No doubt I should find something more useful to do, but out walking by the sea in the sun, one aspect of Graeme Wheeler’s speech, and story, was still puzzling me. How, except perhaps by chance, does he expect to get core inflation back up to the target midpoint again in the remaining two years of his term?
- core inflation, at around 1.3 per cent, is a long way from the midpoint of the target range
- the PTA mandates the Governor to focus on the “medium-term trend in inflation”, and on keeping “future average inflation” (not one year’s headline rate) near the 2 per cent target midpoint.
- The Bank reckons real GDP is currently growing at an annual rate of around 2.5 per cent
- And its best estimate of the rate of growth in potential GDP is around 2.6 per cent
- Inflation expectations are quite close to the target midpoint – and lower, relative to target midpoint, than they have been at any time in the history of inflation targeting.
- The Bank’s current estimate of the output gap (June MPS) is around zero.
- And, although not mentioned in the speech, the unemployment rate is above any reasonable estimate of the NAIRU.
There is nothing in that mix that would tend to raise core inflation from where it is at present.
A conventional model would suggest that to lift core inflation, quite substantially, from around 1.3 per cent to around 2 per cent would take some combination of a lift in medium-term inflation expectation (what people are treating as “normal” rate of inflation when negotiating contracts, and borrowing and lending), and a period in which some fairly material pressures build up on resources (“excess demand”). Increased pressure on resources would require a period, looking ahead, in which growth runs faster than potential and, probably, where the unemployment drops below the NAIRU.
Perhaps any temporary increase in headline inflation, on account of the lower exchange rate, will boost inflation expectations a little, but any lift would be unlikely to be sustained without some new resource pressures
But where is this faster growth going to come from? I searched the speech in vain. The Governor talks of a few factors that might “support” economic growth. He lists “continued high levels of migration and labour force participation, ongoing growth in construction and continued strength in the services sector”. But note the repeated word: “continued”. We’ve had all these things over the last 12-18 months, and they generated “a little below trend growth”. Big increases in immigration boost growth rates, but steady high rates of immigration just, at best, maintain them. Construction activity had stepped up a long way over the previous couple of years, but few commentators (or indicators) suggest the rate of growth will be sustained. And all this is before the decline in the terms of trade – which easier monetary conditions may or may not adequately offset – has had its full effect, on the farm or in the wider economy.
If the rate of potential growth really is around 2.6 per cent, then it increasingly looks as though New Zealand needs two or three years of perhaps 4 per cent growth to be confident of getting core inflation to settle back around 2 per cent. If the NAIRU is 5 per cent, perhaps we need a couple of years with unemployment down around 4.5 per cent to lift core inflation back to around the target midpoint.
These are the sorts of outcomes we might have had in a more normal recovery. But – partly because monetary policy has been kept too tight – our recovery has been anaemic. At present, these sorts of outcomes seem likely only if the OCR is cut quite a bit more than the Governor currently seems to envisage.
But in a sense the ball is in his court. Perhaps he could tell us how he expects to see core inflation reverse the seven or eight years of decline, and get back to around the midpoint of the target range What will boost growth sufficiently, and cut unemployment rate sufficiently, to put sufficient additional pressure on resources to achieve a substantial lift in the “medium-term trend in inflation”?
And all this assumes that the Bank is correct that growth is still around 2.5 per cent. We only have March quarter GDP data, and it is now almost half-way through the September quarter. I have seen some commentators suggesting that the June quarter may already have been weaker than would be consistent with 2.5 per cent growth. I have no idea if they are correct, but, if so, the challenges facing the Governor in getting core inflation back to target will be even greater than those I have outlined here.
In the speech, the Governor put quite some emphasis on the troublesome clause 4(b) in the PTA, and especially the highlighted words
In pursuing its price stability objective, the Bank shall implement monetary policy in a sustainable, consistent and transparent manner, have regard to the efficiency and soundness of the financial system, and seek to avoid unnecessary instability in output, interest rates and the exchange rate.
I describe the provision as troublesome because ever since Don Brash and Michael Cullen added it to the PTA no one – Bank, Minister, Board, markets – have ever known quite how to apply it. I’d just make two observations:
- The medium-term price stability objective is paramount, and the medium-term trend in inflation is currently a long way from the mandated target midpoint.
- Against that backdrop, more (upside) variability in output growth looks to be necessary. Few people object to extra growth, especially when the starting point is one of no apparent pressures on resources or core inflation and lingering high unemployment..
Falling commodity prices and the unsettled world environment mean that it would be difficult for the Bank to deliver a couple of years of 4 per cent annual GDP growth even if they set out now to try. But as things are heading at present, the risks of something rather closer to 0.4 per cent growth are rising. Better to aim for 4, and perhaps deliver 2.5. If 4 per cent growth actually happened, inflation would start heading back to target and more of the people currently unemployed would be in jobs. And if only 2.5 per cent growth was achieved it might be enough to stop unemployment rising again. From where we stand right now, it is far from obvious what is lost, or even risked, by a more aggressive stance.
PS: As it is, in pondering the Bank’s record on inflation in recent years – it just isn’t there when they think it will be – the old rhyme came to mind:
Yesterday upon the stair
I met a man who wasn’t there
He wasn’t there again today
I wish, I wish he’d go away
When I came home last night at three
The man was waiting there for me
But when I looked around the hall
I couldn’t see him there at all!
Go away, go away, don’t you come back any more!
Go away, go away, and please don’t slam the door
Last night I saw upon the stair
A little man who wasn’t there
He wasn’t there again today
Oh, how I wish he’d go away