Price Stability and Inflation in New Zealand

Many people ask why prices increase year after year while the Reserve Bank says the inflation rate is low. I have heard economists who cast doubt about the merit of inflation targeting citing rising prices as a reason!

I bet that if we conduct a survey we would be surprised to know that most people think the same way.

A layman’s explanation first

This is just an example using arbitrary numbers. Table (1) has four columns. Column 1 has four years, 1 to 4. There is a price level in the second column and the percentage change of the price level, i.e. the inflation rate in the last column.

Table 1

So in this example the price increased every year from 100 to 102 to 104... The inflation rate, however, remained stable, 2 percent every year. This is what an inflation-targeting central bank desires to achieve. 

Inflation-targeting central banks treat bygones as bygones. Essentially, the central bank ignores the effects of the various shocks that increase the price level and focuses on maintaining the inflation rate target period by period. The price level is not the concern of the inflation-targeting central bank.Under inflation targeting, the price level will drift up forever. That is why prices keep increasing every year and the inflation rate does not.

The sketch below describes it in a different way. A shock at period 1 increases the price from p0 to p1. The price stays there, but the inflation rate, which is the slope (i.e. the change in the price over time), remained unchanged.

Academic talk - not for the average reader 

We could go further and use academic language for those who are interested. I tested the data for NZ as everyone in this field does routinely. The price level measured by the CPI has a unit root; inflation does not.

Figure (2) 

Thus, the forecast of the price level is meaningless because the forecast error variance grows to infinity as the forecast horizon increases. The mean, variance...of the price level are all functions of time.These are the results of targeting the inflation rate. The RB could target the price level if they want to. I have shown that (with Eric Hansen) in 1995 in an RB conference. No takers. Many scholars have written about price level targeting. Still No takers.

As long as the public demand for money (the stock of money, e.g., M1)keeps increasing, which is the case in NZ, the price level will  increase in proportion because people spend the money (could be spent on assets and housing too and increase asset prices). Money and prices are highly correlated. Inflation and money growth, however, are not correlated at all because the RBNZ rendered inflation stationary, but not money.I studied this issue in 2001 when I was in the RB https://www.rbnz.govt.nz/research-and-publications/discussion-papers/2001/dp2001-02-2 and I don't think anything has changed since. 

If the CPI inflation is under control then What kind of inflation do we have? 

Average annual money growth over the past since 1989 is about 7 percent. Lending to housing plus personal lending average growth rate over the period from Dec 1990 is 9.6 percent. People spend the money. They buy things, but they also buy assets and housing. The CPI inflation does not measure that. Hence, inflation is absent. 

We have much higher housing price inflation than CPI inflation. Figure (3) plots the two inflation rates. Over the same period from Dec 1990 to Dec 2018, the average CPI inflation was 2 percent while housing price inflation, HPI, was 6.2 percent! 

Figure (3)

Low interest rate and the next recession

Recently, more people wonder how the central banks would deal with the next recession given that the interest rate is too low.

Central bankers, and many economists, believe that the short-term nominal interest rate is the main or only policy instrument. However, this may not be entirely true. Central banks could use the money supply, by they never did.

Not many central bankers care about money anymore when setting up policy. Certainly, money does not even play a role in their models. I remember Stanley Fischer giving a lecture in Wellington about 20 years ago on the Russian monetary policy after the collapse of the USSR. I wrote in my notes that he said that the central bank brought down inflation by "controlling money and credit."

People may worry about recessions, but they are impossible to predict. Shocks are random. The propagation mechanism of these shocks - the data generating process - is unknown. Even identifying the shocks ex-post is very hard.

The question though is, what happens to real GDP growth (or the output gap) if the short-term nominal interest rate is literally zero? (In fact Milton Friedman argued that the short-term nominal interest rate should be set to zero such that the marginal cost of producing money is equal to the price.)

Consider this simple counterfactual.

In an open-economy - Keynesian - IS curve (i.e., the good market schedule), real GDP growth could depend on its own past (persistence), real interest rate, real exchange rate, and foreign real GDP growth. To carry out the counterfactual, replace the real interest rate with the negative of expected inflation (lag inflation for simplicity) if the nominal interest rate is zero (the Fisher equation). One could choose / estimate the coefficients and calibrate this IS equation with a random normal errors. One could even use a more elaborate Dynamic Stochastic General Equilibrium model to do this counterfactual experiment. Here is one simple counterfactual for New Zealand under such scenario.

The counterfactual suggests that:

-  Real GDP growth could have been higher the actual on average, 4.1 percent compared to 2.6 percent.

-  Real GDP growth could have been less volatile than actual. The variance is 3.1 compared to 4.5

-  The peaks could have been higher and the troughs could have been lower.

-  No recessions detected in the counterfactual.