The media headlines make a lot of the fact that yesterday’s CPI puts annual headline inflation above the 2 per cent target midpoint (and contractural focal point) for the first time since 2011. The Governor has almost completed his five year term, so it is a first sight for him.
Of course, current headline inflation isn’t the focus of monetary policy. The almost-expired Policy Targets Agreement (PTA) explicitly tells the Governor to focus on “future” inflation, and the “medium-term”. In longstanding words:
For a variety of reasons, the actual annual rate of CPI inflation will vary around the medium-term trend of inflation, which is the focus of the policy target. Amongst these reasons, there is a range of events whose impact would normally be temporary.
There are almost always plenty of those. There are genuine market prices that are quite volatile – oil/petrol prices and fresh fruit and vegetables are the two most obvious examples. There are discretionary government charges – eg ACC levies – developments in which have very little to do with underlying pressures in the economy. And there are straight out consumption taxes that appear directly in the CPI, but again have little or nothing to do with real resource pressures (or even rates of money and credit creation). GST changes – we’ve had them about once a decade – are the best example, but the repeated large increases in tobacco excises this decade are another. Exchange rate changes can also muddy the waters.
As I noted in a post a few months ago, monetary policy works – which shouldn’t surprise anyone, but apparently does – and we’ve seen this as part of the explanation for an increase in inflation over the last year or so. Some increase should be very welcome, since the various core measures had been dropping further below the target midpoint, and people appeared to becoming more used to treating as normal inflation outcomes well below 2 per cent. Reversing the ill-judged OCR increases of 2014 seems to have dealt with that problem/risk for now – although we (like most other advanced countries) remain quite exposed when the next recession hits.
Quite how much core inflation has really increased is a bit of an open question. In various previous posts I’ve highlighted a selection of six possible measures. Here they are again for the year to March 2017.
|Annual inflation rate|
|Yr to March 2017|
|CPI ex petrol||1.7|
|Sectoral factor model||1.5|
|CPI ex food and energy||1.6|
The sectoral factor model measure was the Governor’s avowed favourite measure. A year or so ago, it was the highest of the six measures of core inflation. Right now, it is the lowest. Historically, it tends to be the most stable of all the measures, and although prone to revisions as new data are added, it probably does deserve more weight than the other measures. That measure of core inflation picked up about 18 months ago, but has been steady at 1.5 per cent for the last year or so.
I am sensitive to the suggestion of cherry-picking data. From memory, I was inclined to de-emphasise the core inflation number a year ago, so I don’t want to suggest now that it is the only variable that matters. But in many countries, quite a bit of attention is paid to CPI ex food and energy measures as a proxy for core inflation, and the picture isn’t much different there. It would be interesting to understand quite why the trimmed mean measure – one given quite a lot of attention in Australia – has moved around so much. It was as low as 0.4 per cent (annual inflation) as recently as the end of 2015.
But if core inflation has picked up a bit, there is little in the data that suggests it is, or is about to, race away. When I opened up the SNZ CPI tables, a few things caught my eye:
- on the first page, I noticed that quarterly non-tradables inflation (and non-tradables tends to be more persistent, and hence attract more policy focus) had been 1.0 per cent. That was exactly the same rate as in the March quarter of 2016, and a little lower than in the three previous March quarters. (Non-tradables inflation is high in the March quarter because of the succession of tobacco tax increases.)
- one of my favourite series is non-tradables inflation excluding central and local government charges and tobacco taxes. March quarter inflation there was 0.6 per cent, lower than in the March 2016 quarter (and also lower than in the September and December quarters).
- construction costs look like a potential pinch-point in the economy, and yet the seasonally adjusted data on construction cost inflation (and, in fact, property maintenance costs) both showed quarterly inflation rates for March quite a lot lower than we were seeing for much of last year.
Wage inflation measures are probably also relevant here, not so much through some sort of “cost plus” model of inflation, but because developments in the labour market will also be a good reflection of overall resource pressure (and the wage aggregates aren’t so affected by tax changes, government charges and similar one-offs – although they will be affected, in future, by arbitrary policy interventions like “pay equity” settlements). In some ways, wage measures might be a better (if politically infeasible) policy target for monetary policy.
Here is a chart of the Labour Cost Index (LCI) inflation, using the raw “analytical unadjusted” series.
There isn’t evidence of much, if any, pick-up there, and perhaps especially not for the private sector. The headline LCI numbers aren’t much different and the (volatile) QES data are even weaker.
We’ll get another round of labour market data in early May. Perhaps there will be more signs of an acceleration in wage inflation, or even a material drop in the unemployment rate (suggesting that excess capacity is dissipating and, hence, future inflation risks may be rising) but for now probably the best one can say is that macro outcomes are suggesting that the OCR set at current levels might have been about right. With the unemployment rate still above estimates of the NAIRU, and most indicators of inflation suggesting that core is probably (a) still below target, and (b) not picking up very rapidly, it certainly isn’t time for hawkish talk about near-term OCR increases.
I’ve noticed some market economists talking of altering the timing for their first expected OCR increases. I guess it is an occupational hazard for them having to make such calls, still mostly about the far future. But such are the uncertainties – about the global environment, the domestic economy, the inflation process, let alone about who will be Governor (or MPC) and what the PTA will look like – that it seems something of a fool’s errand. It would, in many ways, be good if the next warranted OCR move were to be an increase, but such are the limitations of our knowledge that probably the best we can say at present is that the current OCR is probably the best prediction of the OCR for the next year or two, with reasonably wide confidence intervals around even that prediction.
Finally, Paul Walker at the University of Canterbury had an interesting and useful post yesterday on his blog highlighting the way that relative price changes muddy reported headline measures of “inflation”. As he notes, and I have already noted here, getting at the “pure” inflation rate is both important but not necessarily that easy.
Walker links to an old paper by a couple of US academics highlighting the possibilities of factor analysis to distill the underlying trends, the “pure inflation”. That is much the same approach used in the Reserve Bank’s preferred sectoral core factor model. Here is Walker.
Using US data Reis and Watson found that
… most of the movements in conventional measures of inflation like the Consumer Price Index (CPI), its core version, or the GDP deflator are due to relative-price changes. Only around 15-20% of the movements in these measures of inflation correspond to pure inflation.
Given that they had measures of relative price changes and pure inflation Reis and Watson could look for evidence of money illusion in their data. They found that once they controlled for relative price changes, the correlation between (pure) inflation and real activity is essentially zero. So,
… when we see that high inflation typically comes with low unemployment or high output, this is indeed driven by the change in relative prices hidden within the inflation measure. When there is pure inflation, that is when all prices increase in the same proportion independently from any relative price changes, nothing happens to quantities.
Which would be fine (and it is a while since I looked at that paper), but here is a chart for New Zealand showing the Reserve Bank’s sectoral factor model measure of core inflation, and the unemployment rate.
Of course, there are other things going on in both series (including changes in inflation targets and inflation expectations). And the sectoral core measure probably isn’t a perfect representation of core inflation. But it is pretty clear that, in New Zealand, there is a (expected) short to medium term relationship between real activity measures (indicators of excess capacity) and developments in inflation even when many (if not all) of the “pure” relative price changes are stripped out.