Saturday, 10 February 2018

Should we obsess about 2% inflation?

For a moment, watching the webcast, I thought there were going to be no questions at all at the Reserve Bank's press conference last Thursday, after its latest Monetary Policy Statement. The Bank had been universally expected to leave policy unchanged, as it did, so there was little "news" in the official statement, and the acting governor Grant Spencer will shortly hand over to the incoming Adrian Orr, so there was no massive interest in what an outgoing caretaker might have to say.

In the end the journalists (with a big assist from Bernard Hickey) filled in the awkward pause* and the conference limped into life. The most coverage was for Grant's remark that people on large mortgages at unusually low interest rates ought to be sure they can handle the payments if rates go up a few per cent. It was a sensible remark, but as the big takeaway, duh.

The questions around the Bank persistently undershooting the 2% midpoint of its target inflation range were more interesting. Some critics have argued for a long time that inflation has been too low, and unemployment correspondingly too high, compared to what would have happened if the RBNZ had run a more stimulatory policy. Michael Reddell for example said it again last week, and added that the Bank's view that inflation is actually heading back to 2% may be proven overoptimistic yet again.

The Bank's responses were first that people shouldn't get obsessed with the 2% number - the Policy Target Agreement says there should be "a focus on keeping future average inflation near the 2 per cent target midpoint" and the Bank seemed to parse this as "a focus" - and second that too many microadjustments of the steering wheel to keep close to 2% will make the passengers in the back seat carsick.

There are arguments both ways. My own take is that central banks virtually everywhere have been blindsided by unexpectedly low inflation: something, still not pinned down, has meant that inflation in the post-GFC world hasn't been behaving like it "should" relative to pre-GFC relationships. In that context, our own Bank hasn't done too badly: at least we've had recent core inflation in the 1% to 1.5% range, when others have fared worse. The European Central Bank still hasn't got core eurozone inflation clearly back over 1.0%, and the Bank of Japan despite extraordinary levels of monetary stimulus has struggled to get up it from zero (currently 0.2%).

The "something" that's changed means that the old 'Philips Curve', if it still exists at all, has shifted to the left. Any given rate of unemployment brings less inflation with it than before, or as critics of the RBNZ would put it, for any given inflation target, like 2%, you can safely drive unemployment down lower than you would have before. But (a) this is all in hindsight and (b) we still don't know exactly how hard you can push unemployment down without setting off an unwelcome bout of too-high inflation.

That's where the RBNZ's latest research will be highly interesting. As the Monetary Policy Statement said on page 5, and both Bernard Hickey and Michael Reddell have picked up on, the Bank's done some new research on where that trigger rate of too-low unemployment (the 'NAIRU' as it's called in the trade) might be. All we know at the moment is that the latest best point estimate is an unemployment rate of 4.7%, within a plausible wider band of 4.0% to 5.5%. Given that we're currently at 4.5%, the Bank would argue it's gone as far as it should.

We don't know the full details yet: the Bank will be coming out with an Analytical Note on the research in the near future. My first reaction (and others') is that 4.7% looks a bit on the high side. But it could well be in the lower 4's somewhere: we're not the States, but it's interesting that the American unemployment rate has needed to drop to 4.1% before there have been a clear pickup in wage growth.

Finally, it's often puzzled me that the media don't reproduce more of the graphs in the Policy Statements. Maybe it's part of the dumbing down of the big media outlets. But in any event here are two interesting ones.

Why are world equity prices currently retreating? Because equity valuations, particularly in the U.S., had been overinflated by a period of unusually low interest rates. But as this graph clearly shows, the interest rate tide has been on the turn for some time. Valuation correction was overdue.

Nearer to home, here's how little inflation is being generated domestically, outside of housing-related costs. The blue bars are everything from school fees to doctor's visits to hairdressing prices, and currently inflation for all those sorts of things comes to only a little over 1.0%. As noted earlier, it's still a bit of a mystery that an economy with 4.5% unemployment is generating so little inflation, but enjoy it while you can: the Bank thinks it won't last.

*I've been at a press conference that died on its feet. As a financial journalist in the early 1980s I went to hear the then Japanese finance minister talk at one of the big annual multilateral meetings (ADB or IMF, can't remember which). Noboru Takeshita gave a speech of such inane banality that none of us could think of a single thing to ask him about it.

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