Monday, 24 June 2013

Inflation expectations

Enough has already been said about the 'solutions' proposed in a joint Labour/Greens/NZ First/Mana report to solve a manufacturing 'crisis'. Even the NZ Herald, which can be a couple of Chardonnays left of centre, called it "neither novel nor necessary". And commentators did not miss the irony of the 'crisis' being utterly at odds with the evidence from the latest (May) BusinessNZ/Bank of New Zealand Performance of Manufacturing Index, which showed manufacturing in very strong shape. Indeed, the BNZ economists said, "Compared with previous May results, the 2013 value was the highest since the survey began in 2002". If only we all could have a 'crisis' like that.

The report, in sum, has been deservedly rucked over, and there isn't  a lot more to add.

There is one aspect, though, that hasn't really got the attention its should have (and it also cropped up in the Greens' money-printing proposal for 'quantitative easing' to drive the Kiwi dollar down, a proposal they have sensibly discarded).

That's the aspect of what happens when you shift monetary policy from the inflation-targetting regime we've got now, to something else - either an exchange rate stability regime (as in the 'manufacturing crisis' report) or outright devaluation (as in money-printing). And what you're explicitly doing when you go down that route is tolerating a higher rate of inflation.

That would not only be a big mistake, and one that would be very difficult to rectify, but it would also be a waste of an important and expensive achievement.

That achievement is low inflationary expectations. It may sound dry and economist-like, but it's a key bedrock item in running a stable environment for businesses and households.

Consider this: what happened to inflation in the 25 years before the present Reserve Bank and its inflation targetting got underway, in 1989? In the 25 years from the fourth quarter of 1964 to the fourth quarter of 1989, the Consumer Price Index went from 62.51 to 697.24: by the end of this period of madness, prices were more than eleven times their starting level. A basket of stuff that had cost you $50 in 1964 now cost $557.70. The rate of inflation over the whole period averaged 10.1% a year.

What happens in that sort of environment is that people understandably start to hold a strong belief that inflation today is 10.1%, it's been 10.1% for a very long time, and it's going to be 10.1% into the indefinite future. Inflationary expectations get into people's heads, and once they are there, they are very hard to dislodge. It takes a big shock, and a prolonged period of getting inflation down, keeping it there, and showing that you mean to keep it there, before people will slowly being to accept that there is a new norm, and gradually adjust their expectations down.

Every developed economy that's had an inflation problem has had to go through this same sequence: a very tough initial monetary squeeze, ongoing firm monetary policy, and clear commitment to maintaining it, before inflation goes down, stays down, and people believe that it really has come down (they tend not to believe the data at first) and that it will really stay down. Central banks that successfully pull off this trick have what the monetary economics calls "credibility".

One of the advantages of high credibility is that the central bank can deal with any future inflationary problems at lower cost to the economy. If times are good, and businesses reckon they can start raising prices with impunity, a credible central bank can raise one eyebrow and businesses will pull their heads in: they know they don't want to mess with a central bank that means business. A central bank with low or no credibility, on the other hand, will be ignored: it will have to raise interest rates a lot to make people pay any real attention.

Today our central bank has high credibility, won at high cost in the early 1990s. Inflation expectations are low and settled (indeed, if anything, going a bit lower again). And we know this for a fact. In its Monetary Policy Statements, the Reserve Bank quotes a range of surveys which ask people and businesses what they think inflation is going to be (they're in table B, in the data at the back end of each Statement). All of them agree: inflation is going to stay low, and within the Bank's target range of 1%-3%. The one that looks furthest forward, and is therefore the one that probably says most about people's long-term inflation expectations, is the AON Hewitt survey of economists' views of inflation four years ahead. It's expecting inflation of only 2.3%  a year. Even if you don't believe the economists on this, other people feel the same way. The Reserve Bank's own survey of inflation expectations in the business community expects only 2.1% a year inflation over the next two years.

Having spent so much time and effort to get to this settled, stable place, why on earth would you even threaten it, or, worse, throw it away?

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