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