Why New Zealand does not need more inflation

New Zealand has achieved the envy of many nations: stable, near-zero inflation. Yet both prominent commentators and the Reserve Bank's mandate give the false impression that this is "bad news."

The latest Consumer Price Index (CPI) showed prices rising at 0.4% per year – admittedly low by international standards.

New Zealand Herald business editor at large Liam Dann soon alerted readers that this meant danger, that low prices were "the biggest problem facing the world economy." In particular, he warned that people might foresee falling prices and delay large purchases.

Moreover, the Reserve Bank’s target range for inflation is 1-3%, which implies that very low inflation and deflation are undesirable. The Reserve Bank, therefore, recently foreshadowed a further cut to the official cash rate (OCR) in an attempt to boost inflation.

Before trying to solve a problem, though, it makes sense to be sure the problem actually exists. Is inflation too low?

Two reasons suggest the CPI doesn't fully account for increases in New Zealand's cost of living.

First, Statistics NZ calculates the CPI to replicate the cost of living faced the typical Kiwi household. For housing-related costs, the department includes rent and the cost of building a new house.

It does not include the value of residential land, which people must pay for if they buy a standalone house. The same goes for apartment prices, which typically incorporate land value.

Five-fold increase in house prices
The cost of land for housing is no trivial item to overlook. In fact, according to the Real Estate Institute, the price of the average house in New Zealand has increased five-fold since 1992, with the underlying land as the chief culprit.

Ironically, this ballooning of house prices has occurred since the Reserve Bank finally achieved “price stability” after years of high inflation.

The second reason relates to how the CPI is constructed. It is not, as many might imagine, simply a measure of how the prices we pay for goods and services change from quarter to quarter. Statistics NZ applies so-called quality adjustments to the CPI, which reduce the prices of goods in the index if they have increased in “quality.”

For instance, a car manufacturer might update one of its models with additional airbags but with no change to the price. This CPI interprets this as a price decline.

It may seem far-fetched to expect people buying a car to regard new airbags as a reduction in their living costs. Nonetheless, similar "quality adjustments" are applied to many other durable goods, such as home appliances. Thus the CPI becomes disconnected from what a household spends to buy goods and services in the real world.

Assessing the overall effect of this policy on the CPI is difficult since Statistics NZ does not release the unadjusted numbers. Regardless, the effect of quality adjustments is meaningful and likely increasing, given acceleration in technological change.

Lower OCR causes harm
All this suggests any further reduction in the OCR, which affects the entire range of interest rates in the economy, would be at best unnecessary and at worst harmful. Lower interest rates would put even more upward pressure on the housing prices – the last thing New Zealand society needs.

Property values nationwide have risen 49% in the past five years, and even the Reserve Bank itself has pointed out this risk and endeavoured to push back with tighter lending requirements.

There is also growing disquiet among economists internationally, including Claudio Borio and Anna Zabai of the Bank for International Settlements, over the way low official interest rates have artificially boosted asset prices.

This inflation, not captured by the targeted CPI, has not only worsened inequality but it has also raised the risk of another disastrous financial bubble and economic downturn.

Once we pierce the shortcomings of the CPI measure of inflation, we would also do well to remember that the Reserve Bank is governed by an act of Parliament.

The bank's primary objective is to maintain price stability. The legitimate fear was and remains the destructive impact of inflation as a tax on savers and fixed-income earners, particularly retirees. Inflation also generates expenses as people have to adapt to and avoid rising prices, and it impedes planning and investment.

Price stability was originally defined in the first Policy Targets Agreement between the Reserve Bank governor and the minister of finance as CPI inflation within a 0-2% range. The government widened that to 0-3% in 1996, before raising it further to 1-3% in 2002.

There was little justification for the latest change, beyond the misperception that the Reserve Bank was excessively focused on achieving low inflation to the detriment of economic growth.

That was a false dichotomy since low or no inflation fosters long-term economic growth and avoids financial bubbles. Serious consideration should be given to lowering the target range back to between 0-2%, since the Reserve Bank’s mandate is placing undue pressure on it to cut the OCR.

Fergus Hodgson (@FergHodgson), originally from Ngaruawahia, is an economic consultant with the Fraser Institute in Canada and a research fellow with the Tax Revolution Institute in Washington, DC. He holds degrees in economics and political science from Boston University and the University of Waikato. Tim Aldridge, a pilot based in Indonesia and former economist with the Reserve Bank of New Zealand, contributed to this article

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