Brian Fallow: Missed inflation forecast a cause for worry

5:30 AM Thursday Oct 18, 2012

A couple of things should worry the Reserve Bank about Tuesday's inflation numbers.

It is the fifth quarter in a row that inflation has proven to be weaker than the bank forecast just weeks before - a cumulative error of 1.6 percentage points over that period.

It is the outlook for inflation that drives its interest rate decisions, rather than the view in the rear-view mirror.

The bank's forecasts have inflation heading back towards the middle of its 1 to 3 per cent target band from here, and market economists doubt the details of the latest numbers will have significantly undermined that view.

But it underscores the fact that the reliability of those forecasts matters.

The other cause for concern is that inflation has dropped below the bottom of its target band for the first time since it was raised from 0 to 1 per cent 10 years ago. It was raised to maintain a buffer above the dreaded condition, deflation, or a falling general level of prices.

While we loosely talk of "inflation-targeting" central banks, what they really target is price stability and that most definitely includes avoiding deflation.

You don't want to go there.

Deflation increases the burden of debt because the dollars people have to repay are worth more than the ones they borrowed. It can raise real interest rates when that is the last thing an economy needs. And it is bad for business inasmuch as if people are already nervous and more inclined to save than spend, the belief that stuff will cost less if they wait will only reinforce that.

The world - the rich parts of it anyway - came perilously close to deflation in 2009. Inflation across the advanced economies was just 0.1 per cent that year, according to the International Monetary Fund, compared with an average 2.2 per cent over the previous 25 years.

It was one indicator of the severity of the financial crisis and associated recession, and helps explain why central banks that had already cut their policy rates to zero resorted to unconventional tools like quantitative easing.

But a doctor is not going to give the same dietary advice to someone with a healthy appetite, and perhaps a tendency to corpulence, that he would give to someone suffering from anorexia. The New Zealand economy is not anorexic.

We have probably just seen the bottom of the inflation cycle, and while there are signs growth is slowing from the brisk clip of the first half of the year, it has not stalled.

Even if further monetary stimulus were called for, the Reserve Bank has plenty of scope - 250 basis points to be precise - to do it the normal way by cutting the official cash rate. It is worth noting that wholesale interest rates (swap rates) were already falling before the weaker-than-expected inflation out-turn kicked them lower. And with the risk premium on top of benchmark rates relatively stable at around 150 basis points, banks' funding costs are low historically - so, accordingly, are the interest rates they charge. Money-market pricing implies an OCR cut by the middle of next year but market economists are unconvinced.

Tuesday's inflation data were very much a game of two halves. Tradeables inflation there was none, reflecting weak global inflation and the lagged effects of a rising exchange rate. But on the domestic or non-tradeables side inflation was 0.5 per cent for the quarter and 2.3 per cent for the year. Not scary, but not negligible either. And it is non-tradeables inflation the Reserve Bank has most impact on through its monetary policy settings. For a country that has had a property boom, but no bust, and is left with dispiriting housing affordability metrics, there are risks in further cuts to mortgage rates.

"Our view is the weak global environment is a good reason for keeping interest rates low," Westpac economist Michael Gordon says. "We are not sure it presents a case for taking them lower. Especially when we have a housing market that is all too receptive to the sugar rush of lower mortgage rates."

Bank of New Zealand economist Doug Steel suspects the Reserve Bank will now see the annual inflation rate returning to the mid-point of its target band more slowly than it previously thought - not just because inflation undershot the bank's forecasts, but also because of a softer tone to the growth indicators lately and a firmer exchange rate than the bank has factored into its September forecasts.

Research the Reserve Bank recently published illuminates one of the models it uses to estimate how much the Kiwi dollar is overvalued (or, more rarely, undervalued). It looks to be between 1 and 9 per cent - too high right now.

Predictably the parties of the left have seized on the latest inflation numbers to support their view that inflation is yesterday's problem, and the Reserve Bank should be instructed to target other things instead. The circularity of the argument - that inflation has been kept in bounds precisely because the monetary policy framework has been doing its job - seems to elude them.

As to how the bank might try to engineer a lower exchange rate, the Swiss are sometimes held up as an example. They have been explicitly defending an exchange rate of 1.20 Swiss francs to the euro since September last year.

In the year ended June their central bank, the Swiss National Bank, expanded its holding of foreign reserves by the equivalent of $215billion.

The lion's share of that increase, equivalent to $146billion, is in euros. That is an awfully big bet to place, with public money, on the eventual recovery of the single currency. Why take such a risk?

It was not only concern about a loss of competitiveness for Swiss exporters relative to the eurozone, which entirely surrounds them. It was also deflation. The Swiss CPI has been falling, in annual terms for nearly a year though the rate of decline has abated lately.

New Zealand has the former problem but, happily, not the latter.