Is inflation going to settle back at 2 per cent?

Financial markets don’t seem to think so.

There is a variety of inflation expectations measures.  None of them is ideal (and few are directly comparable across countries), but together they have been providing a reasonably consistent picture of weak, or weakening, expectations of future inflation in New Zealand.  No one knows quite to what extent people use expectations of future inflation in their planning and economic behavior, let alone whether the expectations they actually use (mostly probably no more than implicit) are similar to what they tell those conducting the surveys.    If anything, many  of the survey measures seem to have had a persistent upward bias over the years –  but whether that has influenced behavior is hard to tell.

When inflation expectations start undershooting the inflation target midpoint, it isn’t necessarily a problem in the short term.  After all, it is generally better if firms and households expect what is actually happening than that they are persistently surprised.  But if expectations are slow to adjust –  as they tend to have been – and if expectations, in some form or another, play an important role in influencing the medium-term trend in inflation (reflecting the norms firms and households have in mind for wage and price inflation when they go into the market), then a sustained weakening in inflation expectations can become quite problematic.  After all, the Reserve Bank has been given a goal of maintaining core inflation around 2 per cent.  And if people no longer really expect that future inflation will be near 2 per cent it can become quite hard to get inflation back up again.  People don’t have to think 2 per cent (or above) inflation is impossible, just that the best guess might now be to act on the assumption that something lower will probably be delivered.  After the best part of two decades in which core inflation persistently overshot the midpoint of the inflation target, that would represent a huge change in mindset.  Not all of it would be unwelcome –  as the Bank has noted, it would be good if firms and households became convinced that inflation average 2 per cent rather than, say, 2.5 per cent.  But good things can be carried too far and it increasingly looks as though that has happened.

Survey measures of inflation expectations are useful, but putting a number in a survey involves no risk for respondents and so no incentive to be particularly accurate.  So economists have tended to hanker after market-based measures, where money is directly at stake.  In a world of incomplete information and incomplete contracts, the best we have available in New Zealand is the difference between the yields on New Zealand government conventional bonds and inflation indexed bonds.  It is not a perfect measure by any means, but if there is a reasonable amount of both indexed and conventional bonds on issue, and at least a moderate degree of liquidity in each market, then any persistent changes in investors’ expectations of inflation should, over time, be reflected in changes in the spread between the yields on the inflation-indexed and conventional bonds.    And whereas most survey measure of inflation expectations are for periods one or two years ahead, implied inflation expectations derived from the bond market can provide information on the next 10 years (or more) –  something about the overall expected inflation climate, abstracting from all the noise of regulatory and relative price changes.

The New Zealand government now has 20 year indexed and conventional bonds on issue in reasonable volumes, but unfortunately I can’t find any time series data on the conventional yields ( eg the Reserve Bank is only providing data on the yield on the 20 year indexed bond not the conventional one).   But for these purposes the 10 year bonds should be fine.  And here is the chart of the gap between indexed and nominal yields since the start of 2014, using the data on the Reserve Bank’s website.

iib expecs to jan 16

A common problem with these sorts of comparisons in New Zealand has been that there were very few indexed bond maturities on issue and rather more conventional bond maturities, so that one wasn’t always comparing the same maturity dates.  But these days the government is issuing conventional and indexed bonds with the same maturity dates.  At least since the middle of 2014, the chart will be showing the gap between indexed and conventional bonds each maturing on 20 September 2025.  [UPDATE: A reader drew my attention to the fact that I had misread the DMO’s bonds on issue page and there are not yet exactly matched maturities. It does not affect the gist of the story, although as ever it is indicative only.]

It is not a pretty picture.  Up until perhaps September 2014, there wasn’t anything obvious to worry about.  Implied expectations for the 10 years ahead were very close to 2 per cent.  In the first half of 2014 much of the market appeared to buy the Reserve Bank’s story that a robust recovery meant that even with a progressively higher OCR inflation was going to settle relatively quickly around 2 per cent.

But since then, the trend decline in implicit market expectations has been striking.  As always, there are ups and downs –  individual pieces of data, or changes in market positioning, push prices this way and that.  But whereas investors 18 months ago were happy to trade on the assumption that the Reserve Bank would deliver inflation averaging around 2 per cent, that has not now been so for some time.  As of yesterday, the implicit expectation (average inflation over the next 10 years) was only 1.17 per cent –  not just nowhere near the target midpoint, but close to the very bottom of the target range.  And recall that these are expectations for the next 10 years –  not just the immediate period of falling oil prices, or the last 20 months of Graeme Wheeler’s term, or any of other stuff that throws around the headline CPI – which is what matters for indexed bonds –  in the short-term.  It increasingly looks as though markets (potential buyers and sellers of these longer-term instruments) are pricing a reasonable prospect of at least a year or two of deflation over the next 10 years.  It is certainly a very long way from a confident expectation that, on average over time, the Reserve Bank will do its job.

I wonder what the Reserve Bank’s Board makes of such developments.

9 thoughts on “Is inflation going to settle back at 2 per cent?

  1. The Board might refer back to pre crisis asset price data and conclude that financial market pricing of future macroeconomic variables over long horizons can often be as useful as a chocolate teapot. Still, perhaps a less than ideal trend, though, given many policy makers around the world have embraced the idea of product market flexibility during the past few decades, I’m not sure why CPI data shouldn’t show a slightly downward trend through time….??


  2. Certainly not suggesting the financial market prices have been accurate forecasts. Then again, neither has the Reserve Bank’s.

    Re mild deflation, if the target was revised to something centred on, say, zero (or perhaps 0.5% to allow for the bias in the CPI) that might be fine – we take our productivity gains in lower prices rather than higher wages. But it would leave the zero lower bound issue even more pressing whenever anything went wrong. As I’ve argued here, if govts and central banks would do something direct about removing the ZLB problem, then I’d have no problem with a CPI inflation target at or very near zero. Sadly, there is not much sign of action on that score, here or abroad.


    • ….maybe the two are linked: remove the inflation target and the ZLB issue vanishes? The replacement target variable or nominal anchor? How about ‘financial stability’. Tough one to measure and communicate but worth pondering as after all, if something does go wrong (ex a systemic bank crisis), the market mechanism should be able to run its course…


  3. The pattern of declining inflation breakevens is very similar in the US, where the 10 year breakeven has fallen to 1.39%. It’s a global phenomenon. While the crashing oil price seems to be a part of the story (that should drop out after 12 months), there seem to be other factors at play. These include demographics, technological change, debt levels that inhibit consumption etc.
    I think there is a bit of an illiquidity premium in the NZ inflation-linked bonds, which reduces the estimate of breakeven inflation, but on my numbers the 10 year breakeven is 1.10% today. I agree that is lower than the RB should be comfortable with.


    • Those in Aus have also fallen, a bit later and a bit less than those in NZ. In all three countries, monetary policy is probably too tight given the respective inflation targets. Of course, in the US there isn’t much that can be done (reverse than 25 bp hike) but there is still material room in NZ and Aus, which should be being used. I agree that demographics is a key global influence, altho am more skeptical about the role of legacy debt levels.


  4. If the RB continues to run interest rates higher than Australia then my answer is that we all go and spend our hard earned dollars in Australia. Next week I am booked for my GoldCoast holiday. My advice to the mortgagebelt of NZ is to go spend your money in Australian retail and see interest rates fall further in NZ as a result.


  5. SNZ just announced Inflation 0.1% for the December quarter. Guess the RBNZ is way off the mark. With Iran oil coming on stream and OPEC unable to control the supply, oil prices continue to drop.

    I do not see how a further drop in the OCR is going to change that. With NZ household debt equating NZ household savings a further drop in interest rates is not going to encourage spending. More cash in the hands of the mortgage belt is offset by less cash available for savers roughly equally.

    I think Wheeler should just leave the OCR at 2.5%.


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