A Look At Inflation In New Zealand

Annual inflation at 1 percent is now at the bottom end of the Reserve Bank's target range. Indeed, without the annual increase in tobacco excise, it would have been just 0.6 percent. New Zealanders are more accustomed to approaching, and occasionally straying over, the top of the band. Floating mortgage rates are at 50-year lows, and business lending rates are also low by historical standards. It is hard to argue that it is the cost or availability of credit which is holding the economy back at this point. The flipside is that savers are stuck with deposit interest rates which are at multi-decade lows, apart from the recessionary levels of 2009. Given the crying need to raise household savings rates, this is unhelpful.

In any case the Reserve Bank has to set monetary policy on a forward-looking basis, trying to keep demand in the economy roughly in balance with the supply side over the medium-term. The bank has been reflecting on how it has done over the last business cycle. A key judgment the bank has to make is the rate at which the supply side of the economy, the capacity to produce goods and services, is expanding. If the economy is operating at its potential, any excess demand will only push up prices and blow out the trade deficit.

Conversely, if demand falls short of potential supply, resources, especially unemployed people, are wasted and if it goes on too long the economy can be caught in a deflationary rip. The gap between actual growth and potential or sustainable growth is called the output gap, which the central bank will seek to minimize by either boosting or curbing the demand side through its influence on interest rates. With the benefit of hindsight, the bank acknowledges it underestimated the output gap during the last boom.

Right now, the bank thinks it is closer to 1 percent, but expects it to rise to 2 percent over the next three years. It is fundamentally driven by what is happening to labour force growth and to labour productivity. With migration to Australia running at record levels, equivalent to about 1 percent of the population per annum, labour force growth in the past year has been just 1 percent. Worse, the bank reckons labour productivity growth has dwindled to just 0.1 per cent per annum, reflecting a dearth of investment by businesses since the global financial crisis. The bank's assumption that economies of scale, and imported materials and labour, will limit the inflationary impact may well prove to be too confident.