John McDermott: The dragon slain? Near-zero inflation in New Zealand
Speech by Dr John McDermott, Assistant Governor and Chief Economist of the Reserve
Bank of New Zealand, to the Waikato Chamber of Commerce and Industry and Waikato
branch of the Institute of Directors, Hamilton, 23 April 2015.
* * *
I am very grateful to Miles Parker for his considerable help in the preparation of these remarks. I also wish to
acknowledge the contribution of many of my colleagues whose work, much of which is cited in these remarks, has
furthered our understanding of the evolving nature of inflation dynamics in New Zealand.
Accompanying charts can be found at the end of the speech.
Introduction
It is a pleasure for me to be here today to address the Chamber. As some of you may be
aware, today is St George's Day, the saint famous for slaying a dragon. The subject of my
speech is inflation, which has in the past been likened to a dragon ravaging society. With
annual inflation in the March quarter at 0.1 percent, is this another slain dragon? I do not
believe so; the dragon is merely sleeping.
Inflation is currently low, and is mostly due to negative tradables inflation caused by the slow
global economic recovery, the high exchange rate, and the recent sharp falls in oil prices
(figure 1). There is little monetary policy can to do influence inflation outturns in the near
term. Our strategy for returning inflation to the midpoint of the target range is to maintain
stimulatory monetary policy to help generate output growth in excess of potential growth for
an extended period.1 This strength in aggregate demand relative to supply will help generate
the inflation required to reach the midpoint objective.
With the benefit of hindsight, the low inflation outturn can be explained. Tradables inflation
has been negative for the past three years as a result of: the slow global recovery; weak or
declining prices of capital goods manufactured products and commodities; and the strength
of our exchange rate. In the three years to March 2015 the cost of new cars fell 9 percent,
major household appliances 9 percent, computing equipment by 32 percent; televisions and
other audio-visual equipment prices fell by 36 percent.
More recently, a sharp decline in the oil price has driven tradables inflation down even
further. The fall in petrol prices alone reduced the headline inflation rate in the March quarter
by 0.8 percentage points. In the face of falling oil prices, the Bank's focus is on the
mediumterm trend in inflation since this is the horizon at which monetary policy can best affect
inflation. The Bank is unable to offset large relative price shocks and any attempt to do so by
sharply reducing interest rates would result in an unnecessary boom then slowdown in
activity. Unnecessary volatility in output and interest rates that our Policy Targets Agreement
directs us to avoid.
In my remarks today, I am not going to focus on the inflation numbers we received earlier this
week. We will consider those, along with all the other indicators of capacity and inflationary
pressures, next week in our April OCR meeting. Instead, I will offer some perspective on low
inflation in New Zealand over the past couple of years. In particular, I will outline the
framework we use to think about inflationary pressures in New Zealand, then consider how
the global economy is affecting New Zealand inflation. I then discuss some factors that might
be contributing to somewhat weaker-than-expected domestic inflationary pressures.
Inflation and its causes
At the horizon relevant for monetary policy, inflation is typically thought of as being influenced
by two main factors: capacity pressure and inflation expectations. The changing balance
between aggregate demand and aggregate supply over the business cycle causes inflation
to rise and fall. While the long run path of output is determined by the supply side of the
economy - labour supply, investment and technology2 - over the business cycle output can
be above this "potential" level (a positive output gap) or below it (a negative output gap) for
several years. Periods of strong demand see inflation rise, while downswings see inflation
fall. The other main influence on inflation is expectations of future inflation, which people
build into price and wage setting.
Economists often summarise the implications for inflation of the output gap and inflation
expectations in a "Phillips curve". This relationship indicates that over periods of several
years inflation tends to be higher when demand is stronger; and that over the cycle and in
the long run inflation will be higher when inflation expectations are higher.
The Reserve Bank pursues its inflation target by setting the Official Cash Rate (OCR). Higher
interest rates tend to lower inflation over the following 18 to 24 months by slowing the growth
in aggregate demand, and reducing the output gap. In the short term, movements in interest
rates can also cause the exchange rate to move, affecting the New Zealand dollar prices of
imports. The long lag involved from changes to the OCR having their full effect on inflation
requires the Reserve Bank to react to expected future inflationary pressure rather than past
outturns.3
International factors
The sharp decline in global oil prices over the past year has had a large impact on headline
inflation. The Dubai price for crude oil is now 44 percent below its June 2014 peak. This
lower oil price affects domestic prices through several channels.4 It directly affects the price
of petrol paid by consumers; petrol prices are 15 percent lower than a year ago, reducing
headline CPI inflation by 0.8 percentage points. If petrol prices remain unchanged over the
coming year, this reduction will unwind, boosting annual inflation by 0.8 percentage points.
Falling oil prices indirectly affect consumer prices by reducing the production costs of other
businesses. How much, depends on the share of oil and petrol in total costs, businesses'
expectations of how permanent the fall will be, and how businesses change their prices in
relation to changes in costs. Our research on price-setting behaviour suggests that New
Zealand businesses are more likely to pass on to customers an increase in costs than a
decrease.5
The significance of this sharp decline in oil prices for inflation depends on whether the fall is
caused by factors specific to the oil market, or is symptomatic of a more general fall in global
economic activity. The Bank's view is that this drop in oil prices is caused by a mix of factors,
but primarily increased supply.
When declining oil prices reflect factors specific to the oil sector, it should be viewed as a
relative price shift, rather than generalised inflation. It is a positive supply shock for New
Zealand: it lowers inflation and boosts output. Since monetary policy operates with a lag, it
cannot react to the immediate impact of oil prices on inflation. Any such response would
affect output and inflation after the initial impact on petrol prices has left the annual inflation
rate. The Policy Targets Agreement directs the Reserve Bank to avoid unnecessary volatility
in output and interest rates and instead focus on medium-term inflationary pressure.
Inflation is low globally (figure 2), and below target in 16 out of 18 inflation targeting
countries.6 The low inflation reflects falling oil prices and the prolonged period of excess
capacity in most advanced economies. But even accounting for oil and weak capacity
pressures, inflation is weak in our trading partners, and lower than policymakers had
forecast.7 Weak inflation and continued excess capacity have resulted in extraordinarily
supportive monetary policy across the world.
Global inflation affects inflation in New Zealand via two main channels.8 Low inflation in our
trading partner economies results in small international price increases for New Zealand's
imports. Extremely low, and in some cases negative, interest rates overseas have been a
factor causing an appreciation of the New Zealand dollar, which further depresses import
prices when expressed in New Zealand dollar terms.
The pass-through of global inflation to New Zealand import prices seems to be taking place
in a normal way (figure 3). Similarly, tradable CPI inflation appears consistent with the
movements in import prices. Nonetheless, the combination of surprisingly weak inflation
overseas and our high exchange rate are the principal reasons why we have had downside
surprises to headline inflation.
While the weakness in tradables inflation is explainable given international factors,
nontradables inflation has also been weaker than expected. In part the weakness in
nontradables may be influenced by international factors, since around a tenth of non-tradable
prices are accounted for by imports.9 Indeed, looking more closely at non-tradables, the
sectors that are relatively more open to international competition exhibit lower inflation at
present.10
5
Parker, M (2014c), "Price-setting behaviour in New Zealand", RBNZ Discussion Paper, No. 2014/04.
6
Carney, M (2015), "Writing the path back to target", Governor, Bank of England. Speech at the University of
Sheffield Advanced Manufacturing Research Centre, 12 March.
7
E.g. Bank of Canada (2014), "Box 2: Assessing the impact of excess supply on inflation", Monetary Policy
Report, April. Carney, M (2015) ibid., Haldane, A (2015), "Drag and drop", Chief Economist, Bank of England.
Speech at the Bizclub lunch, Rutland, 19 March. Sveriges Riksbank (2014), "Why is inflation low?", Monetary
Policy Report, July.
8
For a more detailed description of how the international situation passes through to New Zealand consumer
prices, see Parker, M (2014a), "Exchange-rate movements and consumer prices: some perspectives", RBNZ
Bulletin, 77 (1, March): 31-41.
9
Parker, M (2014b), "How much of what New Zealanders consume is imported? Estimates from input-output
tables", RBNZ Analytical Note, No. 2014/05.
10
See Galt, M (2015), "How do international factors affect non-tradable inflation? Exploratory analysis using
disaggregated trans-Tasman data", RBNZ Analytical Note. Forthcoming. Nonetheless, even accounting for
Domestic inflationary pressures
While non-tradables account for a small part of the overall weakness in headline inflation, the
dynamics of non-tradables inflation is central to our strategy of returning inflation to the target
midpoint. In this context I will discuss our estimates of spare capacity in the economy, how
that spare capacity affects price and wage-setting behaviour, and the inflation expectations
of wage and price setters. None of these areas are directly observable, and require
estimation by economic models based on available indicators.
Spare capacity in New Zealand
Estimates of the output gap are difficult to carry out in real time, and can be heavily revised.
To mitigate this uncertainty, we corroborate our estimates of the output gap from our main
model with a range of other indicators of capacity pressures. These measures suggest that
the output gap was negative for much of the past couple of years, explaining why
nontradables inflation has been weak. The indicators point to the current output gap being
positive, at around half a percent of potential output (figure 4). Monetary policy is currently
supportive, which should help to drive the output gap higher in coming quarters and generate
the additional inflation to return to the target midpoint.
The weakest indicators, though, are consistent with a negative output gap, and hence lower
inflationary pressure. The weakest one at present is based on the unemployment rate, which
could be influenced by immigration and structural changes in participation. Net immigration is
running at historically high levels, and has two offsetting effects on inflationary pressure.
Immigrants require housing and new capital equipment to work, increasing aggregate
demand. At the same time, immigrants may increase the labour force, increasing supply in
the economy and reducing wage inflation. These offsetting forces make it hard to calibrate
the net effect of migrants on the output gap in the short run.11
Labour force participation in New Zealand is currently at record levels, due to the upward
trend in participation of female workers and higher participation among older cohorts. Should
that high rate of participation prove permanent it would imply a greater level of potential
output than we currently estimate, a smaller positive output gap and lower non-tradable
inflation.
The impact of capacity pressure on inflation
All of the various indicators of capacity pressures have one thing in common. Each indicator
shows a gradual tightening of capacity pressure over the past couple of years, which should
be consistent with gradually increasing inflationary pressures and higher inflation outcomes.
The subdued nature of the actual increase in domestic inflationary pressure raises the
question of whether the output gap is having a smaller influence on actual inflation than it has
in the past. In other words, has the slope of the Phillips curve become flatter?
Consider a stylised version of the New Zealand Phillips curve, mapping the outturns for
inflation and a simple output gap measure - the deviation of unemployment from trend
(figure 5).12 During the 1970s, there were large movements in inflation without much
corresponding movement in the unemployment gap. In part this may be a function of labour
hoarding by businesses as the general shortage of labour made them reluctant to lay off
workers even faced with large swings in output.
During the 1980s, there is a clear negative relationship, with higher unemployment gaps
associated with lower outcomes for inflation. Since the introduction of inflation targeting in
1990, the curve is markedly flatter- large movements in the unemployment gap have not
resulted in corresponding changes in inflation. The flattening of the Phillips curve is
witnessed in many countries. Nonetheless, experience since the global financial crisis has
led many policymakers to question whether it has flattened further in recent years.13 During
the depths of the global financial crisis, non-tradables inflation remained stubbornly high, in
New Zealand and elsewhere, despite large negative output gaps.
This anchoring of inflation at low levels represents a success for the monetary policy
framework, as shocks hitting New Zealand do not result in big changes to general price
inflation. But it also poses a challenge. With a flat Phillips curve it becomes more difficult for
the Reserve Bank to influence inflation by affecting the demand for resources and the size of
the output gap. The current flatter Phillips curve could mean that the positive output gap is
exerting less inflationary pressure than we currently believe, slowing our eventual return to
target midpoint.
Has pricing behaviour changed?
Survey measures of inflation expectations have fallen in recent quarters. The decline in
expectations is consistent with the decline in actual inflation over the period. In the decade to
2012, CPI inflation averaged 2.6 percent and was in the upper half of the Reserve Bank's
target range. The current Policy Targets Agreement (signed in 2012) put greater focus on
achieving the midpoint of the target range, so some decline in inflation expectations should
be expected. Lower inflation expectations have been observed across the globe.14
What matters for inflation is not the average response to a particular survey of expectations,
but how general inflation expectations held by businesses and households translate into
price-setting behaviour and wage bargaining. Research on price-setting by New Zealand
businesses suggest that many only take into account current inflation when setting prices,
and very few businesses are purely forward looking.15 Preliminary work on wage setting in
New Zealand also points to the importance of past inflation outturns.16
The evolution of inflation expectations over coming quarters merits vigilance. If price and
wage setting is very backward looking, the temporarily low headline inflation from falling
petrol prices could become more widely entrenched.17 There is certainly a growing
13
See Yellen, J (2014) "Labor market dynamics and monetary policy", Chair, Board of Governors of the Federal
Reserve System. Speech given at the Federal Reserve Bank of Kansas City Economic Symposium, Jackson
Hole. Haldane, A (2015), op.cit. The IMF estimates that the slope of the global price Phillips curve has fallen
from around 1 in the 1970s to 0.1-0.2 most recently. See IMF (2013), "The dog that didn't bark: Has inflation
been muzzled or was it just sleeping?", World Economic Outlook, April 2013.
14
For example, see Nechio, F (2015), "Have long-term inflation expectations declined?", Federal Reserve Bank
of San Francisco Economic Letter, No. 2015-11; Haldane, A (2015) op cit.; Miccoli, M and S Neri (2015)
"Inflation surprises and inflation expectations in the euro area", Banca d'Italia Occasional Papers, No. 265.
15
Parker, M (2014c), op. cit.
16
Armstrong, J and M Parker (2015) "How wages are set: evidence from a large survey of firms", Reserve
Bank of New Zealand. Forthcoming.
17
Our research suggests that when supply shocks are permanent in nature, monetary policy will need to focus
more on inflation outturns and less on the output gap than is the case when supply shocks are temporary. The
intuition behind this result is that with supply shocks having permanent effects, inflation expectations will
eventually become unanchored unless the central bank acts to keep inflation stationary around target. See
discussion of low inflation captured in the media (figure 6). Recent research has pointed to
possible asymmetries in behaviour, with inflation expectations becoming more backward
looking in periods of low inflation, and reacting more to downside inflation surprises than
upside ones.18 A certain degree of movement in expectations is to be expected, particularly
for short-term measures, but the more firmly anchored expectations are, the smaller the
overall inflation impact.19
Longer-term survey measures of inflation expectations are currently consistent with the
midpoint of our target (figure 7). Estimates from a range of economic models are somewhat
lower and have declined recently. A market-based measure using the return on an
inflationindexed bond has also fallen sharply over the past year.20 The level of these other measures
are consistent with inflation expectations at or just below the target midpoint of 2 percent, but
all highlight the downward direction over the past year (table 1).21
The outlook for monetary policy
I have talked today about the causes of recent low inflation in New Zealand. The outlook for
inflation is also subdued, and suggests that monetary policy should remain stimulatory for a
prolonged period. This cycle is unusual in that CPI inflation is staying very low, requiring
interest rates to also remain low. The timing of future adjustments in interest rates will
depend on the evolution of inflationary pressures in both the traded and non-traded sectors.
We continue to monitor and carefully assess the emerging flow of economic data.
The impact of some factors influencing headline inflation will prove temporary. Past declines
in oil prices will reduce headline inflation substantially in 2015, but absent any further falls
this negative contribution will drop out of the annual inflation rate by the start of next year.
Looking ahead, we will ensure that monetary policy is stimulatory to support output growth
above potential. Increasingly, this positive output gap will help lift non-tradables inflation,
returning headline inflation gradually to the target midpoint. Real GDP growth has been
above potential growth for a number of years and is currently underpinned by high net
immigration, strong construction activity and robust household spending. Employment growth
is strong and the unemployment rate is low and projected to fall.
At present, the Bank is not considering any increase in interest rates. Before considering any
tightening in monetary policy we would need to be confident that increased capacity
utilisation and labour market tightness was generating, or about to generate, a substantial
increase in inflation.
Evidence of weakening demand and domestic inflationary pressures would prompt us to
consider lowering interest rates. There are some areas of uncertainty surrounding the
outlook for capacity pressures, including the lingering effects of the recent drought in parts of
the country, fiscal consolidation, lower dairy incomes and the impact of the high exchange
rate on some export and import substitution industries. Beyond these factors, we are also
Yao, F (2014), "Stabilising Taylor rules when the supply shock has a unit root", Journal of Macroeconomics.
Forthcoming.
18
Ehrmann, M (2014), "Targeting inflation from below - how do inflation expectations behave?", Bank of
Canada Working Paper, No. 2014-52. The impact of downside surprises in inflation outturns on expectations
has been observed recently in the euro area, see Miccoli, M and S Neri (2015) op. cit.
19
Wong, B (2014), "Inflation expectations and how it explains the inflationary impact of oil price shocks:
evidence from the Michigan survey", CAMA Working Paper, No. 45/2014. demonstrates these facts for the
United States following oil price shocks using the Michigan survey of household inflation expectations.
20
Limited liquidity in this bond, and the lack of a long history suggests caution should be taken over the reliability
of this measure, but the direction of change is indicative of lower inflation expectations.
21
Lewis, M (2015), "Measuring inflation expectations", RBNZ Analytical Note. Forthcoming.
assessing the outlook for tradables inflation that is being dampened by global conditions and
the high exchange rate. The fact that the exchange rate has appreciated while our key export
prices, such as dairy, have been falling, is unwelcome.
We remain vigilant in watching wage bargaining and price-setting outcomes. Should these
settle at levels lower than our target range for inflation, it would be appropriate to ease policy.
Concluding comments
Inflation has been low in New Zealand for a number of years. At present, the outlook requires
a period of supportive monetary policy. Our approach, as a flexible inflation targeter, is to
support ongoing sustainable growth in New Zealand that should help raise costs and prices
in order to achieve our inflation target. We will not react to temporary deviations from target,
as this will only generate unnecessary volatility in activity.
7
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The series for China has a shorter history, but adding it does not qualitatively affect the path for trading partner
export prices.
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