Inflation and the output gap

Yesterday's Monetary Policy Statement from the Reserve Bank said (eg at p ii) that "a sustained decline in capacity pressures in the New Zealand economy is required to ensure that headline inflation returns to the 1 to 3 percent target": the economy needs to move from a hothouse above-capacity state (a 'positive output gap' with people trying to chase after scarce resources, driving up their prices) to a below-full-capacity state (a 'negative output gap', where resources are more available and less in demand).

Here's what the relationship that's being relied on has looked like over the past twenty odd years. It shows how the output gap has affected domestically-generated ('non-tradables') inflation. The numbers come from the underlying data supporting the Statement, which the RBNZ helpfully supplies as a spreadsheet. I've taken the impact of the 2010 GST increase out of the inflation data. I've also advanced the output gap by three quarters, which looks to be a good stab (tested by a couple of quick regressions) at the lag between the hot or cold state of the economy and subsequent heating up or cooling down of inflationary pressures.

It's a reasonably robust relationship (a simple regression had an R squared of 0.54) but it's obviously not infallible. In the mid 2000s for example the economy ran quite hot but non-tradables inflation never picked up, and the years immediately before Covid also saw the economy in reasonably good fettle without provoking the inflation genie. But that said, and especially when there are really large moves (the post GFC slump, the post-Covid fiscal and monetary policy fuelled boom), it holds up pretty well.

Two things struck me when I looked at the chart. One is that the RBNZ is projecting a large move in the output gap by historical standards. Peak to trough, the GFC setback amounted to a 5.8% of GDP swing, from 2.8% above capacity to 3.0% below it. The projected move in coming years is almost as large: a 5.5% swing from 3.9% above full capacity to 1.6% below. Maybe that will indeed happen as monetary policy continues to bite, fiscal policy very likely turns less supportive and strong net immigration swells the available labour supply. I wouldn't say it's an implausibly big or improbable ask to see a turnaround of that order, but getting on top of inflation is reliant on a pretty large change in economic conditions coming to hand.

The other thing that struck me is that if the output gap does indeed evolve as the RB expects, non-tradables inflation might even drop more than projected. My little regression says that if we get down to a negative output gap of -1.6%, non-tradable inflation (with a three quarter lag) would get down to 2.3%, a bit lower than the 3.0% the RBNZ anticipates. Or put it another way: the 3% or so non-tradables inflation the Bank expects is the sort of outcome you'd get if the economy was roughly at a Goldilocks zero output gap, neither too hot nor too cold. If we actually stay below that level (as the Bank thinks), non-tradables inflation could well recede more than currently anticipated.