GDP and Inflation


Tuesday May 30, 2017 Konrad Hurren

Taking the definition of inflation as an increase in the price level of goods and services that the Reserve Bank of New Zealand (RBNZ) uses. And combined with the Policy Targets Agreement (PTA) which specifies that this measure should remain at 2% on average we could be forgiven for thinking inflation is a non-issue right now.


The following chart plots annual inflation (as measured by the CPI) with the PTA rate shown as a dashed line. The chart shows that annual inflation has been below the specified target since mid-2011, and has only just reached the target rate. The CPI can help us understand the source of decisions by the RBNZ on monetary policy.


Next to the CPI chart we plot an inflation rate for producer prices. This chart tells a similar story, prices really don’t seem to be growing at any rate to write home about. Indeed, in 2014 – 2015 input and output prices were falling. This likely reflects the relative strength of the New Zealand Dollar at the time (Jun 2014 this was at $0.86 USD for $1 NZD, falling to a bit over $0.73 USD by 2015).


In more recent times the input prices of producers have started to increase more rapidly, and are now growing at around 3% p.a.


consumer prices cpi3



producer prices

This data is reflected in recent Monetary Policy Statements by the RBNZ. The Official Cash Rate (the interest rate charged by the RBNZ on settlements with the commercial banks) has been at %1.75 since November 2016. Historically, the OCR has been below %5 since 2009. The RBNZ believes that setting the price of credit, using the OCR as a price control, to be low is working to boost aggregate demand and economic growth. And since inflation has been under target the RBNZ believes that this low rate can be sustained.


There’s a catch, inflation defined in the narrow sense of the CPI doesn’t tell the whole story. When we define inflation properly; as an increase in the money supply; we can then expand our range of indicators to show that inflation is far higher than that measured by the CPI.


To the extent that we can measure the money supply we provide a chart indicating its growth. We can see from this chart that in 2009 when the OCR was decreased quickly in response to the Global Financial Crisis of 2008, the growth of money supply began to shoot up.


money credit

There is no hard and fast rule that states that inflation must occur in all markets at the same rate. Nor one that states that consumers only care about consumer goods prices. If this increased money supply hasn’t flowed into consumer goods then where has it gone? In short, it has flowed to assets.


Below we provide indicative charts of the general prices in the New Zealand share market and the residential housing market. A caveat to these data is that they are “messy”; these increases are not the sole result of increases in the money supply (inflation) but they do provide another indicator of the growth of money in the economy. For example, house prices increase in response to population increases due to supply constraints, and share prices increase due to the increase in expected profits of firms over time.


Prices of these assets are also not determined solely by factors of the New Zealand economy. Asset markets are global, and money flows relatively freely in and out of New Zealand. To that extent, these charts provide an indication of the effect of rapid increases in the money supply from multiple sources: A combination of RBNZ policies, Quantitative Easing, security purchases, and other forms of “loose” monetary policy by other central banks; notably the European Central Bank and The Federal Reserve (US).


median house sale price



nzx5 share price index
The perniciousness of inflation is that it blow bubbles in asset prices, prices rise reflecting growth in money supply rather than increases in economic value. This results in misallocation and subsequent destruction of real wealth when the bubble “bursts”.


To summarize, we can use the CPI to understand the actions of the RBNZ in the context of attempting to spur on economic growth, while attempting to limit price inflation. But it would be a mistake to conclude that inflation; as an increase in the money supply; is low.


We also need to understand the context of the RBNZ, all central banks are constrained in their ability to raise their respective settlement rates (OCR for the RBNZ) currently. To do so would result in a quick realisation of malinvestment by market actors and a subsequent recession. In the realpolitik world this is a no-go.


So expect more of the same “loose” monetary policy from central banks around the world. And expect that the longer the realization of malinvestment is prevented from occurring the worse the recession following it will be.