Bernard Hickey: Deflation denial starts to hurt

Deflation might mean cheaper holidays, but is bad news for employers and the taxman. Photo / Thinkstock

On the face of it, there's everything to love about deflation and nothing to hate.

For consumers, falling prices seem unequivocally good, particularly if shoppers' wages and house prices are rising.

It means that any income growth is more powerful and the wealth in homes can be leveraged for even greater consumption or investment because consumer price deflation is usually combined with falling interest rates.

That's how a lot of Aucklanders are feeling. Median household after-tax income rose 3.6 per cent over the past two years to $1537 a week in Auckland, and the median house price rose by $140,000, producing equity gains each week that almost matched take-home pay.

Meanwhile, the price of tradeable goods and services, which means imported items and those where the prices are set on international markets, fell 2.3 per cent over the past two years.

That means cheaper clothes, shoes, overseas holidays, cars, double-cab utes and imported food.

But the picture isn't quite as bright for those on below-median wages and who don't own a home. Their costs are rising much faster than their wages.

Deflation is also no fun at all for businesses and governments.

Employers are still having to increase wages but often have to cut prices if they are competing with cheaper imports.

Governments struggle to grow their tax revenues when prices stop rising. Finance Minister Bill English has warned repeatedly that low inflation is making it difficult for the Government to reach its surplus target this year.

This is where the deflation debate starts to get controversial. Reserve Bank Governor Graeme Wheeler has agreed, with English, to target inflation of about 2 per cent and within a range of 1-3 per cent. Annual inflation has been below 2per cent for almost four years.

Wheeler is looking through the 0.9 per cent cut in the annual inflation rate because of the slump in the oil price last year and remains confident inflation is heading back towards 2 per cent.

Prime Minister John Key has said he would cut the Reserve Bank some slack on the current target and referred to the bank's efforts as being like a supertanker that takes time to turn.

English also seems relatively relaxed, saying New Zealand had a good type of deflation.

Unlike Japan and Europe where slow-to-no GDP growth and high unemployment dragged on prices and wages, New Zealand had strong GDP growth and low inflation caused by a high currency and falling oil prices. Do Wheeler and English care a lot more about inflation over 3 per cent than inflation under 1 per cent?

So far, the Reserve Bank and the Government have taken the good deflation route to explain and justify the current deflation, or simply deny it will last long.

This fuzzy decision making has consequences.

The dollar is higher than it would be if the Reserve Bank cut interest rates in response to deflation.

The end result of running a high Official Cash Rate in defiance of deflation is the continued stagnation of the exporting part of the economy. It's why regional New Zealand has struggled over the past seven years relative to Auckland and Christchurch.

Deciding to turn a blind eye to deflation may turn out to be the right thing to do. The Bank for International Settlements, which is the central bankers' bank, argued deflation could be a sign of a supply shock whereby a new technology or resource discovery is producing a lot more supply, driving down prices.

But we're not having that debate. The Reserve Bank is simply denying deflation is more than a passing phase and the Government is turning a blind eye.

A solution could be to widen or lower the target to account for good deflation caused by supply shocks.

We should have that debate because deflation, high interest rates and an overvalued currency have real consequences for renters, beneficiaries, exporters, the Government's revenues and the regions.