Defending the Bank’s attack on “prices”

Yesterday I said that I thought the Bank’s speech on bringing down the price level was ridiculous. Not only is asking for a decline in prices a strange thing for a central bank to do, the mentioning of “oil companies” was slightly off the mark – given that they have slashed prices in the face of falling crude oil (although to be fair the Bank was just asking them to keep going – it was the Dom Post that exaggerated it – or maybe I was being generous!).

Now I am going to defend it.

Say that we have a situation where firms in the economy are all oligopolies, and all set prices as their “‘choice”. When demand was rising these firms increased prices, and furthermore managed to implicitly collude to some degree (tacit collusion).

Now, when demand falls, each firm still has their “high” price but their output declines markedly. These firms realise that they each face a “relatively elastic” demand curve – such that they can cut the price they charge and the increase in revenue they experience will dwarf any increase in costs from having to produce more (especially as they will have capacity for this extra production, given that they were previously producing at an even higher level). So it is in the individual firms interest to decrease prices!

However, the firms in the industry realise that this incentive also holds for all the other firms. As a result, they know that if everyone acted on this incentive the demand that a specific firm faces would decline (as the price of substitutes would fall) and overall they would EARN LESS than if the whole industry kept prices up.

So we have a prisoner’s dillema, if the firms can co-operate and keep prices up they are all better off. However, there is the incentive for an individual firm to “deviate” by cutting prices.

As a result, we could be in a situation where, given the history of competition, firms in these industries are still “tacitly colluding”, and are thereby holding up prices in the face of falling demand.

When the Bank then tells people that prices are unfair, they increase the elasticity of the demand curve near the current price by even more – as people value “fairness” and they inform the consumer that things are unfair – this increases the incentive to deviate. Also, by doing so they make the firms feel bad – which further increases the incentive to deviate.

Once one firm has deviated, the collusion is likely to collapse like a pack of cards – as a result it may only take a small push by the RBNZ to get us from the collusive equilibrium to another equilibrium with lower prices and higher output.

This is my defense of the speech against the railing criticism I raised yesterday.

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  • Come on. Didn’t you just post that petrol prices are (as expected) competitive? And didn’t Bollard just take a completely unwarranted swipe on petrol companies? Don’t we already have a competition commission?

  • “Come on. Didn’t you just post that petrol prices are (as expected) competitive? And didn’t Bollard just take a completely unwarranted swipe on petrol companies? Don’t we already have a competition commission?”

    Yes, yes, and yes. Hence the first paragraph.

    Even so, I wanted to TRY to justify what the Bank was doing for something to do – also, I like industrial economics and wanted to see if I could still put together some sort of arbitrary argument 😛

    To be honest, I’m pretty embarrassed about the speech – the swipe and petrol companies was ESPECIALLY ridiculous, but the attack on other types of retailing was still silly. If he is really concerned about inflation he should do something about it – instead of looking for scapegoats.

  • insider

    Seems to me Roger Kerr the analyst not BRT man was close to it when he said it was a sign that the methods of managing inflation the RB had were not working. It did seem a muddled, populist and slightly desperate speech.

  • insider

    I should add that I’m hearing stories the govt is going to lean on SOEs to be more efficient and generate more cash. What does that say for where prices might go?

  • “Seems to me Roger Kerr the analyst not BRT man was close to it when he said it was a sign that the methods of managing inflation the RB had were not working”

    I would say that they didn’t fully apply their method for controlling inflation when it was required – in 2003. If they had we wouldn’t be worrying about it now.

    They’ve realised this now, but the global financial crisis is preventing them from doing anything to try and make up for it – in that sense the speech could be construed as desperate.

    However, I don’t even think the speech was necessary – it just hurts the Bank’s credibility, as it makes it look like they depend on firms to control inflation, rather than being the strong body that can anchor expectations which they should appear to be

  • “I should add that I’m hearing stories the govt is going to lean on SOEs to be more efficient and generate more cash. What does that say for where prices might go?”

    Be more efficient – that should see “shadow” prices for whatever the hell the SOE produces fall.

    I don’t know about the government sector – it is definitely a strange one

  • insider

    I’d also add more, that if we are to get new electricity generation to meet increased demand, then that to me implies prices have to rise to provide the return needed to justify building more expensive plant. This is based on the assumption that generators sequence their building from the cheapest or best value plant to the most expensive. Surely Bollard understands this?

    This is why I don’t understnad successive energy ministers promising to build more AND cheaper power. Why would you overbuild firstly, and secondly why would you collapse prices? They set silly expectations then rant when they are not delivered and undermine confidence in markets overall as a result. Personally I blame Max Bradford 🙂

  • Insider,

    Spot on – energy policy is not a government strong point 🙂

    The best thing the government can do is reduce the uncertainty surrounding the investment – rather then prattling on with popularist jargon.

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  • Miguel Sanchez

    What bugs me the most about this speech is the motivation he’s offering – to paraphrase, “we need to see rates/ fuel/ power prices come down so that inflation will fall… then we can top it up again with rate cuts”. These price rises are bad not because they increase the cost of living, but because they prevent Bollard from looking like the hero.

    If just further fuels my suspicion that Bollard sees his role as to keep interest rates as low as possible within the constraint of the inflation target – meaning that 3% average inflation is not the maximum but the minimum, as there’s no incentive or pressure to aim for anything lower.

  • “If just further fuels my suspicion that Bollard sees his role as to keep interest rates as low as possible within the constraint of the inflation target”

    Indeed, I suspect that the Bank is giving people that feeling – how can inflation expectations fall below 3% if the Bank isn’t interested in getting medium term inflation down in the first place 😛

  • Andrew Coleman

    I am curious to know what new information inspired this speech. The bank has long had a view that inflation is always and everywhere a monetary phenomena, and that relative prices are ordinarily a second order issue when it comes to the inflation rate. Indeed, research published in the Bulltin in 2007 showed that relative price movements in Australia and New Zealand were almost the same; sectors such as electricity which had higher than average price increases in NZ has higher than average price increases in Australia, and sectors (such as imported electronic goods) that had lower than average price increases in New Zealand had lower than average price increases in Australia. While electricity has been going up faster in NZ than Australia, it proved that many of the goods that increased fastest in NZ compared to Australia were in fact items that fell in both countries, but fell much more rapidly in Australia than NZ: durable good retail items. I don’t recall he picked out these sectors for chastisement. More generally, this research suggested (although did not prove) that common cost shocks are behind relative price movements in differnet countries, and that the choice of the inflation rate comes down to the central bank. It is not that non-tradeable price increases should have been ten percent less over the last five years than they were, while tradeable price increases were ok; it is that both should have been ten percent less, so that prices maintain their international relativities, but we have a more acceptable (ie low) inflation rate.

    What i suspect is happening is that the Bank is running scared on inflation . Relative price movements become important precisely when a blip in some relative prices (eg oil or food) cause a temporary blip in the inflation rate, and then this blip is passed on and incorporated into wages, which then get passed on in turn as further price changes. The Bank’s disinflation in the early 1990s and 1999 relied precisely on this principle; temporary price cuts in the recession led to lower headline inflation rates, and then lower wage rounds etc. Given the very high headline rate, the bank must be hoping for the headline rate to come down fast in the next six months in order to lead to low wage increases. They have a very short opportunity for this mechanism to work because costs have been increasing and will increase (because of the depreciation of the dollar) and will eventually be passed on; so unless the headline figure is very low very soon, they might find that the recession hasn’t killed inflation. Hence the encouragement of high profile sectors to hang off on increasing prices.

    This doesn’t sound like an optimal way to conduct monetary policy: pray/ask firms to not pass on cost increases.

    Disclaimer: I wrote the referred to Bulletin article.

  • Hi Andrew,

    I think you’ve hit the nail on the head. At the MPS they sounded like they were solely after a slump in headline inflation which they felt would then lead to a reversal of some of the nasty inflation expectations numbers we’ve seen.

    Personally, I’m not so sure if a fall in fuel prices is enough to change the inherent inflation premium households will ask for, and firms are willing to pay for, during the wage bargaining. I would ask the question “is the recession that the RBNZ is forecasting enough to drive down these implicit inflation expectations” – given their forecasts, I just don’t see it.

    Of course, it is possible that the outlook for domestic economic activity is actually worse then they are forecasting …

    “This doesn’t sound like an optimal way to conduct monetary policy: pray/ask firms to not pass on cost increases.”

    Indeed – my “attempt” to defend the statement above was the best I could do, and it really didn’t convince me 🙂