Thursday, March 02, 2006

Brian Fallow: Inflation fighters get better news

The news has been better lately for the inflation-fighters at the Reserve Bank.

Two surveys this week - the National Bank's business outlook and the Reserve Bank's own survey of expectations - record a drop in inflation expectations, which had been on a rising trend over the past couple of years.

The exchange rate, long impervious to mounting evidence of weakness in the economy, has fallen from 70USc in mid-January to a little over 66USc. It is widely believed that the bank would like to see monetary conditions ease through the exchange rate first.

Even the hideous state of the external accounts - the annual trade deficit hit a record $7.1 billion - testifies to the openness of New Zealand markets, which is structurally important from the standpoint of keeping inflation in check.

In a paper for a central bankers' conference late last year, Reserve Bank economist Bernard Hodgetts reflects on how the dynamics of inflation have changed since an inflation target for monetary policy was adopted in the late 1980s.

Comparing the decade before inflation was brought under control in the early 1990s with the period since then, Hodgetts concludes that "inflation has become more muted in its response to what we traditionally regard as its immediate determinants - the exchange rate, import prices, wages, oil prices and some measure of excess demand in the economy".

A key factor in that has been the move to lower and more stable inflation expectations.

Expectations of inflation two years ahead have remained relatively stable during the latest economic cycle. They have trended up as inflation has risen, but much less steeply, and the most recent reading was a turn for the better. "This seems to have made the task of countering a pick-up in inflation associated with the economic cycle a little easier than might have been the case if expectations had been more responsive to a lift in inflation," Hodgetts said.

But he warns that despite the bank's confidence that expectations have probably become more stable and less prone to being disturbed by temporary perturbations to inflation, "we are still some way from showing that empirically".

The bank was extremely wary of simply assuming that inflation expectations were "anchored" and taking risks with monetary policy based on that assumption.

Governor Alan Bollard said in a speech last November he would not stand in the way of a falling dollar, even though it would temporarily push up inflation.

Indeed, in several comments in recent months he has done his best to jawbone the dollar down, even sending officials to Tokyo to warn of the risks of uridashi issuance, one of the biggest sources of demand for the kiwi.

At first glance, this is odd, since a lower exchange makes imported goods including oil more expensive and inflation is already above the top of his 1 to 3 per cent target band.

But the bank has been saying for some years now that it has a more medium-term focus in running monetary policy. So it is less concerned about the short-term price impacts of a weaker or stronger currency than with the effects the exchange rate has on stimulating or constraining economic activity a couple of years ahead and, therefore, the overall balance of supply and demand in the economy.

This was part of a broader repositioning of the Reserve Bank in the latter years of Don Brash's tenure as a kinder, gentler central bank.

In essence, it was saying that if people promised not to get spooked by swings in the inflation rate, and remained confident that it would keep inflation under control, the trade-off would be less of a roller-coaster ride in economic growth and in the interest rate cycle. Hence the importance of inflation expectations.

Hodgetts cites research which suggests the exchange rate has a weaker and slower impact on consumer prices than it did before the dollar was floated and inflation brought to heel. "In a floating exchange rate environment if businesses consider exchange rate fluctuations as temporary, they may well choose to absorb exchange-rate related changes in costs in [their] margins rather than risk losing market share by moving prices."

Then there is the China effect.

The price in foreign currencies of imported manufactured goods has fallen by an average of about 2.5 per cent a year since 1997. Before that the trend had been for manufactured imports to get more expensive in world price terms.

It is no coincidence that this trend to imported disinflation has coincided with a rise in the share of imports coming from China.

Finally, wages seem to have become less important as a driver of inflation. While wages led prices in the 1970s and 1980s, the relationship reversed in the 1990s, with wage movements tending to follow inflation rather than the other way around.

Indeed wage rises, adjusted for productivity, were often lower than inflation over much of the last decade, Hodgetts said, and rarely exceeded it significantly.

In addition to the shift away from centralised wage bargaining to individual and site-specific agreements, there has been a shift to longer-term settlements spanning two or three years. That reduces the likelihood that temporary blips in inflation get passed through to wages.

"Wage inflation still accelerates following periods of labour market tightness but less dramatically and with a somewhat longer lag than was previously the case."

Helpful as that is, Hodgetts said: "We have remained wary of the potential for wage inflation to reassert itself as a direct driver of inflation."

In other respects, the Reserve Bank's task has not got any easier.

Large tracts of the economy are undisciplined by international competition and impervious to the exchange rate. Inflation in that non-tradeables sector, which includes housing, is much more closely related to the output gap - the extent to which demand has outstripped or fallen behind the economy's capacity to meet that demand.

Westpac economists argue that the cyclical inflation problem has been narrowly concentrated. Most of the consumer price inflation in the past year, or three years, has been from petrol, housing, central and local government charges and electricity.

Of those four areas, the only one that the Reserve Bank can "get at" with its sole instrument, the official cash rate, is housing. And that takes a lot longer than it used to with the prevalence of fixed-rate mortgages.

The use of exchange rate hedges and the pain and comfort thresholds business balance sheets need to cross before investment and employment decisions are changed have also tended to lengthen the lag between what the Governor does to the official cash rate and its impact on the real economy and then, with a further lag, on inflation.

The Westpac economists believe the lag between monetary policy and inflation is about two-and-a-half years.

Today's out-of-bounds inflation rate is the result of Bollard testing the speed limit of the economy back in 2003, they argue, accusing him of erring the other way by losing patience and hitting the brakes again late last year.

The Reserve Bank of Australia's less heavy-footed approach looks good by comparison.

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