Category Archives: Inflation

Looks like inflation might hit 2% in New Zealand

The ASB Bank produce a very good Economic Report and below are some of the points they make with regard to inflationary pressures – useful for NCEA Level 2 and 3 as well as CIE AS and A2 level. The CPI will be on the rise with higher global commodity prices (see graph below) as well as the weakening NZ dollar which in turn makes imports more expensive.

  • Commodity-price related influences are expected to directly contribute around 1 percentage point to annual CPI inflation over 2018. The direct impact is expected to wane.
  • The period of retail deflation looks like it might be coming to an end. The lower NZD and pending increases in wage costs could see this component add to inflation. The extent to which prices will firm will depend on retail margins.
  • Administered price increases will add roughly half a percentage point to annual inflation despite the impact of the free tertiary fees policy. Higher prices for tobacco and local authority rates seem to be a fact of life: one driven by health objectives, the other by perennial infrastructure demand and a lack of competitive pressure.
  • The labour market is likely to become more of a source of price increases. We note that higher wages need not impact on consumer prices if they are offset by a corresponding increase in labour productivity/trimming in producer margins.
  • Price increases from the housing group are expected to subside. It is no longer a sellers’ market for existing dwellings. The balance of power for building work looks to be increasingly shifting towards the customer and away from the provider. Rental dwelling inflation is expected to remain moderate.

Breakdown of CPI Weighting

Source: ASB Bank – Economic Note – Inflation Watch 26 July 2018

Dairy debts make NZ Banks vulnerable

New Zealand dairy farmers are making banks worried about their ability to keep up with their mortgage payments. Four recent issues haven’t helped the cause:

1. Falling produce prices making it harder for farms to service debt
2. Mycoplasma bovis cutting productivity and profitability of the sector
3. Regulatory changes  – restrictions on foreign ownership and therefore reducing the value of dairy farms
4. Environmental regulations – increasing operating costs for farms

Whilst the last two might improve the long-term sustainability of the dairy sector they could reduce the profitability of highly indebted farms and their equity buffers.

Banks are closely monitoring about 20% of their dairy farm loans because of concerns about the borrowers’ financial strength. Although a dairy downturn is unlikely to threaten the solvency of the banking system, it does weaken their position if there is another external shock like another GFC. Bank lending in the dairy sector has been consistent over the last few year years but the proportion of loans on principal and interest terms has increased from 6% in January 2017 to 12% in March this year.

Although the average mortgage for most farm types has decreased in dollar value over the past six months, the average mortgage amount increased in the dairy farms – see graph below. The average mortgage for dairy farms is the highest at $5.1 million for the first time since the survey began in August 2015.

The table below shows the average current mortgage by sector over the years shown. Dairy farmers continue to hold the largest proportion of mortgages in excess of $2 million. They are also more likely to have a mortgage over $2 million – 62.5% of all dairy farms – and $20 million – 3.4% of dairy farms.

Source: Federated Farmers of New Zealand – Banking Survey – May 2018

The NAIRU in New Zealand

Below is an extract from a RBNZ paper from March this year on Estimating the NAIRU and the Natural Rate of Unemployment. Especially useful for A2 students.

The headline unemployment rate in New Zealand has been trending down over time. This fall in the unemployment rate has not been accompanied by a rise in inflation, suggesting that the underlying natural rate and the NAIRU may have also declined through time. In this section, we document some of the changes in the New Zealand economy that have influenced the unemployment rate over history.

As a first step, we disaggregate the unemployment rate into three sub-components as follows:

a. Cyclical unemployment results from changes in aggregate demand conditions over the course of a business cycle. As firms experience weaker demand, existing workers may be laid off and fewer new workers will be hired.
b. Frictional unemployment refers to the regular short-term churn in the labour market, both within, and in and out of, the labour force. It is determined by the efficiency of the matching process given the diversity of job-seekers and vacancies.
c. Structural unemployment represents a more fundamental mismatch between those hiring and job seekers given their skills and geographic location. This could arise from long-lasting changes in the structure of the economy such as socio-demographic trends, technological change, or a rapid change in the mix of industries.

The lines between these categorisations can be indistinct. For example, some argue that a prolonged period of cyclical unemployment could also lead to hysteresis effects that could spill over to structural unemployment. For example, an extended period of unemployment may lead to an erosion of human capital making workers less attractive to employers and hence reducing their bargaining power. In principle, frictional unemployment and structural unemployment should be captured by the trend in the NAIRU or the natural rate, as both forms of unemployment may continue to exist even if the labour market is in equilibrium. This is because those that are structurally unemployed may not be easily drawn back into employment despite an increase in labour demand and an upward adjustment in wages. In addition, the level of frictional unemployment is largely determined by the efficiency with which potential workers and employers can find jobs. In contrast, cyclical unemployment captures when the labour market may be operating below capacity as a result of a shortfall in demand.

Monetary policy has little influence over the level of frictional and structural employment. These are largely determined by the evolution of technology and the obsolescence of skills, and by structural policies to facilitate the acquisition of new skills and improve the match between employers and job-seekers. For example, policies that affect the cost of hiring (e.g. employment protection laws), the incentives for job finding (e.g. unemployment insurance), or the bargaining power of workers (unionisation and labour contract laws).

In Figure 3, we decompose the pool of unemployed workers on the basis of unemployment durations. In particular, we categorise those who have been unemployed for less than 4 weeks as contributing to frictional unemployment, 4 to 52 weeks as cyclical unemployment, and greater than 52 weeks as structural unemployment.

New Zealand’s Phillips Curve 1993-2017

Bill Phillips (a New Zealander) discovered a stable relationship between the rate of inflation (of wages, to be precise) and unemployment in Britain from the 1850’s to 1960’s. Higher inflation, it seemed, went with lower unemployment. To economists and policymakers this presented a tempting trade-off: lower unemployment could be bought at the price of a bit more inflation. The downward-sloping Phillips curve is apparent in the graph below which plots core inflation against headline unemployment for New Zealand.

There has been also an apparent shift inwards of this relationship where lower rates of unemployment have become possible for a given level of inflation, particularly relative to the 1990s. The simple plot in the graph does not take into account other factors such as changes in import prices, inflationary expectations and capacity constraints which also have the potential to shift the Phillips Curve. These are discussed further below:

1. The price of imports. As the price of imports increase whether it is raw materials or finished products, the price of local goods become more expensive which increase the general price level. Also if a country finds that its exchange rate depreciates the price of imports rises. Oil is a very inelastic import and with a barrel of oil below $30 in 2016 there was little pressure on the CPI. Where inflation has been higher is in those countries that have withdrawn price subsidies and also had sharply falling currencies – Argentina 24% and Egypt 32%.

2. Public Expectations. In recent years more attention has been paid to the psychological effects which rising prices have on people’s behaviour. The various groups which make up the economy, acting in their own self-interest, will actually cause inflation to rise faster than otherwise would be the case if they believe rising prices are set to continue.

Workers, who have tended to get wage rises to ‘catch up’ with previous price increases, will attempt to gain a little extra compensate them for the expected further inflation, especially if they cannot negotiate wage increases for another year. Consumers, in belief that prices will keep rising, buy now to beat the price rises, but this extra buying adds to demand pressures on prices. In a country such as New Zealand’s before the 1990’s, with the absence of competition in many sectors of the economy, this behaviour reinforces inflationary pressures. ‘Breaking the inflationary cycle’ is an important part of permanently reducing inflation. If people believe prices will remain stable, they won’t, for example, buy land and property as a speculation to protect themselves. In Japan firms and employees have become conditioned to expect a lower rate of inflation. Prime minister Shinzo Abe has called for companies to raise wages by 3% to try and kick start inflation.

3. Capacity pressures. This refers to how much ‘slack’ there is in the economy or the ability to increase total output. If capacity pressures are tight that means an economy will find it difficult to increase output so there will be more pressure on prices as goods become more scarce. Unemployment is the most used gauge to measure the slack in the economy and as the economy approached full employment the scarcity of workers should push up the price pf labour – wages. With increasing costs for the firm it is usual for them to increase their prices for the consumer and therefore increasing the CPI. However many labour markets around the world (especially Japan and the USA) have been very tight but there is little sign of inflation. This assumes that the Phillips curve (trade-off between inflation and unemployment) has become less steep. Research by Olivier Blanchard found that a drop in the unemployment rate in the US has less than a third as much power to raise inflation as it did in the mid 1970’s.

This flatter Phillips curve suggests that the cost for central banks in higher inflation of delaying interest-rate rises is rather low.

Don’t cry for me Argentina – collapsing peso and 40% interest rates

To avoid a run on the peso the Argentinian Central Bank has increased interest rates from 27.5% on 27th April to 40% on 4th May. Argentina’s peso has lost 20% of its value against the US dollar since the start of the year making it the worst performing emerging-market currency.
The problems began in January when the central bank wanted to ease interest rates by increasing the inflation target from 12% to 15% – the government were concerned that the high interest rates were having a detrimental effect on economic growth. However when the Central Bank eased interest rates by 0.75% expectations about inflation started to rise and then investors began to question what the Argentinian Central Bank and Government were trying to achieve with economic policy.

In order to prop up the peso the Argentinian Central Bank sold $4.3bn of its dollar reserves over 5 days and it raised interest rates by 6%. But the peso lost 7.8% of its value during trading on 3rd May so inevitably came an interest hike to 40%. However if inflation figures continue to disappoint the peso will continue its downward slide.

Interest rates are set to continue at high levels and if the central bank cuts rates too early they run the risk of a rerun of the crisis. Fitch (credit rating agency) recently downgraded their outlook for Argentina from positive to stable citing high inflation and economic instability.

But high interest rates are damaging to an economy. By increasing the borrowing costs you make it very difficult for business grow and the economy slows with the threat of a recession and higher unemployment. The key for Argentina will be to keep rates high just long enough to inspire confidence that policymakers have halted the currency run, but not so long that the increase drains the economy.

New Zealand vegetables prices spike in March with bad weather

Tomato, lettuce, cauliflower, cabbage, and broccoli prices rose sharply in March 2018, boosting vegetable prices 9.5 percent in the month after adjusting for typically seasonal changes.

“Vegetable crops have been affected by a run of storms in recent weeks – lower supply (supply curve to the left) due to bad weather usually means higher prices,” consumer prices manager Matthew Haigh said.

“In February, we saw rising prices for lettuce, broccoli, and cauliflower, due to a combination of humid weather and cyclone Gita. As expected, that wet weather has affected vegetable prices in March too.”

Tomatoes rose more than 60 percent in March to $4.65 a kilo. In March last year, tomatoes were 83 cents cheaper at $3.82 a kilo.


Wages in the English Premier League – Demand-Pull Inflation

You are no doubt are well aware of the staggering wages that the English Premier League player receive especially when you consider other occupations.

What ultimately the salary explosion has been driven by the huge amounts of money that is now at the disposable of some of the top clubs. In economics this refers to the concept of demand-pull inflation where the supply has not kept apace with the demand for world-class players. Below is graph showing both demand-pull and cost-push.

Is the Natural Rate of Unemployment in the US lower than economists think?

The natural rate of unemployment is the difference between those who would like a job at the current wage rate – and those who are willing and able to take a job. In the above diagram, it is the level (Q2-Q1).


The natural rate of unemployment will therefore include:
Frictional unemployment – those people in-between jobs
Structural unemployment – those people that don’t have the skills that fit the jobs that are available.

It is also referred to as the Non-Accelerating Inflation Rate of Unemployment (NAIRU) – the job market neither pushes up inflation nor holds it back.

US Labour Market – tight but little wage growth.

The recent (February 2018) US Federal Reserve Monetary Policy Report stated that the US labour market appears to be near or a little beyond full employment. In theory this should suggest major labour shortages which ultimately end in higher wages for workers. Although employers report having more difficulties finding qualified workers, hiring continues apace, and serious labour shortages would likely have brought about larger wage increases than have been evident to date. The unemployment rate appears to be below most estimates of the natural rate.

January US unemployment rate = 4.1%
Congressional Budget Office’s (CBO) current estimate of the natural rate = 4.6%

The Unemployment Gap

The unemployment rate gap is the unemployment rate minus the CBO’s estimate of the natural rate of unemployment. The shaded bars indicate periods of business recession.

The median of Federal Open Market Committee (FOMC) participants’ estimates of the longer-run normal rate of unemployment and the CBO’s estimate of the natural rate of unemployment have both been revised down by about 1% over the past few years, one indication of the substantial uncertainty surrounding estimates of the “full employment” rate of unemployment.

The US Fed have suggested that with many advanced economies experiencing such low inflation that more persistent factors may be restraining price growth therefore the NRU could be lower in some countries than many economists think. Prices in many industries have been subdued due to technological changes – internet shopping which allows easy comparison – which restricts businesses ability to demand higher prices.

What could be the reasons for less wage growth?

• Employees need less compensation as the inflation rate has been low
• An increase in part-time employment
• Spare capacity in the labour market
• Employees keen on job security so put less emphasis on wage bargaining
• Increasing number of people participating in the labour force.
• Shorter working week
• Ageing and declining working age population

Although in the US there have been labour shortages in some areas of the economy, this hasn’t flowed through into the aggregate labour market. However speculation of higher inflationary pressure through higher wages has alerted markets that the US Fed may increase interest rates although they will remain reluctant to tighten too aggressively.

Source: US Federal Reserve Monetary Policy Report – February 2018.

Venezuela’s hyperinflation and collapsing currency

I have blogged in the past about the ongoing problems in Venezuela of hyperinflation, food shortages and social unrest. One of the consequences of hyperinflation is the loss of confidence in its economy which leads to an outflow of money and a lack of foreign investment. The result of these events is the fall in the Venezuelan currency – the bolívar. One way of monitoring its decline is the use of The Economist’s Big Mac index – it is based on the theory of purchasing-power parity, the notion that a dollar should buy the same amount in all countries. The Big Mac PPP is the exchange rate that would mean hamburgers cost the same in America as abroad – the video explains PPP and shows how undervalued / overvalued an exchange rate is relative to a Big Mac exchange rate.

According to the Big Mac index the price of Big Mac in
Caracas = 145,000 bolívars
USA = US$5.28

Purchasing Power Parity
Purchasing power parity (PPP) is when an amount of money in one country can be exchanged for a quantity of foreign currency, and the two amounts will buy identical baskets of products in both countries. So if we take the above example the PPP exchange rate is:

145,000 bolívars ÷ US$5.28 = 27,462 bolívars

However the Big Mac index seems to underestimate the slide in the Venezuelan currency as the black market is estimated to be around 260,000 bolívars. A US based website called DolarToday provides black market exchange rates that are updated daily for Venezuelans who cannot exchange currencies with the Venezuelan government for the dwindling supply of the US dollar. According to DolarToday, the estimated exchange rate is 230,228.36 VEF/USD in Venezuela’s free market as of 21 February 2018, which makes it the least valued circulating currency in the world – see graph from Wikipedia. Notice the reduced time for the bolívar to lose 90% of its value.

The company bases its computed exchange rates of the Venezuelan bolívar to the Euro or the United States dollar from the fees on trades in Cúcuta, Colombia, a city near the border of Venezuela. Currently, with no other reliable source other than the black market exchange rates, these rates are used by Reuters, CNBC, and several media news agencies and networks.

Therefore traders in Caracas check the DolarToday rate before presenting the bill to their customers. But local goods have no reference price and don’t keep up with the collapsing value of money – a monthly mobile phone tariff is 38,000 bolivars = 15 cents and a haircut is 25 cents. The minimum wage has increased regularly and it now stands at 800,000 bolívar = less than US$4 at the black market exchange rate.

If wages were perfectly indexed, it would serve only to speed up inflation. But their slow and uneven adjustment means the pain of hyperinflation is shared haphazardly. As Juan Perón of Argentina supposedly said, if prices take the lift, wages cannot take the stairs.

The Economist – Hyperinflation in Venezuela – January 27th 2018
Wikipedia – Venezuelan bolívar

Fed might tighten but emerging markets could ease.

From the Espresso app by The Economist I came across a useful graph showing inflation figures in emerging economies. I used this with my NCEA Level 2 class when we discussed inflation and how if the inflation rate is below the target rate there may be room to loosen monetary policy and cut interest rates. This should stimulate demand in the economy and increase output and employment.

In America investors are experiencing the novelty of an inflation scare. But in many emerging economies, including several of the biggest, price pressures are at unusual lows. In China and Indonesia inflation is below target. In Brazil, for the first time this century, it has remained under 3% for seven straight months. And in Russia, where the central bank is meeting today, prices are rising at their slowest pace since the fall of the Soviet Union. This lack of inflationary pressure gives central bankers some welcome room for monetary manoeuvre. Even if America’s Federal Reserve turns hawkish, emerging markets need not slavishly follow its lead.