dec 2015 Mar 2016 Jun 2016
Source: Statistics New Zealand, RBNZ estimates.
Annual inflation is expected to return to the lower end of the target band in the
December 2016 quarter, as previous petrol price declines drop out of the annual
calculations and housing-related goods and services prices continue to increase
strongly.
Stability in the cost of living maintains the purchasing power of New Zealanders'
incomes. Inflation that is too high or too low has economic costs, and is of concern to
the Reserve Bank. High inflation distorts the signals being sent from relative price
movements, which results in resources in the economy being misallocated. On the
other side, low inflation becomes a concern if it leads to the possibility of deflation.
Although we do not see any significant risk of deflation in New Zealand, deflation
carries important costs. Deflation would likely lead to consumers and businesses
significantly delaying purchases or investment, in the expectation that these will
become cheaper in the future. By delaying purchases and investment on a large
scale, demand in the economy as a whole is reduced. This then leads to even lower
prices. Deflation is particularly concerning as monetary policy eventually reaches a
point where it cannot go any lower in order to stimulate the economy (known as the
effective lower bound). A buffer above zero inflation is also needed to account for
any measurement error in the price index. Across inflation-targeting central banks
around the world, inflation of about 2 percent per annum is generally viewed as an
appropriate medium-term goal.
Although headline CPI inflation is expected to remain low in the near term, lowering
interest rates now would do little to change these outturns. Monetary policy operates
with long and variable lags. Accordingly, monetary policy in New Zealand is focused
on the medium-term outlook for inflation, as directed by the Policy Targets
Agreement (PTA) between the Governor of the Reserve Bank and the Minister of
Finance. Focusing on inflation a year or two ahead avoids unnecessary instability in
output, interest rates and the exchange rate, again consistent with the PTA. The
Reserve Bank must also have regard to the efficiency and soundness of the financial
system.
The Bank responds to low inflation outcomes if these outcomes are expected to
have an effect on medium-term inflation. If households and businesses respond to
low inflation outcomes by reducing their expectations for future inflation, and wages
and prices are set accordingly, then these lower inflation expectations would weigh
on future actual inflation over the horizon relevant for monetary policy. We carefully
monitor developments in inflation expectations, at various horizons.
Looking back over recent years, annual CPI inflation in New Zealand has been lower
than expected by the Bank and other forecasters. Understanding why this has been
the case - and what the effects on inflation expectations have been - is important in
order to set policy going forward.
Annual CPI inflation has been below the 2 percent target mid-point since it was
formalised in 2012, and below the bottom of the target band since the final quarter of
2014. Low inflation has been accounted for by an unusually long period of falling
prices in the tradables sector (those exposed to international competition), as well as
a decline in average non-tradables inflation (figure 2). Various measures of core
inflation have also been low, although appear to have trended higher since the start
of 2015 (figure 3).
Figure 2: Headline CPI inflation and components (annual)
Non-tradable contribution Tradable contribution Headline
%
6
5
4
3
2
1
0
-1
-2
2007 2008 2009 2010 2011 2012 2013 2014 2015
Source: Statistics New Zealand.
Figure 3: Core inflation measures (annual)
Source: Statistics New Zealand, RBNZ estimates.
At a high level, low inflation could be due to two factors:
•
Developments in the cyclical drivers of inflation; or
•
Structural changes in the way in which the New Zealand economy generates
inflation.
A key factor that has led to low inflation has been the underlying weakness in the
global economy (figure 4). Although GDP growth in New Zealand's trading partners
has been near average levels, this moderate growth has required a significant
degree of monetary stimulus abroad in the major economies. Quantitative easing
and negative interest rates have become regular features of the global economy.
Figure 4: Trading partner growth (annual)
Current forecast period Mar 14 Mar 15 Dec 15 Mar 16 Aug 16
%
5
4
3
2
1
0
2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: Haver Analytics, RBNZ estimates.
A weak world economy has been a key factor underpinning the New Zealand dollar,
with New Zealand's performance relative to other advanced economies supporting
demand for New Zealand dollar assets. The New Zealand dollar exchange rate has
been higher than the Bank had assumed for much of the period (figure 5). The New
Zealand dollar has remained elevated despite periods of increased risk aversion and
steep declines in New Zealand's export prices. The strength of the New Zealand
dollar has dampened the prices of New Zealand's imports, and contributed
significantly to the current low inflation, particularly in the tradables sector.
Figure 5: Nominal New Zealand dollar trade weighted index and the evolution
of RBNZ estimates (actual shown in bold)
Index
85
80
75
70
65
60
55
50
45
2000 2002 2004 2006 2008 2010 2012 2014 2016 2018
Source: RBNZ estimates.
The prices of the goods and services that New Zealand imports have also been
lower than expected - even once the effects of high exchange rate have been taken
into account. Again, a weak global economy has been the contributing factor, with
significant spare capacity across the globe dampening the world prices for New
Zealand's imports.
In addition to this impulse, there was a sharp decline in the price of oil over 2014 and
2015, reflecting a combination of increased global supply and a moderation in growth
in emerging economies. This drop in oil prices has contributed further to low inflation
in New Zealand.
It is possible that structural changes may have also contributed to negative tradables
inflation in New Zealand. This could include developments such as a change in
exchange rate pass-through, or a permanent shift in distributor or retailer margins.
However, Bank research suggests that such structural developments do not appear
to account for weakness in internationally-driven inflation in New Zealand. That is,
although movements in the drivers of low tradables inflation - the exchange rate, oil
prices and global prices for our imports - have led to negative tradables inflation, it
does not appear that there has been a material or permanent change in the ways
that these drivers transmit through to domestic inflation.1
Domestic inflation in recent years has been dampened by some sector-specific
factors. Communications prices have been falling since 2011 (figure 6). The lower
measured prices reflect an increase in quality: an increase in the size of broadband
packages offered (at similar monthly charges); increased data and call minutes for
mobile services; and the more-recent introduction of ultra-fast broadband. The net
reduction in vehicle relicensing fees (reflecting a change in the way ACC calculates
levies for light vehicles) has also held inflation lower since the September 2015
quarter (figure 7).
Figure 6: Telecommunication services (contribution to annual CPI inflation)
Ppts Ppts
0.2 0.2
0.1 0.1
0.0 0.0
-0.1 -0.1
-0.2 -0.2
-0.3 -0.3
-0.4 -0.4
2008 2010 2012 2014
Source: Statistics New Zealand.
Figure 7: Other transport services (includes vehicle relicensing fees;
contribution to annual CPI inflation)
Ppts Ppts
0.2 0.2
0.1 0.1
0.0 0.0
-0.1 -0.1
-0.2 -0.2
-0.3 -0.3
-0.4
2008 2010 2012 2014 2016-0.4
Source: Statistics New Zealand, RBNZ estimates.
Other cyclical developments have also contributed to weakness in non-tradables
inflation. New Zealand experienced a sharp decline in the prices of its exports over
2014, following a boom in commodity prices that had seen New Zealand's terms of
trade reach a 40-year high. The key driver of the fall was a substantial decline in the
global price of dairy products (figure 8).
Figure 8: New Zealand's export commodity prices (USD, by sector)
Index Dairy Meat, pelts, and wool Forestry Aggregate
450
400
350
300
250
200
150
100
50
0
2000 2002 2004 2006 2008 2010 2012 2014 2016
Source: ANZ Bank.
A number of developments contributed to the fall in dairy prices over 2014. A broad
range of commodity prices declined over that period in line with the sharp decline in
the price of oil, likely reflecting a combination of weaker global demand and the
pass-through of lower energy costs. More specifically in the international dairy
market, supply increased substantially - particularly in Europe following the
relaxation and subsequent removal of production quotas that had been in place for
nearly 30 years.
This drop in New Zealand's commodity prices acted as a headwind to the domestic
economy, reducing on-farm investment and rural spending. The flow through to
demand in the economy more generally ultimately contributed to weaker domestic
inflation.
A key structural development that has led to persistent weakness in inflation has
been the stronger growth in New Zealand's potential output (figure 9). This has
enabled the New Zealand economy to grow at a robust pace without generating
significant inflation, and is likely to continue to do so over the medium term.
Figure 9: RBNZ potential output growth estimates through history (annual
growth, August 2016 estimate shown in bold)
%
4.0
3.5
3.0
2.5
2.0
1.5
1.0
0.5
2000 2003 2006 2009 2012 2015
Source: RBNZ estimates.
Over recent years, most of the increased growth in potential GDP has been due to
an increase in labour supply - through greater participation in the labour force and
high net immigration. Employers, like yourselves, have been able to absorb this
additional labour supply over recent years. More people entering the New Zealand
workforce acts to dampen labour costs, and general inflation as a result.2 The ability
of New Zealand businesses to find a productive use for the remarkable increase in
the supply of labour is one of the most positive aspects of the current economic
expansion.
More people increase both demand in the economy and growth in potential output. In
previous cycles, the increase in demand has often outweighed the contribution to the
supply capacity of the economy. Migration in previous cycles was therefore usually
associated with an increase in overall capacity pressures and inflation, as well as a
strong pick up in house price inflation.
The consequences of the recent migration inflows on consumer price inflation have
been much more modest in this cycle. Two key factors can account for this more
muted response. First, the composition of migration matters a great deal for
inflationary pressures. Younger migrants (17-29 years old) tend to have a positive
but more muted impact on domestic demand compared to older cohorts (30-49 years
old).3 Second, the source of the migration impulse also matters - higher inward
migration to New Zealand that is driven by a weaker Australian economy tends to
result in a higher unemployment rate - all else equal - while inward migration to New
Zealand driven by other factors has the opposite effect.4 That is, people who move to
New Zealand because their job prospects in Australia have deteriorated are likely to
spend less once here.
In recent years, we have seen a larger share of younger migrants than in previous
cycles (figure 10), and weakness in the Australian labour market has been a driver of
trans-Tasman flows.
Figure 10: Composition of net immigration by selected age groups (annual
total)
15 to 29 30 to 49 Other
000s
80
70
60
50
40
30
20
10
0
-10
-20
1990 1993 1996 1999 2002 2005 2008 2011 2014
Source: Statistics New Zealand, RBNZ estimates.
There also appears to have been a structural change in how households and
businesses form their expectations of prices. Inflation expectations now seem to
respond more to past inflation outcomes than they did prior to the global financial
crisis (GFC).5 This would mean any direct shocks to headline inflation (even if the
shocks themselves are expected to be short-lived) now appear to have more
persistent effects on inflationary pressures than they did in the past, via the
expectations channel. This suggests that weak tradables inflation may have had a
greater dampening impulse on non-tradables inflation through inflation expectations
than would have occurred in previous periods.
Two key factors that businesses and households take into account when setting
prices are the degree of capacity pressure and inflation expectations. The Bank has
reviewed its frameworks for estimating capacity pressure (also known as the 'output
gap' - the difference between actual and potential GDP) and inflation expectations in
New Zealand.
Reserve Bank research re-emphasised the challenge in accurately estimating the
output gap in real time.6 When assessed against a vast range of possible capacity
indicators, the Bank's estimate of the output gap in 2015 was around the middle of
this range of estimates.
The Bank also developed a methodology to better incorporate and monitor the vast
amount of information on inflation expectations into the Bank's policy making.7 The
analysis shows that low inflation outcomes have lowered expectations of inflation at
shorter horizons, which may dampen near-term price- and wage-setting. However,
analysis points to longer-term inflation expectations remaining well anchored close to
the mid-point of the bank's inflation target (figure 11).
Figure 11: Inflation expectations curve (annual, by number of years ahead)
Source: ANZ Bank, Aon Hewitt, Consensus Economics, RBNZ estimates.
In view of low inflation outturns since 2014, the Bank undertook a review of its
forecasting performance. Reviews of forecast performance help to update our
understanding of economic relationships and identify any areas were we could
improve our accuracy.8 Generally, the Bank's recent forecasts have performed better
than external benchmarks.9 Looking at the period since the GFC, the Bank has
generally been better than others at forecasting inflation, and its forecasts have been
of a similar quality to those produced by a suite of statistical models.10 This forecast
review suggests that there were no obvious sources of new information that the
Bank could reasonably have been expected to incorporate when preparing its
forecasts.
Conclusion
Annual CPI inflation for the September quarter is going to be low, as incorporated
into the Bank's most recent projections. However, it is expected to rise in the
December quarter and be at the bottom of the target range as the transitory effects
of earlier declines in oil prices dissipate. As described in the September OCR
Review, monetary policy will continue to be accommodative. Our current projections
and assumptions indicate that further policy easing will be required to ensure that
future inflation settles near the middle of the target range.
Actual inflation has been low, and lower than forecast, for several years - both here
and abroad. The potential reasons for this are a topic of discussion around the world.
In New Zealand, much of this weakness can be attributed to global developments
that have presented themselves via the high New Zealand dollar and low inflation in
our import prices. Strong net immigration and increased labour market participation
have also boosted the supply potential of the economy, meaning that New Zealand
has been able to grow at a robust pace without generating significant inflation.
There also appear to have been changes in how inflation is generated in New
Zealand: the drivers and composition of net immigration influence the degree of
associated inflationary pressure for any given migration flow, and inflation
expectations appear to now place more weight on past inflation outcomes than they
did prior to the GFC. The Bank will continue to closely monitor developments in the
drivers of inflation and investigate any persistent changes in how inflation is
generated. Our goal will be to achieve future inflation outcomes within the target
range on average over the medium term, with a focus on keeping future average
inflation near the target mid-point.