Brian Fallow 's Opinion

The Economics Editor of the NZ Herald

Brian Fallow: 1pc inflation rate in unfamiliar territory

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They kept assuming house prices would level off, but it kept not happening.A general softness of demand is limiting companies' pricing power. Photo / Sarah Ivey
They kept assuming house prices would level off, but it kept not happening.A general softness of demand is limiting companies' pricing power. Photo / Sarah Ivey

The lowest inflation rate we have seen so far this millennium is per se a good thing.

But it also testifies to a general softness of demand which is limiting firms' pricing power. The question is, for how long?

Annual inflation at 1 per cent 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 per cent.

This is unfamiliar territory.

We are more accustomed to approaching, and occasionally straying over, the top of the band. Between 2004 and 2008 inclusive the compound average annual inflation rate was 3 per cent.

Does low inflation mean the Reserve Bank should cut the official cash rate? No.

The interest rates that matter are retail rates.

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. Its conclusions, summarised in a paper by Willy Chetwin and Michael Reddell in the bank's June bulletin, carry important lessons for incoming governor Graeme Wheeler.

It was surprised, it confesses, by the strength and length of the boom - with its associated rise in debt and asset prices - and even more surprised at how tepid the recovery of the past three years has been.

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.

Hence the conventional metaphor of referring to the potential growth rate as the economy's speed limit - it can be exceeded but doing so for any length of time is dangerous.

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 minimise 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.

"However much pressure we thought there was on resources at the time a forecast was done, we expected that degree of pressure to abate quite quickly. And as the boom became increasingly prolonged, we increasingly [and materially] underestimated how much excess demand and pressure on resources there was even at the time the forecast was done," it says.

"With the benefit of hindsight, the sustainable potential growth rate during the boom years was lower than we had implicitly assumed."

During the boom it thought of the potential growth rate as a number around 3 per cent.

Right now the bank thinks it is closer to 1 per cent, but set to rise to 2 per cent 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 per cent of the population per annum, labour force growth in the past year has been just 1 per cent.

Given the mobility of labour across the Tasman, looking at New Zealand's unemployment rate in isolation from Australia's may give an exaggerated picture of how much spare capacity there is in the labour market.

There is also the issue of the quality of the labour supply, with a recent report highlighting a mismatch between the skills employers are looking for and those on offer.

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.

Its expectation - or is it hope? - that business capex and productivity will recover is the main factor in the improvement, such as it is, in the potential growth rate it expects over the next few years.

The other big miscalculation by Reserve Bank forecasters related to the size and durability of the housing boom.

They kept assuming house prices would level off, but it kept not happening.

That suggests we should be wary of putting too much weight on the bank's current view that the pick-up in the housing market now under way is not the start of another boom.

It is true that the legacy of the last one, household debt levels which will weigh the economy down for years and depressing affordability metrics, should reduce the chances of another one taking off, but that is no guarantee.

Rising house prices in Auckland, economists like to say, are just the market signalling the need to build more houses, after a period when the housing stock has grown at about a third of the rate needed to keep pace with the city's population growth.

But will the construction industry respond as it should?

As the Productivity Commission's report on housing affordability points out, the building industry is geared to building one-off houses on demand, rather than the mass production of starter homes.

The commission's report still awaits a response from the Government.

Then there is the massive task of rebuilding Christchurch.

We have, fortunately, no experience of anything on this scale. That means forecasters have to guess what the spillover effects on regions other than Canterbury and sectors other than construction will be.

The bank's assumption that economies of scale, and imported materials and labour, will limit the inflationary impact may well prove to be too sanguine.

- NZ Herald

Brian Fallow

The Economics Editor of the NZ Herald

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