Thursday, 13 March 2014

Here's that stubborn home-grown inflation again

You'll have seen or heard about today's Monetary Policy Statement - the OCR up 0.25% to 2.75% and lots more to come, since "The Bank’s assessment is that the OCR will need to rise by about 2 percentage points over the next two years for inflation to settle around target. That assessment is conditional on the economic outlook, and will be reassessed over time as new data are released and events unfold" (p5 of the Statement) - so I won't further belabour the obvious.

But I do want to come back to what I hope isn't becoming a bee in my bonnet (I've talked about it here and here) and that's the amount of domestically-generated ('non-tradables') inflation that's coming down the pike. Here's the latest forecast from the RB (on p24).

You'll see that non-tradables inflation, already 2.9%, is heading for 4% or so, and even when it comes down a bit thereafter, it doesn't drop below 3.5% within the Bank's forecast horizon.

Is this worrying?

Maybe not. I appreciate, for example, that some of this rise in domestic inflation is down to the capacity pressures being generated by the Canterbury rebuild (and the increasingly strong pace of housebuilding in Auckland) as well as more general cyclical capacity pressures within an economy that's pretty buoyant overall. You might even argue that the rise in domestic inflation reflects some welcome flexibility in the economy, as scarcer resources see their prices bid up.

Or - and this is more my view - you might worry that we seem lumbered with a rather inflexible domestic economy where, rain or shine, large parts of it are able to mark up their prices, year after year. Here, for example, is the longer-run relationship between annual non-tradables inflation and the annual growth rate of GDP (it starts in the June quarter 2000 as Stats' non-tradables inflation series starts in the June quarter 1999).

When even an event as cataclysmic as the GFC doesn't see locally generated inflation dropping below 2%, you begin to think dark thoughts about structural inflexibilities. Over this period (and excluding that temporary GST-induced spike in 2010-11), non-tradables inflation has averaged 3.3%. That should be a worry, both for the Governor and more generally. Because let's face it: if the exchange rate hadn't been abnormally high, and tradables inflation abnormally low, that stubborn domestic inflation would have seen us uncomfortably close to, or even above, the Bank's 3% inflation limit.

The other thing that I thought of some interest was the Bank's comment (p18) that "While still negative, tradables inflation has increased over the past six months. The Bank will monitor whether firms' pricing behaviour in response to the high exchange rate is changing as domestic demand conditions strengthen".

I think the Bank is right to be on the case. As we all know, the shops have been full of extraordinarily sharp-priced goods as retailers have used the high exchange rate to put attractive offers in front of us.

But that was then: this is now, and the Bank's probably right to assume that what retailers did when the consumer dollar was harder to tickle out, is not what they're likely to do now that households are in more of a mind to splash out.

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