Remember what inflation is

There are a larger and larger number of analysts and journalists complaining about inflation at present.  The view seems to be that since the price of some goods are increase (fuel and food primarily) there is an inflation problem, and “something must be done”.  Because people have heard the RBNZ mention inflation they figure that the Bank should do something.

But I’ll tell you right now, as one of the most hawkish people I know I still do not see an inflation problem.  Yes, GST has pushed up the price level.  Yes, food and fuel prices have spiked – and they are hurting peoples real incomes!  But none of this is inflation.

What is inflation?  Inflation is the trend rate of growth in the price level.  In less wonkish terms, inflation of x% is when the price of all goods and services rise consistently by x% excluding any changes in “relative prices”.

The increase in GST was one-off, so its not inflation.  The increase in petrol and food is a relative price increase because petrol and food are relatively more scarce.  Does the increase hurt the economy and the people in it – hell yes.  Does it lower our real incomes and welfare – yes.  Can we do anything about it – no.

Unless the Reserve Bank can discover a large oil deposit and process it for our use they can do nothing about this.

So what we have at present IS NOT an inflation problem.  What we have is a negative economic shock, where we are being forced to reduce our standards of living because the resources we use are more scarce.  Having the price represent this scarcity means that we will take that into account, try to substitute away from the good, and hopefully come up with technologies that reduce our reliance on it.  But there is nothing the Bank can do about this.

20 replies
  1. Matt Nolan
    Matt Nolan says:


    I’ve been looking at their core numbers and it isn’t quite as bad.

    However, if any country is currently facing a “stagflation” via supply shock type scenario it appears to be the UK.

    I would need to see some good inflation expectations numbers before I would demand tightening though 😉

    You should post on it Goonix, as our British correspondent 😉

  2. andrew coleman
    andrew coleman says:

    “To shake ourselves free of these illusions, it would help greatly if for the phrase ‘a general rise in prices’ we should substitute the phrase ‘a fall in the purchasing power of the dollar’. Our attention then would be focussed on the money, which is the chief controller and disturber of prices. ” (Irving Fisher)

    As much to the point

    ” Inflation means that your money won’t buy as much today as it did when you didn’t have any” (M Hepker)

    And finally
    In light of their failure to control inflation in the past, do you mainly believe the Reserve Bank will be successful in ensuring a temporary increase in the price level will not lead to an increase in the inflation rate because the RB is now better at not debasing the currency than they have been for the last decade or so? Or do you think we are in the middle of a downturn that means a wage price spiral will not be ignited?

  3. Matt Nolan
    Matt Nolan says:

    @andrew coleman

    So you are asking me whether I think inflation will not respond to the myriad of shocks to the price level because I believe expectations are anchored, or because I believe the output gap is sufficiently large/wage bargaining conditions are sufficiently weak.

    Why can’t I believe both 😉 . The Reserve Bank has stayed within its band – it has consistently been pushing the top end, and it is a matter I’ve been unhappy with. But, just because they have been targeting a higher level of inflation then we may believe they have a mandate to does not mean they don’t have the credibility to keep it anchored at that level.

    Beyond that, as you state, a wage price spiral is unlikely in the face of:

    a) a lack of union/competitive issues in the labour market
    b) a large negative output gap/unemployment above its natural rate.

    Both these factors imply that any second round effects of these price level shocks will not be substantive enough to drive underlying inflation outside the Bank’s target zone.

    Of course, this is also premised on a belief that the Bank will respond when conditions change – this has yet to be seen, but I don’t feel that policy failure is necessarily the best belief to hold 😉

  4. andrew coleman
    andrew coleman says:

    Ahhh, the triumph of faith over experience, so touching to observe.

    I’m in bed with Frederick Leith-Ross on this one

    ” Inflation is like sin; every government denounces it and evey government practices it.”

  5. Matt Nolan
    Matt Nolan says:

    @andrew coleman

    I wouldn’t go as far as to frame it that way. After all, they haven’t violated their mandate and measured inflation expectations have shown themselves to be relatively fixed during the global financial crisis.

    With these factors in mind, even if my prior was completely neutral I would surely Bayesian update towards a belief that the RBNZ will respond appropriately. This is no more faith based than any other prediction – in fact given the fact they haven’t violated their mandate it is probably less faith based.

  6. Miguel Sanchez
    Miguel Sanchez says:

    The nine stages of inflation denial:

    (1) There is no inflation.
    (2) Commodity prices have risen, but this will only be temporary.
    (3) Commodity prices have continued to rise, but they won’t feed through into core inflation.
    (4) Commodity prices have fed through into core inflation, but it remains within the target.
    (5) Inflation is outside the target, but will return back soon.
    (6) Inflation hasn’t returned back to the target, but at least it’s not feeding through into inflation expectations.
    (7) Higher inflation has fed through into expectations, but we don’t think people will be able to turn that into action.
    (8) Wages and prices are rising.
    (9) Damn.

    My guess is that most Western central banks are somewhere between stages 3 and 5.

  7. Matt Nolan
    Matt Nolan says:

    @Miguel Sanchez

    The transition from the 1970s to the 1980s.

    It will not happen – if 5 occurs (using core) then it will elicit a strong response.

    On the note of inflation expectations though, could definitely do with some market based measures …

  8. Miguel Sanchez
    Miguel Sanchez says:

    “It will not happen – if 5 occurs (using core) then it will elicit a strong response.”

    Your faith is touching. And (5) is definitely happening in the UK – let’s see if the Bank of England committee can get itself over the line anytime soon.

  9. Matt Nolan
    Matt Nolan says:

    @Miguel Sanchez

    In all seriousness, I don’t see what is wrong with assuming that policy makers – who have remained inside their mandate for two decades – will continue to do so.

    The UK will be interesting – but they are moving to both fiscal and monetary consolidation now aren’t they. But actually, hold up a second – they have increased VAT and they are experiencing the same price level shocks we are.

    I hadn’t realised that before, but now I know that they are experiencing the same things as us I’m surprised that people are so hard on them.

    China and India have inflation problems. Yes. I’m not as concerned about the developed world – and even if this is faith (as is anything forward looking) the fact they haven’t betrayed me the last 20 years makes this comfortable.

  10. rauparaha
    rauparaha says:

    “Matt Nolan, a faith based economic forecaster claims that inflation is likely to stay within the target band, as it has for much of New Zealand’s recent history. Others, who reject Nolan’s faith based approach, believe that the future will be systematically different from the past and present. They suggest Nolan is living in a parallel universe in which the past and present are good indicators of the future.” — TVHE Newswire.

  11. andrew coleman
    andrew coleman says:

    “They have remained inside their mandate for the last two decades.”

    The 1992 Policy Target agreement was for 0- 2% inflation.
    End of year inflation rates for 1992, 1993, 1994, 1995, 1996 were 1.3, 1.4, 2.8, 2.9. 2.6.
    This means the the average was 2.2, and the target was missed 3 out of five years.

    The 1996 policy target agreement was 0- 3% inflation.
    The end of year inflation rates for 1997 – 2002 were 0.8, 0.4, 0.5, 4.0, 1.8, 2.7. The average was 1.7, the target was only missed one year.
    Mind you this includes a short sharp recession accentuated by poor monetary policy.

    The 2002 policy target agreement was 1 – 3% inflation
    The end of year inflation rates for 2003 – 2010 were 1.6, 2.7. 3.2. 2.6. 3.2. 3.4. 2.0, 4.0.
    The average is 2.8 and the target is missed 4 out 8 years. In the 5 years to 2008, the average was 3.016 percent, which must be stretching the boundaries of 1-3 percent in the medium term; in the 7 years to December 2010 the average is 3.01.

    So we have a pattern of frequently missing the target on an annual basis (8 out of 19 years overall; 7 out of 13 in 1992- 1996, 2002 – 2010) ; having average inflation exceed the target zone for two non-overlapping five year stretches; and creeping increases in the target zone. An uncharitable person would even say the Government selected a governor prepared to sign off on a watered down policy target agreement to make it appear as if they achieved their mandate even though the policy target agreement is probably not consistent with the Reserve Bank Act. (But who wishes to be uncharitable.)

    No matter, “They have remained inside their mandate for the last two decades.”

    Personally, I don’t think it is likely that the CPI will increase by more than 20% in the next five years. But perhaps, as an evidence based person, and given the past record, I should put up $100 that the December 2015 CPI is more than 15% above the December 2010 CPI , and see how much you would be willing to bet against it.


  12. Miguel Sanchez
    Miguel Sanchez says:

    Ha ha. Actually, my nine stages of denial are precisely what you get if you extrapolate from the last decade.

  13. Matt Nolan
    Matt Nolan says:

    @andrew coleman

    Fair point on the early 1990s, however with a number of those misses NZ was facing a positive price level shock – so measured inflation exaggerated underlying inflationary pressure. Having a single year spike because of an unanticipated lift in petrol prices, or an unanticipated slump in the currency, does not violate their mandate.

    I agree with you (as I have said before) that I am uncomfortable with them seemingly targeting the top of the target band – however, they are still targeting a level of inflation and their performance has still been credible. We would both agree that targeting a higher level of inflation is a bad thing – but at least they are still targeting a level and aiming to hit it.

    “But perhaps, as an evidence based person, and given the past record, I should put up $100 that the December 2015 CPI is more than 15% above the December 2010 CPI, and see how much you would be willing to bet against it. ”

    Sounds good – so that is annual price level growth of 2.8% between December 2010 and 2015. I still think that we will be on the weak side of the economic cycle in Dec 2010 (update disregard this, I for some reason thought we were in the start of 2010 now …) , but as the Bank says that history doesn’t matter this is irrelevant – so I’m in.

    If we exclude any changes to GST during that period I’m down for a $100 bet where I take less than 15% and you take more than 15%.

    Update If you are keen for the bet, just email me or comment here – then I will make a blog post to make it official 😉

  14. Matt Nolan
    Matt Nolan says:

    @Miguel Sanchez

    I see what you are saying – hell that was exactly how I felt before the GFC. Since then I’ve stepped back a bit, and I don’t feel as concerned about their performance.

    What got me nervous was the sharp increases in the adjusted LCI, for me that is the closest we have to a real inflation expectations measure. But that is still only one-year ahead – and without more information I’m a bit cautious about just “expecting” policy failure, especially when the policy is being determined by economists 😉

  15. andrew coleman
    andrew coleman says:

    Unfortunately, I’m up for the bet; but will you pay up in 2010 dollar terms or debased 2015 terms?

  16. Matt Nolan
    Matt Nolan says:

    @andrew coleman

    HAHAHA, good point. I had that discussion at work just before. We’ll make it December 2010 dollar terms – just so I don’t have the perverse incentive to try and create hyperinflation if it looks like I’m going to lose 😉

  17. Andy Bartlett
    Andy Bartlett says:

    Interesting outcomes from the British Government Budget. Will the drop in fuel duty cost so many jobs that it’s detrimental to the British public anyway? Sometimes it just can’t be done right either way.

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