Not expecting enough inflation

I’ve been banging on about the decline in inflation expectations, and the apparent indifference of the Reserve Bank to that, for most of this year.

It was different late last year.  Then, the Bank was making the case –  at least after the event –  for easing monetary policy fairly aggressively with one of the considerations being avoiding the risk of inflation expectations settling lower than was really consistent with the target.  Then –  last year –  the Governor went so far as to suggest that he would prefer to be in a situation where hindsight proved that they had overdone things a little, with expectations rising, and needing to think about raising the OCR again.   They were totally conventional sorts of line for central bankers to enunciate, especially if they were getting uneasy about approaching the conventional limits of the OCR.  I commended the Bank at the time.

This year the Bank –  Governor and MPC –  seem to have given up again, just when it matters; amid the most severe economic downturn in ages, amid significant actual falls in inflation expectations.  As a reminder, unless steps have been taken to remove the effective lower bound on nominal interest rates (and that has not been done anywhere yet) then the lower inflation expectations are, all else equal, the less monetary policy capacity there is to do the core macro-stabilisation job of monetary policy.   And that risks being a self-reinforcing dynamic.

There is no single or ideal measure of inflation expectations.  There are different classes of people/firms for whom such expectations matter, and different time horizons that matter.   Very short-term expectations get thrown around by the short-term noise (notably fluctuations in oil prices).  Very long-term expectations (a) may not matter much (since there are few very long-term nominal contracts) and (b) probably won’t tell one much about the current conduct of macro policy (whatever inflation is going to be between, say, 2045 and 2050 isn’t likely to much influenced by whatever is going on now, or those –  ministers or MPCs –  making monetary policy decisions now.

For a long time, the Reserve Bank’s preferred measure of inflation expectations was the two-year ahead measure from the Bank’s survey of the expectations of several dozen moderately-informed or expert observers.  Two years got beyond the high-frequency noise, and the survey only added questions about five and ten years expectations in 2017.

2 yr expecs july 2020

In the latest published survey expectations fall very sharply.    There will be an update on this series published next week.  I wouldn’t be surprised if there was a bit of a bounce, but I wouldn’t expect it to be large.  The Reserve Bank’s own Monetary Policy Statement will be released the following week.  Perhaps they may have become a bit more optimistic, but recall that in May their inflation outlook –  even backed by their beliefs about the efficacy of their LSAP bond purchases –  was very weak.   Two years ahead their preferred scenario had inflation just getting back up to about 1 per cent.

Now, of course, things are somewhat freer in New Zealand than they were back when those earlier surveys and forecasts were done –  perhaps even more so, sooner, than most expected back then.  On the other hand, the border restrictions remain firmly in place and the wider world economy –  which seems to get all too little comment here –  is only getting worse.   I noticed in the Dom-Post this morning that that is now the official advice of The Treasury to the Minister of Finance.

All of this is, however, known by people participating in the government bond market.  And since the New Zealand government now issues a fairly wide range of bonds, and a mix of conventional bonds and inflation-indexed bonds, we can get a timely read on the inflation rates that, if realised, would leave investors equally well off having held a conventional bond or an inflation-indexed bond (the “breakevens”).   They aren’t a formal measure of inflation expectations, and at times can be affected by extreme illiquidity events, but it is also unlikely there is no relevant information (although Reserve Bank commentary tends to act as if this data can/should be completely ignored).

For a long time, there was only a single indexed bond on issue in New Zealand.  The Bank had persuaded the government to issue them back in the mid 1990s, but then emerging budget surpluses meant issuance was discontinued.  The single indexed bond matured in February 2016.  For a long time the longest conventional bond was a 10 year maturity.  But even with all those limitations, the gap between the indexed bond yield and the Bank’s 10 year conventional bond rate looked plausibly consistent with “true” inflation expectations.  Through much of the 00s, for example, the breakeven was edging up to average about 2.5 per cent.   Recall that there was never much of the indexed bond on issue, and never much liquidity either.

Since 2012 there has been a new programme of inflation-indexed bond issuance, and there are now four maturities on issue (September 2025. 2030. 2035, and 2040).   Go back five or six years to the time when the Reserve Bank (and most the market) thought higher interest rates were in order and you find that the breakevens were close to 2 per cent.  Given that in 2012 the government had slightly reframed the Reserve Bank’s monetary policy goal to require them to focus on the target midpoint of 2 per cent, breakevens around that level were what one would have hoped to see.  And did.

After that, things started to go wrong, with the breakevens beginning to fall persistently below target.  As it happens, of course, by this time it was increasingly realised that actual core inflation was also falling below target.

But what of the more recent period?   One problem in doing this sort of analysis, if you don’t have access to a Bloomberg terminal, is that the data on the Reserve Bank website used to provide yields for the four individual inflation-indexed bonds, but only benchmark five and ten year yields for conventional bonds (ie not yields on specifically identified individual bonds).  That didn’t much over very short-term horizon –  there just aren’t that many bonds on issue –  but potentially did for slightly longer-term comparisons.  However, in the last week the Bank has started releasing daily data on yields on all the individual government bonds on issue, indexed and conventional, back to the start of 2018.  That is most welcome.  As it happens, the government has also now started issuing a conventional bond maturing in May 2041, reasonably close to the maturity of the longest inflation-indexed bond.

In this chart I’ve calculated breakevens as follows:

  • take each of the indexed bond maturity (September 2025, 2030, 2035 and 2040)
  • use conventional bonds maturing in April 2025 and May 2041, and interpolated between bonds maturity in April 2027 and April 2033, and between bonds maturing in April 2033 and April 2037 (to give implied conventional bond yield for April 2030 and April 2035)
  • calculate the difference between each indexed bond and the yield on the conventional bond with the closest maturity date.

long-term breakevens

These breakevens, or implied inflation expectations, were uncomfortably low (relative to the target) even back in 2018. Things have only got worse since then.

Not that these are not breakeven inflation rates (or expectations) for a single year –  say 2025-  in the way that survey expectations (including the RB survey) are.  They are indications about average CPI inflation over the whole period to, say, 2025.

I thought there were several things that were interesting about the chart:

  • breakevens seemed to be trending downwards (if only modestly) well before the current recession began.  That seemed pretty rational –  the growth phase (here or abroad) wasn’t likely to last forever, and it was becoming increasingly clear that central banks were likely to feel quite constrained in the next downturn,
  • the divergence between the blue line and the other two this time last year.  That was when the Reserve Bank felt obliged to cut the OCR quite bit, and to start running those lines I referred to at the start of this post about downside risks around inflation expectations.  One could interpret the subsequent closure of the gap as a mark of some credibility for the Reserve Bank.  Expectations of inflation over the next five years rose a bit, and the gap between the 2025 and later expectations closed up again.
  • the sharp decline in the breakevens, for all three maturities, beginning in March.  Some of that will have been about the extreme illiquidity event in global (and local) bond markets in mid-March (something similar happened in 2008/09), prompting various central banks, including our own, to intervene in bond markets,
  • perhaps most importantly, the substantial divergence that has now opened up between the breakevens for the period to 2025 and those for the longer maturities.  All three lines picked up to some extent after the Reserve Bank added inflation-indexed bonds to the list of assets they would buy under LSAP, but since then the breakeven for the period to 2025 has gone basically nowhere, sitting at just above 0.4 per cent per annum (compared to an inflation target over the period of 2 per cent per annum).  By contrast, the grey line is back close to 1 per cent, not that much below where it was last year.   Even these lines understate the extent of divergence, because the breakeven to 2035 includes the five years to 2025.    If we could back out an implied breakeven just for the five years from 2030 to 2035 it might be around 1.3 per cent –  still not great, still not consistent with the target, but no worse than last year.
  • to the extent one can yet read anything into the 20 year numbers, and implied breakeven inflation rate for 2035 to 2040 would be higher still, although still below 2 per cent.

There are pluses and minus to be taken from all this.

The positive feature is that if one looks 15 years ahead, markets don’t expect New Zealand to deliver on a 2 per cent inflation target, but their (implied) view on that is no worse now than it was last year.  That isn’t great but it is better than the alternative.   On the other hand, it tells you almost nothing about the current conduct of monetary policy, since (a) current monetary policy won’t be affecting inflation outcomes 15 years hence, and (b) almost certainly, neither will the current key players (Orr or Robertson).

The negative feature is just how weak those five-year average expectations are, averaging around 0.4 per cent, well below the bottom of the target range, let alone the 2 per cent midpoint the MPC is supposed to focus on.   And this is the horizon that current monetary policy is affecting, and which the current key players (Orr, Robertson, and the MPC) will be affecting.    And these breakevens are down so far this year that real interest rates have not fallen much at all.   Here, for example, is the real yield on the 2025 inflation-indexed bond.

2025 real yield

No change over a year.  Or even if there was something odd going on at the end of July last year, no material change since (say) February this year, even as a severe recession and deflationary shock hit New Zealand and the world.  Even with the Reserve Bank intervening to support this market.   That is a pretty damning commentary on monetary policy simply not doing its job –  real yields over a five year horizon will always be heavily influenced by expected changes in short-term real policy rates.

As a final cautionary note, the deflationary shock was pretty much global in its effect, but here is the five year breakeven chart for the United States since the start of 2018.

US 5 yr

Not only can you see how much closer the breakeven has been to the Fed’s target for the inflation rate but, more importantly in the current context, how strongly the five-year breakeven has rebounded since March.   It is a very different picture to what we’ve seen in New Zealand.   There are some differences: the respective inflation-indexed bonds are slightly differently specified, and the Fed is not buying indexed bonds (unlike the RBNZ). But all else equal, the fact that the RB is buying indexed bonds and the Fed is not should be pushing New Zealand breakevens up relative to those in the US.  [UPDATE: A reader  draws my attention to the fact that the Fed is buying TIPS.]

The Governor and the MPC seem to have been all too keen to abdicate responsibility in this crisis, deferring almost everything to fiscal policy and simply refusing to cut the OCR further.  How much fiscal stimulus to do is a political matter outside the Bank’s control, but however much the government has done –  and it will soon be doing less, as the wage subsidy ends –  it is increasingly clear that the Reserve Bank is simply not doing enough.  Low and falling inflation expectations are inappropriate, inconsistent with the mandate, at the best of times, but far more troubling when central banks are unwilling to take official short-term rates deeply negative.  The Governor and his colleagues seemed to know that last year when it wasn’t much of an issue, but to have forgotten –  or simply chosen to ignore it –  this year.  It is as if they are simply indifferent to the (un)employment consequences.  That shouldn’t be acceptable, including to the Bank’s Board and the Minister of Finance who are responsible to us for the MPC’s stewardship.

 

Why economic policymakers need to respond aggressively

Yesterday I dug out some discussion notes I’d written while I was working at The Treasury during and just after the last New Zealand recession.  One of them –  written in June 2010, already a year on from the trough of the global downturn (although as the euro-crisis was really just beginning to emerge) – had the title “How, in some respects, the world looks as vulnerable as it was in 1929/30”.     The point of the “1929/30” was that the worst of the Great Depression was not in the initial downturn from1929 –  which, to many, seemed a more-or-less vanilla event – but from 1931 onwards.    It was only a four or five page note, and went to only a small number of people outside Treasury/Reserve Bank, but in many respects it frames the way I’ve seen the last decade, capturing at least some of issues that still bother me now, and lead me to think that  –  faced with the coronavirus shock –  macro policymakers should err on the side of responding aggressively (monetary and, probably, fiscal policy).

The more serious event –  akin to the 1930s –  didn’t happen in the last decade, at least outside Greece.    At the time, much of the focus of macroeconomic policy discussion  –  including in New Zealand –  was around ideas of rebalancing and deleveraging.    My note pointed out that, starting from 2010, it was very difficult to envisage how those processes could occur successfully over the following few years consistent with something like full employment.     To a first approximation it didn’t happen.  There was fiscal consolidation in many advanced countries, but not material private sector deleveraging. In most OECD countries it took ages –  literally years –  to get the unemployment back to something like the NAIRU.  And, of course, there was a huge leveraging up in China.  In much of the advanced world investment remained very subdued.

There were twin obstacles to getting back to full employment.  On the one hand, short-term policy interest rates in many countries had got about as low as they could go.  And on the other hand there was a view –  justified or not –  that fiscal policy had done its dash, and whether for political or market (or rating agency) reasons, further fiscal stimulus could not be counted on (even in a New Zealand context: I found another note I’d written a year earlier just before the 2009 Budget, which noted of “scope for conventional market-financed fiscal easing” that “our judgement –  more or less endorsed by the IMF and OECD – is that we are more or less at that point [scope exhausted]”.

The advanced world did, eventually, get back to more-or-less full employment.   But the world – advanced world anyway –  never seemed more than one severe shock away from risking dropping into a hole that it would be very hard to get back out of.  The advanced world couldn’t cut short-term interest rates by another 500 basis points.   For a time that argument didn’t have quite as much force as it does now –  when excess capacity was still substantial one could tell a story about not being likely to need so much policy leeway next time –  but that was then.  These days we are back starting from something like full employment.   There was also the idea of unconventional monetary policy instruments: but while some of them did quite some good in the heat of the financial crisis, and in the euro context were used as an expression of the political determination to hold the euro-area together come what may, looking back no one really regards those instruments as particularly adequate substitutes for conventional monetary policy (limited bang for buck, diminishing marginal returns etc).  And then there is fiscal policy.   Few advanced countries are in better fiscal health than they were prior to the last recession –  and New Zealand, reasonably positioned as we are –  is not one of the few, and the political/public will to use huge amounts of fiscal stimulus for a prolonged period remains pretty questionable.

Oh, and there is no new China on the horizon willing and able to have its own massive new credit/investment boom – resources wisely allocated or not – on a global scale to support demand elsewhere.

How about that monetary policy room?  Here are median nominal short-term interest rates for various groupings of OECD countries.

short-term 2020

You can see where we are 10 years ago.   Across all the OECD monetary areas (countries with their own monetary policy plus the euro-area) the median policy rate is about where it was then (of the two biggest areas, the US is a bit higher and the euro-area a bit lower).  Same goes for the G7 grouping.  And as for “small inflation targeters” (like New Zealand) those countries typically have much less conventional monetary policy capacity than they had in 2010 (New Zealand, for example, had an OCR of 2.75 per cent when I wrote that earlier note, and is 1 per cent now).

Back then, of course, the conventional view –  not just among markets but also to considerable extent among central banks –  was that before too long things would be back to normal.  Longer-term bond yields hadn’t actually fallen that far.  Here are the same groupings shown for bond yields.

long-term 2020

One could, at a pinch, then envisage central banks acting to pull bond yields down a long way (and with them the private rates that price relative to governments).  These days, not so much.  Much of the advanced world now has near-zero or even negative bond rates.  A traditionally high interest rate country like New Zealand now has a 10 year bond rate around 1 per cent.   Sure those yields can be driven low, but really not that much if/when there is a severe adverse shock.

And 10 years ago if anyone did much worry about these sorts of things –  and there were a few prominent people –  there was always the option of raising global inflation targets.  In the transition that might have supported demand and getting back to full employment. In the medium-term it would have meant a higher base level of nominal interest rates, creating more of a buffer to cope with the next severe adverse shock.   It would have been hard to have delivered, but no country even tried, and now it looks to be far too late (how do you get inflation up, credibly so, when most of your monetary capacity has gone, and it would hard to convince people –  markets –  of your sustained seriousness).

My other point 10 years ago in drawing the Great Depression parallels was that the Great Depression was neither inevitable nor inescapable.  But it happened –  in reality it might have taken inconceivable cross-country coordination to have avoided by the late 1920s –  and it proved very difficult (not technically, but conceptually/politically) to get out of.  The countries that escaped earliest –  the UK as a prime example –  did so through a crisis event, crashing out of the Gold Standard in 1931 that they would have regarded as inconceivable/unacceptable only a matter of months earlier.  For others it was worse –  in New Zealand the decisive break didn’t come until 1933, and even then saw the Minister of Finance resigning in protest.    If we get into a deep hole in the next few years –  international relations generally not being at their warmest and most fraternal, domestic trust in politicians not being at its highest –  it could be exceedingly difficult to get out again.  Look at how long and difficult (including the resistance of central banks to even doing all they could) it proved to be to get back to full employment last time.

In the Great Depression one of the characteristic features was a substantial fall in the price level in most countries.   The servicing burdens of the public and private debt –  substantial in many countries, including New Zealand/Australia –  escalated enormously, and part of the way through/out often involved some debt defaults and debt writedowns.

Substantial drops in the price level seem unlikely in our age.  Japan, for example, struggled with the limits of monetary policy and yet never experiencing spiralling increases in the rates of deflation (of the sort some once worried about).  But equally, inflation expectations ratcheted down consistent with the very low or moderately negative inflation, meaning real interest rates were never able to get materially negative.  Japan at least had the advantage that in the rest of the advanced world, nominal interest rates and the inflation rate were still moderately positive.

That could change in any new severe downturn.  A period of unexpectedly weak demand, with firms, households and markets all realising that authorities don’t really have much useable firepower, could see assumptions/expectations about normal rates of inflation dropping away quite sharply (in New Zealand they fell a lot, from a too-high starting point, last time round, even with unquestioned firepower at our disposal).  In that scenario, authorities would struggle to lower real interest rates at all for long –  falling nominal rates could quite quickly be matched with falling inflation expectations.  As people realise that, it becomes increasingly hard to generate a sustained recovery in demand, and very low or negative inflation risks becoming entrenched.  It isn’t impossible then to envisage unemployment rates staying very high –  unnecessarily and (one hopes) unacceptably high –  for really prolonged periods (check the US experience in the 1930s on that count).  An under-employment “equilibrium” brought by official negligence is adequately dealing with the effective lower bound on nominal interest rates.

I cannot, of course, tell if the current coronavirus is that next severe adverse shock.  But it looks a great deal as though it could be, and the risks are sufficiently asymmetric –  not much chance of inflation blowing out dangerously –  that we shouldn’t be betting that it won’t be.  Some people argue that since the virus will eventually pass for some reason it isn’t as economically serious as other shocks.   That seems wrong.  All shocks and recessions eventually pass –  many last not much more than a year or two  –  and the scale of disruption, and reduction in activity, we are now seeing (whether in the New Zealand tourism and export education industries, or much more severely in northern Italy, Korea and the like) has the potential to markedly reduce economic activity, put renewed downward pressure on inflation and inflation expectations (we see the latter in the bond market already), all accompanied by a grim realisation of just how little firepower authorities really have, or are really politically able to use.  (Ponder that G7 conference call tomorrow, and ask yourself how much effective leeway the ECB has now, compared to 2007, or even 2010. )

Against that backdrop, it would seem foolhardy now not to throw everything at trying to prevent a significant fall in inflation expectations, by providing as much support to demand and economic activity as can be done.   That means monetary policy, to the extent it can be used –  in New Zealand for example, a central bank that was willing to move 50 points last August, on news that was weak but not very dramatically so, should be champing at the bit to cut at least that much this month.  The downside to doing so, in the face of a very real threat to norms around inflation –  and a likely material rise in unemployment – is hard to spot.  And since everyone knows monetary policy has limited capacity –  and those who haven’t realised it yet very soon will –  we need to see fiscal policy deployed in support, in smart, timely, and effective ways.   In some countries it is really hard to envisage that being done well –  the dysfunctional US in the midst of an election campaign, starting with huge deficits –  but there really is no such excuse in countries such as New Zealand and Australia.  (Oh, and of course –  and after all these years –  something needs to be done decisively re easing the effective lower bound.)

(There is, of course, widespread expectations of a huge Chinese stimulus programme.  That is as maybe, although it will bring both its own risks –  domestic ones just kicked a little further down the road –  and the risk of new immediate dislocations, including the possibility of a significant exchange rate depreciation, exporting (as it were) deflationary pressures to the rest of the world.)

We are only one serious adverse shock away from a very threatening economic outlook, where the limits of macro policy would mean it would be difficult to quickly recover from. By the day, the chances that we are already in the early stages of that shock are growing.  Perhaps it will all blow over very quickly, and normality resume, but (a) even if that very fortunate scenario were to eventuate, the risks are asymmetric, and (b) we’d still be left sitting with very low interest rates and typically high debt, one serious adverse shock away from that hole.

 

Where in the world is inflation?

According to the IMF these are the countries that will have an inflation rate in excess of 20 per cent this year.

Turkey 20.3
Liberia 27.2
Yemen 30.0
South Sudan 40.1
Zimbabwe 42.1
Argentina 47.6
Islamic Republic of Iran 51.1
Sudan 72.9
Venezuela 1555146.0

I’m guessing there is some margin of error around that curiously specific estimate for Venezuela.

In most of these countries, inflation is forecast to be higher this year than it was last year.  Here is one stark example.

arg infl

It can be done –  although one might well wish to avoid the Argentine experience.

On the other hand, the IMF also forecasts that there will be 13 countries with 2019 inflation rates of 0.5 per cent or less.    (The median inflation rate across all countries this year is expected to be 2.4 per cent.)

In the advanced economies there isn’t much sign of any rebound in (core) inflation

core inflation 19

What about expectations?    Bond yields are falling again, and not all of it seems to be falling real rates.  Here is a chart I saw yesterday showing implied five year forward expectations for average inflation in the euro-area.

euro infl swaps

That is a long way below 2 per cent.

Things aren’t as bad in the US.  Here is the latest chart for 10 year inflation breakevens.

US breakevens may 19

And in both Australia and New Zealand the gap between indexed and conventional government bond yields is not much more than 1 per cent.  That is a long way from the 2.5 per cent and 2.0 per cent targets respectively.

This was a bit of context for the last IGM survey of economics academics that I saw the other day.

IGM Fed

I guess the question was asked in the specific context of the aborted nominations of Stephen Moore and Herman Cain, but it is posed more generally.

I’d probably have answered the same way, especially bearing in mind the way the question is phrased (note that “primarily”).  Apart from anything else, choosing anyone for anything primarily based on their political views is a recipe for trouble (even in Cabinet or the organisational side of a political party one usually wants competence as well).

And yet, and yet.  It is hardly as if the actual monetary policymakers in much of the advanced world have done such a great job in the last decade that things couldn’t have been improved on.  Arguably, the US Federal Reserve has done better than most central banks, but even then it was hardly a record to write home about (slow to recognise the recession in the midst of it, constantly champing at the bit to tighten afterwards, nothing done to prepare for the next serious recession etc).

When I was young the predominant narrative around central banks was that one needed to keep politics and politicians clear, because otherwise high inflation would be a recurring –  perhaps permanent –  problem.  I’ve long been fairly sceptical of that view, even as an explanation for history during the Great Inflation, but look at where we’ve been for the last decade, with inflation sitting below target in most advanced countries even as unemployment was (for a long time) slow to fall.    It isn’t impossible that in those specific circumstances (even if not generally) monetary policy decisionmakers with a stronger political focus might have done less badly than the actual decisionmakers did.   That, at least, should have been the out-of-sample forecast of the more vocal champions of technocratic rule if this argument had been run a decade ago.   (Of course, political bias can cut both ways: there have been both technocrats and politically-attuned people on the right in the last decade championing the case for higher interest rates, arguing that if anything raising interest rates pre-emptively might assist in rebalancing the economy.)

I’m not arguing to junk professional expertise when it comes to monetary policy, any more than one should in any other area of policy, but in and around monetary policy the limits of technical expertise are pretty real and substantial (or we’d have easy compelling and generally accepted answers to the issues of the last decade) and it isn’t obvious that professional experts are necessarily the best final decisionmakers.  In the face of great uncertainty, I’m increasingly inclined to think that the decisions should rest more squarely with those who are electorally accountable –  drawing on professional expertise to the extent it can help, but recognising the need for contest, scrutiny, and considerable scepticism about the best insights of institutional “experts”.  In that world, central bankers provide analytical inputs, and operational implementation of policy choices, but have less weight in the policymaking itself.

In a New Zealand context, it was sobering to read the other day that the UK statistics office had just announced that the British unemployment rate had fallen to the lowest rate since 1975 (and the US unemployment rate is the lowest since 1969), without inflation having become an obvious problem.    In New Zealand, the unemployment rate in 1975 was about 2 per cent.  Just to get back to the lowest unemployment rate this century in New Zealand we’d need to see a drop of another 0.9 percentage points.   In view of our central bank’s statutory mandate around “maximum sustainable employment” it would be interesting to see their analysis of why we can’t manage something like that.  Perhaps there are regulatory or welfare obstacles (eg high minimum wages relative to median wages) –  and if so, central banks can’t do much about those – but with inflation still persistently a bit below target, it sure looks as though New Zealand’s unemployment rate could be a bit below 4.3 per cent without creating inflationary trouble.

 

What to make of the inflation data?

There seemed to be a little in this week’s CPI numbers for everyone.   The Reserve Bank’s favoured core inflation measure was unchanged at 1.7 per cent (and the model slightly revised downwards the estimate for a couple of quarters back), bringing up now a full nine years in which this core measure has been below 2 per cent.   The CPI ex food and energy series –  a standard international core inflation indicator –  doesn’t get much attention in New Zealand, but annual inflation in that measure was (up a bit) 1.6 per cent.  The last time that inflation measure was above 2 per cent –  excluding the GST change –  was late 2007.  That was so long ago, there will be voters in next year’s election who don’t even remember 2007.

New Zealand inflation measures –  even the sectoral core measure –  are biased upwards these days by the repeated large increases in tobacco taxes.  The price indexes rise as a result, but these tax increases aren’t what economists typically think of when they use the term “inflation”.     Neither Statistics New Zealand nor the Reserve Bank publish a decent core measure that also excludes government charges and tobacco taxes, so I’ve come to quite like the series SNZ does publish for non-tradables inflation excluding government charges and cigarettes and tobacco.  Here is the annual inflation rate in that series.

nt ex jan 19

The annual inflation rate in this measure did pick up a little, but (a) is no higher than the last couple of local peaks, and (b) even 2.5 per cent core non-tradables inflation just isn’t consistent with core overall inflation being back to 2 per cent.   The Reserve Bank was still cutting the OCR in late 2016 when this particular inflation rate series was around current levels.

What about the wider world environment?  Here is CPI ex food and energy inflation for the G7 group of countries.

g7 cpi ex

The picture for China also doesn’t suggest global inflation is rising.

And all this is against a backdrop in which both the world economy and New Zealand’s economy seem to be losing steam.      The pick-up in the sectoral core factor model measure of inflation to 1.7 per cent in the last couple of quarters might be “encouraging” in some sense, if one could readily point to factors that were likely to intensify resource pressures from here, or drive up perceptions of a “normal” or natural inflation rate.  But….the Christchurch rebuild is winding down, immigration seems to edging down, and the terms of trade show no sign of moving to a new higher plateau. There is no fresh wave of productivity growth, inducing firms to invest heavily, and encouraging consumers to spend in anticipation of future higher living standards.  If you believe in housing wealth effects (I don’t see any evidence in aggregate for them), even house price inflation has faded.   There is some fiscal stimulus in the pipeline, but it is nothing like some of the positive demand shocks we’ve gone through in the last 10 or 15 years.  This has the feel of being about as “good as it gets” (thoroughly lousy when contemplating productivity, but here I’m just thinking of capacity pressures, and things which might boost core inflation).

And it isn’t too different abroad.   Global growth projections are getting revised down a little: in the US fiscal stimulus is fading and monetary tightening is beginning to bite, in the euro-area activity indicators are weakening (and add in some Brexit uncertainty on both sides of the Channel), and in China things don’t seem to be developing well.  Commodity prices were a big worry at the end of the last boom, in 2007 into 2008 –  concern about spillover into inflation expectations and wage demands – but not so much now.  And it isn’t as if global monetary policy has suddenly got a lot looser either.  There just isn’t much reason to think core inflation –  here or abroad –  is likely to rise further, and neither here nor in most countries abroad is inflation at target.   When the next recession comes, core inflation is likely to fall from here.

The market doesn’t seem convinced that there is higher inflation in prospect either.  Breakevens from the indexed and conventional government bond market have been falling in other countries.  And here is the New Zealand picture, updated so that the last observation in this monthly chart is yesterday’s data.

breakevens jan 19

In the US, at peak, markets were pricing future inflation averaging a touch above 2 per cent.  Here we never quite got even to 1.5 per cent, and in the last couple of months the breakeven inflation rate (implied expectation) has dropped away again.  People putting real money on these things are implicitly pricing the average inflation rate over the next 10 years in New Zealand at 1.1 per cent.   That seems too low to me, even allowing for an excessively cautious central bank over the last decade (and hardly a vote of confidence in the amended Reserve Bank legislation passed last month), but even if you are sceptical of the level, the direction should be troubling the Governor (and his associates just about to be appointed to the new Monetary Policy Committee).   There doesn’t seem to be any sense any longer that a normal inflation rate in New Zealand is 2 per cent. (My thoughts on making sense of the indexed bond numbers are here.)

It is clear that, with the benefit of hindsight, the OCR should have been a bit lower over the last couple of years.    That is simply the same as observing that core inflation has again undershot the target (and implied expectations suggest that outcome isn’t simply an anomaly).    That isn’t the same as recommending now that the Governor should cut the OCR at next month’s review – and I’m quite he won’t anyway.   There is a reasonable case to be made for a cut now – low inflation, growth pretty insipid etc, tempered by the fact that the unemployment rate (a lagging indicator) is probably around the NAIRU –  but the cautious bureaucrat still lurking in me probably wouldn’t yet go that far.  But the case for a more explicit easing bias does seem increasingly clear.

(It is always good to have diversity of views. My post the other day on the Prime Minister’s FT article seems to have excited another local economics blogger.  Apparently I am a member of the “New Zealand establishment” –  surely a thought that would appal them as much as it appals me –  and some sort of lackey of the National Party (and, worse, the US Republican Party).  I almost fell off my chair a few months ago when someone told me that Simon Bridges had made some positive remarks about this blog, but I doubt any regular readers would ever have taken me as sympathetic to a party that failed to do anything about productivity, failed to do anything about housing, and which seems more interested in pandering to the PRC –  and keeping the funding going –  than in the wellbeing of New Zealanders and the integrity of our society.)

 

 

Inflation-indexed bonds: are they telling us anything?

Data from New Zealand’s inflation-indexed bond market has been a bit of a mystery for some time.

If one looks at US data, the gap between conventional and indexed government bond yields –  the “breakeven” or implied inflation expectation – makes sense.  Here is the data for the last five years or so.

US IIBs

The US inflation target is around 2 per cent and for the last couple of years the breakevens have been pretty close to that.  There was a period of real weakness in 2015/16 but it didn’t last that long, and even then the breakevens were only averaging around 1.5 per cent.   If you were inclined to focus on the severe limitations US monetary policy will face in the next serious recession, you might even think 2 per cent breakevens for the average of the next 10 years is a bit high –  after all, the Fed has struggled to get inflation to average 2 per cent in the last decade –  but that would be a non-consensus perspective, and I’ll leave it to one side for now.

The New Zealand indexed bond market was, for a long time, rather patchy to say the least.  Indexed bonds were tried for a while in the 1980s, and then one more-modern-style long-term indexed bond was issued in the mid-late 1990s (about the time I and a colleague wrote this article).  But The Treasury was never very keen, and there was a diminishing volume of public debt anyway.     If there is any upside to the higher volume of public debt this decade (in general I’m not convinced) it is the advent of a range of government inflation-indexed bonds.  There are four on issue now, with maturity dates out to 2040.

Unlike the situation in the US, no one makes readily available here constant-maturity data for either indexed or conventional bond yields.  When the “10 year bond yield” is quoted here, it is rarely actually 10 years.  But the Reserve Bank does publish a yield series for each of the indexed bonds.  If one time-weights the (September) 2025 and 2030 indexed bond yields, one gets this approximation to a 10 year indexed yield since September 2015. (I’ve also show the yield for the 2025 bond from the end of 2013 to September 2016, when it was at least moderately close to 10 years).

indexed bond yield NZ

The fall in long-term real interest rates is certainly striking –  consistent with the fact that five years ago the Reserve Bank and most of the market thought short-term interest rates would be more like 4 or 5 per cent looking ahead. In fact, of course, the OCR has been 1.75 per cent for the last couple of years, and is currently expected to remain low pretty indefinitely.

And what if we then take the Reserve Bank’s “10 year bond yield” series for conventional bonds, and subtract the indicative indexed bond series in the previous chart?

NZ IIBs

This is the chart that parallels the US one at the start of the post.  As you can see, the two charts (one daily, one monthly) look quite similar at the start.  Breakevens here were also around 2 per cent, the target set for the Reserve Bank.  But then they diverge –  the short term cycles are similar, but the levels are very different.  On this measure, it has been three years since the New Zealand breakeven rate got even to 1.5 per cent.  As of yesterday’s data, the gap was 1.34 per cent.

Meanwhile, of course, at every opportunity the Reserve Bank assures us that inflation expectations –  survey measures, which involve respondents staking no money, and rarely any reputation (since responses are published mostly in aggregated form) –  are “securely anchored” at 2 per cent.   And, rather than address the indicators from the indexed bond market, the Bank simply passes by in silence.

Over the years, there have been various stories put forward for why information from the indexed bond market should be discounted.  For a long time, there was only one maturity, and there really wasn’t all that much of that bond on issue (just over $1 billion).   Then there were stories about illiquidity –  not much trading in indexed bonds and few or no price-makers.   Glancing through the historical data for turnover in the Feb 2016 bond, there were lots of weeks when the outright trades totalled less than $5 million, and quite a few when there were no trades at all.

But these days there are four bonds on issue, totalling about $16 billion.  Talking to a funds manager recently, I learned that another bank has just become a pricemaker in indexed bonds, such that there are now three local and three offshore institutions offering two-way prices in these instruments.  And the Reserve Bank turnover data suggests that if these markets aren’t exactly awash with trade, there is now a respectable volume of secondary market turnover in at least the 2025 and 2030 maturities (and there isn’t much turnover in conventional bonds beyond 2030 either).

I queried the fund manager as to his view on why the New Zealand breakevens are so low.  He argued that it wasn’t now a market liquidity issue (although you have to think that if you wanted to dump a $200 million position it would still be a great deal easier in the conventional market than the indexed market).   His argument was the market was still new and that there limited interest still from the buy side, including the offshore market in particular.    I was a bit surprised by that, as I recalled (long ago) when the indexed bonds were being issued in the 1990s that a lot of demand initially came from offshore (it surprised us at the time, and New Zealand inflation indexation seemed like something more naturally appealing to local pension funds than to offshore funds).   But I looked up the data, and this is what I found.

Per cent of bonds in market held by non-residents, Oct 2018
Conventional
Apr-23 67.7
Apr-25 52.2
Apr-27 67.1
Apr-29 75
Apr-33 46
Indexed
Sep-25 50.7
Sep-30 37.6
Sep-35 21.3

And, sure enough, a materially smaller proportion of the indexed bonds is owned offshore than of the conventional bonds.   The offshore proportion isn’t trivial by any means, but it is smaller (and, if anything, looks to have been shrinking a bit over the last few years).

I don’t have a good story for why that might be.  After all, New Zealand indexed bonds offer some of the highest yields in the advanced world (our longest maturity yields 50 basis points more than the US 20 year indexed bond, and the US is now a high yielding advanced economy), and much of the story of the last few years has been of a search for yield.  Search for yields often involves sacrificing liquidity.  And (critical as I am of New Zealand economic performance) the creditworthiness of our bonds, indexed and nominal, looks better than ever in relative terms, as being among the handful of advanced countries with budget surpluses and low debt.

I did hear a story a while ago suggesting that the government has simply glutted the market by issuing too many inflation indexed bonds too quickly.  At one level it is an argument that looks a bit hard to refute (the resulting yields are high relative to equivalent maturity and credit risk conventional bonds), but standing back a bit I’m not sure how persuasive a story it is.  The world markets are big, New Zealand is small (and fairly sound), and the appetite for yield has been strong.

Which is partly why I don’t think it is safe for the Reserve Bank to simply ignore that New Zealand inflation breakevens.  They may well be telling us something about medium-term expectations of inflation (implicit expectations as much as explicit ones).  After all, core inflation this decade has averaged around 1.5 per cent, the Bank has (twice) proved too quick to tighten, and if inflation has picked up a little recently, it would be reasonable to think that there will be a downturn along again before too long.

sec factor model nov 2018

Perhaps there is a more compelling story that “exonerates” the Reserve Bank.  But it would be good to see them make it, and to be able to test the quality of their analysis and research.  Simply ignoring a pattern that has now persisted for three years –  breakevens averaging less than 1.5 per cent when the inflation target as 2 per cent –  seems not particularly responsible, not particularly transparent, not particularly accountable.

 

What to make of the inflation data

The CPI data were released a couple of days ago.   There was, inevitably, a lot of commentary around higher petrol prices, although most commentators noted that the Reserve Bank was likely to “look through” what we are seeing, and not adjust monetary policy just because of higher petrol prices.  That would, indeed, be consistent with the Bank’s mandate –  and practice –  over almost thirty years of inflation targeting.

One can have all sorts of debates about what sorts of effects should be “looked through”.  We used to have lengthy discussions attempting to distinguish between petrol price effects themselves, indirect effects (eg higher airfares or courier costs directly resulting from higher fuel prices) and second-round effects –  the real worry, if changes in oil/petrol prices came to affect the entire inflation process, including medium-term expectations of inflation.   Those risks were real, and realised, back in the 1970s oil shocks, and that set the scene for much of the subsequent discussion and precautionary debate.

SNZ only has a CPI ex-petrol series back to 1999.  In this chart, I’ve shown the headline CPI inflation rate, the CPI inflation rate ex-petrol, and the Reserve Bank’s preferred core inflation measure, the sectoral factor model.

petrol price inflation

I’ve highlighted four episodes in which petrol price inflation was much higher than overall CPI inflation, and one (quite recent) when it was much lower.

In the first of those episodes –  around 2000 –  the surge in petrol prices coincided with quite a lift in core inflation.  Bear in mind that the economy was recovering from the brief 1998 recession, and the exchange rate had fallen sharply.

In the second episode –  2004 and 05 – the surge in petrol price inflation coincided with no change in core inflation.

In the next episodes –  2008 and 2010 –  the surge in petrol price inflation coincided with a fall in core inflation.  In the 2008, the Reserve Bank explicitly recognised some of this at the time, and talked of scope to cut the OCR soon, despite the high headline inflation.

And in the recent episode when petrol price inflation was very low, there was no fall in core inflation –  if you look hard enough, it may actually have increased very slightly.

There is talk that, if oil prices persist, headline inflation could get as high as 2.5 per cent before too long.  The experience of the last couple of decades suggests that will tell us nothing useful about underlying/core inflation trends, or about the appropriate stance of monetary policy.  And the preferred core inflation measure remains below the target midpoint, as it has been for almost a decade now.

Here are a couple of other series worth looking at.

other infl measures

The blue line is a fairly traditional sort of exclusions-based core inflation measure: excluding volatile items (food and fuel) and (administered) government charges (altho not tobacco taxes), and the orange line is non-tradables inflation excluding government charges and cigarette and tobacco taxes (which, you will recall, have been raised relentlessly each year, in a political non-market process).  There is no sign in either of these series of underlying inflation moving higher in the last year or two.  Core non-tradables inflation of under 2.5 per cent is not consistent, typically, with core (overall) inflation being at 2 per cent.

Having said all that the financial markets appear to have taken a slightly different view of this week’s inflation data.  Here is a chart of the breakeven inflation rate from the government bond market –  the difference, in this case, between the 10 year conventional bond rate and the 2030 indexed bond (real) rate.  I’ve highlighted the change since the inflation data were released.

IIBs oct 18 2018

At 1.4 per cent, the gap is still miles off the 2 per cent target midpoint (or than the comparable numbers in the US), but the latest change does look as if it is worth paying at least a bit of heed to.  Perhaps it will dissipate over the next few weeks, but if not it wouldn’t be a cause for concern, but some mild consolation that –  after all these years –  there was some sign of market implied inflation expectations edging a little closer to target.

What about a longer run of data?   We only have a scattering of inflation indexed bonds, in this case one maturing in September 2025 and one maturing in September 2030.  The 2030 bond was first introduced five years ago this month.    Creating a rough constant maturity 12 year indexed bond series –  the 2025 bond had 12 years to run in 2013, and the 2030 one has 12 years to run now –  and subtracting the result from the Reserve Bank’s 10 year conventional bond series produces this (rough and ready) chart.

iib constant maturity breakeve

A clear rebound from the lows of 2016, but implied breakeven inflation rates still much lower than they were five years ago.

There still seems to be quite a long way to go for the Reserve Bank to really convince investors that, over the decade ahead, they will do a better job of keeping inflation averaging near target than they have done this year to date.

Continuing to talk down the risks of the next serious recession, and the limitations of policy here and abroad to act decisively to counter such a recession and the likely deflationary risks, is cavalier and irresponsible.  It might (seem to) help confidence in the short-run, but if those risks crystallise –  and central banks should focus on tail risks in crisis preparedness –  the Bank will bear a lot of the responsibility if the economy performs poorly, and inflation ends up so low as to vindicate (and more) the evident lack of confidence among people putting real money on a view about the average future inflation rate.

 

Inflation and the tax system

When I went looking for the interim report of the Tax Working Group, I found that various other papers had been released.   These include background papers prepared by the Treasury and IRD secretariat looking at various possible options for reducing other taxes if, for example, new capital taxes were to provide more government revenue.

Among them was a short and rather unconvincing paper on productivity.   It was notable for highlighting how difficult it was to give any concrete meaning to the aspiration repeatedly expressed by the Minister of Finance, and included in the terms of reference, of “promoting the right balance between the productive and speculative economies”.  And it was also notable for the aversion of officials to lowering the company tax rate (or the effective tax rate shareholders pay on company income), even though they accept that our business income tax rates are now high by international standards, and that business investment (including FDI) is low by international standards. This chart is from the paper.  In general, what is taxed heavily you get less of.

corp income tax

But this time I was more interested in another of the background papers, this one on the possibility of inflation indexing the tax system.   Even with 2 per cent inflation, failing to take explicit account of inflation in the tax system introduces some material distortions and inefficiencies.  Many of the costs of inflation arise from the interaction with the tax system, and these distortions may be greater in New Zealand than in many other countries because of the way we tax retirement income savings (the TTE system introduced, as a great revenue grab at the time, in the late 1980s).

In the days of high inflation there was some momentum towards doing something about indexation. It had, for example, been a cause championed by former Reserve Bank Governor Ray White.  And in the late 1980s, the then government got as far as publishing a detailed consultative document.  But then inflation fell sharply (and maximum marginal tax rates were cut) and the issue died.  We don’t even have the income tax thresholds indexed for inflation, allowing Ministers of Finance ever few years to present as a tax cut an increase in revenue that should never have occurred in the first place.

In the early days of inflation targeting there might even have been a case for letting the issue die.  The inflation target was centred on 1 per cent annual CPI increases, and that target was premised on a view that the CPI had an annual upward bias of perhaps as much as 0.75 per cent per annum).  But since then, the extent of any biases in the CPI have been reduced, and the inflation target has twice been increased.   The inflation target now involves aiming for “true” inflation” of at least 1.5 per cent per annum.

The distortions are most obvious as regard interest receipts and payments.  Take a short-term term deposit rate of around 3 per cent at present.  Someone on the maximum marginal tax rate (33%) will be taxed so that the after-tax return is only 2 per cent. But if, as the Reserve Bank tells us, inflation expectations are 2 per cent, that means no real after-tax return.  Compensation for inflation isn’t income and it shouldn’t be taxed as such.  Only the real component of the interest rate (1 per cent) should be taxed.   The same distortion arises on the other side, for those able to deduct interest expenses in calculating taxable income: in the presence of inflation, this tax treatment subsidises business borrowing.  The amounts involved are not small.   As economist Andrew Coleman notes in his (as ever) stimulating TWG submission

Even at low inflation rates, these distortions are substantial. In 2017, for instance, residential landlords borrowed $70 billion. Even if the inflation rate is as low as 1 percent, this means residential landlords can deduct $700 million of real principal repayments from their taxable income, a subsidy worth over $200 million per year. New Zealand households lend in excess of $150 billion. When the inflation rate is 1 percent, lenders are expected to pay tax on $1.5 billion more than they ought. Many people who invest in interest-earning securities are elderly, risk averse, or unsophisticated investors. For some reason the New Zealand Government believes these investors should pay more tax than any other class of investors in New Zealand. It is a strange country that taxes the simplest, most easily understood, and the most easily purchased financial security at the highest rates. It suggests the Government has little interest in equity, its protestations notwithstanding.

There are other distortions too, notably around trading stock valuations and asset valuations on which true economic depreciation would be calculated.

As reflected in the paper released this week, officials are very wary about doing anything about fixing these distortions (and they fairly note that “no OECD country currently comprehensively inflation indexes their tax system”), and they devote many pages to outlining the practical challenges they believe would be involved, and the new distortions they believe would arise from partial approaches to indexation.

I have some sympathy with the stance taken by officials on the specific challenges to doing comprehensive indexation, especially in a way that does not bias transactions through favoured institutional vehicles.  But it is a particularly bloodless document that seems to reflect no sense of the injustice involved in taxing so heavily relatively unsophisticated savers (while subsidising business borrowers, especially those financing very long-lived assets).

This seems like a case where some joined-up whole-of-government policy advice would be desirable.  There would be no systematic distortions arising from the interaction between inflation and the tax system if there was no systematic or expected inflation.   Systematic inflation isn’t a natural or inevitable feature of an economic system –  in some ways it is about as odd as changing the length of a metre by 2 per cent a year, or the weight of a gram by 2 per cent a year.  In the UK, for example, (and with lots of annual variation) the price level in 1914 was about the same as it had been in 1860).  And the most compelling reason these days for targeting a positive inflation rate is the effective lower bound on nominal interest rates, itself created by policymakers and legislators.   Take some serious steps to remove that lower bound and (a) we’d be much better positioned whenever the next serious economic downturn happens, and (b) we could, almost at a stroke, eliminate the distortions –  and rank injustices –  that arise from the interaction between continuing, actively targeted, positive inflation, and a tax system that takes no account of this systematic targeted depreciation in the value of money.

It wouldn’t be hard, but our ministers, officials (Treasury and IRD), and central bankers currently seem utterly indifferent to the issue.

Exchange rate moves: trivial in historical context

I saw a curious story the other day which reported the Minister of Finance and the National Party spokesperson on finance arguing over who was to blame (or who could take the credit) for the fall in the exchange rate that followed the Reserve Bank’s Monetary Policy Statement.  From one side there seemed to be talk of the fall being part of the much-vaunted (but little seen) economic transition –  the Prime Minister herself has claimed this –  and from the other talk of loss of confidence in the economy, combined with some inflation risks.

Mostly it seems to be a difference about almost nothing.  Here is one of the OECD measures of New Zealand’s real exchange rate, for which data are available back to 1970. Obviously, we don’t have Q3 data yet, but I’ve taken the fall in the nominal TWI measure of the exchange rate for this quarter to date (latest observation for the RB website today) and applied it to the Q2 data to proxy a current observation.

RER ULC aug 18

Over almost 50 years, there have been lots of ups and downs in the series, even in the period (up to early 1985) before the exchange rate was floating.  Some have been the start of something pretty sustained –  see the falls in the mid 70s, or after 1987.  Others have been very shortlived (see for example the fall in 1986 or 2006 –  times when, for example, markets got a bit ahead of themselves in thinking our economy was slowing and interest rates would be falling).     Over the full period (and this is quarterly average data, which takes out some of the noise anyway) there have been at least eight episodes when this real exchange rate index has fallen by at least 10 index points (roughly 10 per cent).  The last occasion was in 2015, as markets somewhat belatedly realised –  not quite as belatedly as the then Governor – that the Reserve Bank’s OCR increases weren’t going to be sustained.

This episiode isn’t one of them.  The latest (estimated) observation is a mere six per cent below the most recent peak (18 months ago).  And the latest observation is nowhere near the low reached in the second half of 2015.

In fact, the current level of the TWI is 2.4 per cent below the average level for the June quarter.   Over the entire life of the series (fixed and floating periods) the average quarterly change (up or down) has been 2.7 per cent.  Taking just the floating period (since March 1985), the average quarterly change has been 3.1 per cent per quarter, and if we take just this decade (which, eyeballing things, has been a bit more stable, at least as regards big sustained moves) the average quarterly change has been 2.4 per cent.

Perhaps the fall we’ve seen so far this quarter (or even since the MPS last week) will be the start of something more.   If there is a serious global risk-off event, or a serious New Zealand downturn, that probably would happen.  But all we’ve seen so far is a change that is about the size of the change one sees, on average, each and every quarter –  some up, some down, and most not implying anything very much for the economy.

The idea that the fall foreshadows some promised rebalancing in the economy is pretty laughable.  There have been no policy changes to bring about any such rebalancing (any more than there were with the other –  larger –  falls in the previous 20+ years).  Then again, so is the notion that a lower exchange rate –  a modest fall at that –  is a material inflation risk.    The Reserve Bank itself published research a few years back suggesting noting that, in fact, a lower exchange rate has tended to be associated with lower non-tradables inflation, and often –  notably when commodity prices are also fallling –  with lower overall inflation.

 

Unpicking the inflation numbers

On the face of it, the CPI numbers released earlier in the week seemed quite noteworthy.  The Reserve Bank’s preferred sectoral core measure of CPI inflation is still clearly below the 2 per cent the Bank has been told to focus on, and was last at 2 per cent in the year to December 2009, almost a decade ago.  But the sectoral core measure has increased again, now up to 1.7 per cent, having averaged about 1.4 per cent (without a lot of short-term noise) for the previous five years.   If the trends suggested by this series continue, sectoral core inflation could be back to 2 per cent some time next year.

sec core infl to june 18

That would, all else equal, represent good news not bad (after all, three successive governments now have taken the view that a target midpoint of 2 per cent inflation is best for New Zealand).

But even on this series alone there is still some reason for caution.  The sectoral factor model filters the data, and the nature of the filter means the endpoint estimates (in particular) are prone to revision, and as the paper I just linked to illustrates there are margins of error around any of these estimates.  I’m reluctant to back away from the sectoral factor model numbers –  it has generally been quite a good guide in the years since it was introduced, and tells plausible stories about history.  But, equally, it doesn’t make sense to focus only on this one series.

For example, the CPI ex-petrol is a very simple core measure.  Petrol prices are quite volatile.

CPI ex petrol to June 18

And yet the latest observation in this series is still a touch below the average inflation rate for the previous five years (and at 1.2 per cent well below the target midpoint).  And that is so even though the exchange rate has been unusually high in the last 12-18 months (headline CPI is sensitive to changes in the exchange rate).

There isn’t much sign of rising core inflation being an issue abroad either.  Here is the OECD data on CPI inflation ex food and energy, for the G7 grouping as a whole, and the median of the countries/areas with their own currencies (thus the euro area, like the US, is just one observation).

OECD core inflation jul 18

Both series bounce around a bit, but there isn’t much sign of any sort of breakout to a consistently higher rate of inflation.  Even among the G7, the latest observations suggest that if US core inflation is edging up a bit, that in the UK and the euro-area is falling back a bit (Japan’s June numbers aren’t available yet).

New Zealand might be different of course.  It isn’t obvious why we would be – eg our unemployment rate hasn’t fallen away further or faster than those in most other OECD countries –  but we might.   Here is the NZ version of the same series: CPI inflation ex food, vehicle fuels, and household energy.

cpi ex nz jul 18 2

Indirect taxes and government charges also complicate the interpretation of the inflation numbers.  Weirdly, SNZ still does not publish a straightforward series excluding these effects, to give us a clean read on market prices.  It is not as if these are trivial issues either –  there was the GST increase a few years ago, there are large increases in tobacco taxes every year (which have had the effect of materially increasing the tobacco weight in the CPI), and there are changes in things like ACC levies and (this year) in government subsidies for tertiary fees.

Here are some individual exclusion measures.

cpi ex jul 18

And here is a series SNZ does publish: non-tradables inflation excluding both central and local government charges and tobacco.

NT ex govt and tobacco jul 18

That might suggest a moderately encouraging story, of core non-tradables picking up.  But even if so, it would be the third pick-up in the past five or six years, and neither of the previous ones amounted to much.   Perhaps this time will be different?

One reason to think it might be a little different is developments in housing inflation: construction costs and rents make up quite a substantial proportion of non-tradables.

housing components

Rents are a much larger component of the CPI (9.2 per cent) than construction costs of new houses (5.5 per cent) but most of the cyclical fluctuations are in the construction cost component.   Construction cost inflation has been dropping away quite markedly since the start of last year (and for all the talk of renewed waves of housebuilding –  which I rather doubt will happen) there isn’t any obvious reason to think that phase of the cycle will reverse soon.   Some of the earlier increases in core non-tradables inflation will have reflected increasingly high inflation in construction costs, but since construction costs have been slowing for the last 18 months, the latest pick-up can’t be simply written off as a construction story.  But, whatever the story, core non-tradables inflation of only around 2.4 per cent is simply not going to be high enough to be consistent with core CPI inflation getting back to 2 per cent.  We’d need to see further increases in core non-tradables inflation from here, and with the rate of growth of demand having weakened it isn’t yet obvious that that is the most likely outcome.

And what do the bond markets make of the situation?  Recall that there are two indexed bond maturities either side of the 10 year nominal bond.

IIB breakevens jul 18

There has been some drift high in the inflation breakevens, or implied inflation expectations, over the last 12 months or so.  But however one looks at things, it is hard to see the market pricing average inflation for the next decade much higher than about 1.6 per cent.  That is still a long way from the target midpoint of 2 per cent.

So where does all that leave me?    At very least, there is no sign that core inflation is falling and perhaps some reason to be encouraged, and to think it is picking up.   But however one looks at the numbers, current core inflation isn’t even close to 2 per cent, and by this stage of a long-running cycle (especially one characterised by weak productivity growth) one might have hoped –  even expected –  that core inflation might be running a bit above any target midpoint.   Notwithstanding the sectoral core measure, it seems too early for too much encouragement –  perhaps things are finally on course for a return to 2 per cent, but there are conflicting signs, and not too many compelling reasons to yet think that this time will be different.

What of the outlook?   With ebbing population pressures, weak business confidence, no fixes for the over-regulated and dysfunctional urban land markets, and various policy proposals that not only engender uncertainty but could act as considerable drag on actual and potential growth (eg net zero emissions targets), it isn’t obvious why core inflation is likely to rise from here.   Headline measures will, as always, be tossed around by oil prices developments (and petrol taxes), and a weakening exchange rate will push prices up a little.    Some might argue that public sector wage pressures, and higher minimum wage rates, will themselves contribute to higher domestic inflation.   Perhaps so, although I remain a bit sceptical that they will amount to much (even if there are some material relative price changes).   And, although no one knows when, the next recession is coming –  here and abroad.  From an inflation perspective, including positioning ourselves for the next downturn, we’d have been better off if the OCR had been a bit lower over the last couple of years

Inflation bonds and breakevens

I spent a large chunk of Friday interviewing funds managers.  In the course of our conversations, talk turned to the yields on government inflation-indexed bonds (a sensible asset for funds offering indexed pensions) relative to the yields on conventional government bonds.  There are a lot more inflation-indexed government bonds on issue now than there used to be, and I was encouraged to learn that, as a result, bid-ask spreads are also tighter.

The gap between nominal and indexed bond yields is what is known as the “breakeven” inflation rate –  the actual inflation rate that, over the life of the respective bonds, would generate the same return whether one was holding indexed or nominal bonds.   It can be seen as a proxy for market inflation expectations.

As regular readers know, one of my favourite charts is this one, showing the gap between those yields in New Zealand for the last few years.

IIB breakevens June 18

10 years from now is June 2028, so something nearer the average of the two series is at present a reasonable fix on a 10 year inflation breakeven for New Zealand.  But whichever series you use, the numbers have been consistently well below 2 per cent for several years now.  By contrast, at the start of the chart, it looks as though 10 year inflation breakevens were around 2 per cent (10 years ahead then was 2024, so the blue line was the more relevant comparator).

You might expect that a chart like this one would bother the Reserve Bank (paid to keep inflation around 2 per cent).  Instead, they simply ignore it.   Their statements repeatedly claim that inflation expectations are securely anchored at 2 per cent, relying on surveys of a handful of economists.  They simply ignore the indications from market prices.

It isn’t as if what we see in New Zealand is normal.   Here is the chart of US 10 year breakevens for the same period.

US breakevens jun 18

At something a little above 2 per cent, US breakevens are around the US inflation target (expressed in terms of the private consumption deflator, rather than the CPI-  which the bonds are indexed to).

What about other countries?  Courtesy of Fisher Funds, here are a couple of charts.  First the 10 year breakevens for the last year or so.

global breakevens

“DE” here is Germany.  As Fisher noted to us, it seemed a little anomalous that New Zealand 10 year breakevens are lower than those in Germany (although the German economy is one of the stronger in Europe, and they have no domestic monetary policy).

And here are the 20 year breakevens

20 year breakevens

BEI 2035 and BEI 2040 are New Zealand.   I’ve always tended to discount the UK numbers, because of the different tax treatment of indexed bonds there, but both the US and Australian breakevens look a lot closer to the respective inflation targets (2.5 per cent in the case of Australia) than is the case here.

One of the fund managers we talked to on Friday made a throwaway comment about people simply looking at the last headline CPI number.    Maybe, but annual headline CPI inflation in New Zealand for the last six years has averaged 1.0 per cent.   The Reserve Bank’s favoured core measure has averaged 1.4 per cent over the same period.  And the Reserve Bank has never reached the limits of conventional monetary policy (the OCR hasn’t gone lower than 1.75 per cent) – inflation could have been higher had they chosen differently.  It might not be irrational for investors to treat the track record of the last several years as a reasonable pointer to the period ahead.  After all, the last six years has been a period with a strong terms of trade, and sustained (albeit moderate) growth.    Even if, as all the fund managers we talked to suggested, we are now in a “late cycle” phase when inflation might be expected to pick up, “late cycle” phases tend to come just before the end of the cycle.  There will be downturns in the next 10 or 20 years.

What of other possible explanations for these now persistently narrow New Zealand inflation breakevens?  In years gone by there was almost no liquidity in the indexed-bond market (for a long time there was but a single indexed bond).  All else equal, that might mean investors demanding a higher yield to hold the indexed bond (relative to a conventional bond), narrowing the observed breakevens relative to “true” market expectations of future inflation.

But if it was true once, it must be a less important story now.  There are four indexed bonds on issue, each with principal of several billion dollars.  As I noted earlier, if bid-ask spreads are still wider than those (a) on nominal bonds, and (b) on indexed bonds in say the US, they are tighter than they used to be.  It isn’t an attractive instrument for high frequency trading, but these are multi-month, even multi-year, trends we are looking at.

The other possible story I heard a while ago was the suggestion that the government had glutted the market by issuing too many indexed bonds.    It had an air of plausibility about it.  It isn’t as if there are many natural holders of these instruments –  there are no indexed bond mutual funds in New Zealand, they don’t count as a separate asset class in many mandates, and so on.  Then again, in a low yield (and yield hungry) global environment, these instruments offer a pretty juicy yield (the government has a AAA or AA+ credit rating, and its 2040 indexed bonds are offering just over 2 per cent real –  there isn’t much around to match that combination).  Here is the 10 year indexed bond yield chart (again from Fishers –  ignore the UK again).

real 10 year yields

Over the last few years, this is the proportion of New Zealand government bond sales that have been in the form of indexed bonds.

indexed bond share

About 24 per cent of New Zealand government bonds on issue are currently inflation-indexed.

I’m not sure how that compares generally with other countries, but in the UK –  long a keen issuer of inflation indexed government bonds – the share is also about a quarter.  The British also appear to be winding back their issuance –  to 21 per cent of new sales this year.  According to a  FT story from earlier this year

Robert Stheeman, chief executive of the UK’s Debt Management Office, said that “no other country regularly issues a quarter of its debt in inflation-linked bonds”, which “gives us pause for thought”. In contrast Italy — the continent’s largest issuer of inflation-linked bonds — raises just 13 per cent of its debt in this way, according to figures from the DMO.

It may well have been prudent then for our own government to have wound back its issuance plans for index-linked bonds.  But that news has now been out since the Budget last month, and there is still no sign that 10 year breakevens are more than about 1.5 per  cent –  still well short of the 2 per cent inflation target, that was recently reaffirmed by the new government.

There is an OCR review announcement later this week.  We don’t get much analysis in a one page press release, but as the Governor mulls his decision, and his communications, and looks towards the next full Monetary Policy Statement, it might be worth him inviting his staff to (a) produce, and (b) publish any analysis they have, as to why we should not take these indications from market prices as a sign that inflation expectations are not really anywhere close to the 2 per cent the Bank regularly claims.  Perhaps there is a good compelling alternative story. If so, it would be nice of them to tell us.  But given the actual track record of inflation, it would be a bit surprising if breakevens persistently below 2 per cent were not telling us something about market expectations (right or wrong) of inflation.