The drop in Producer Price Inflation to 0.8% (for outputs) in the March quarter adds to confusion as to where inflation is heading and the appropriate stance for monetary policy. The Reserve Bank had only days before lifted its inflation forecast and tightened monetary policy in consequence. Yet commentators tell us underlying inflation is only 4%. Then we have a lift in food prices, up in the last two months, to contemplate. How about throwing into the pot a 0.6% fall in import prices in the March quarter?
The moral is that there is no perfect measure of inflation. The Reserve Bank has in frustration created its own index. But that is only a check on the CPI, it will never replace it as the inflation rate targeted by policy. Warts and all, the CPI is the beast that must be tamed. Forget the PPI as it does not even pretend to measure inflation as it is normally understood and is not a good predictor of the CPI. Its weightings reflect the output of industry, not consumption. The importance of agriculture and food processing in New Zealand make the PPI hostage to the movement in the price of a narrow range of commodities. In the March quarter their prices were weaker and the PPI dutifully slowed. This slowdown had already been reflected in the March quarter’s food prices.
Discussion of the CPI’s failings has focused on its inclusion of house prices and interest rates which it is said reflect the cost of an investment not the cost of shelter to the household. The Reserve Bank’s index adjusts for this, but that still leaves a host of government taxes and user charges which can and are throwing the index around. The index is also prey to the effect of industry restructuring which in a small economy can have a disproportionately large impact. The two players dominating domestic air travel call it quits in a pricing war and air fares lift. The sole telephone company decides to rebalance its charges between residential and commercial charges and communication costs in the CPI rocket. The power boards are considering a similar exercise under pressures to perform commercially. The local body reorganisation is an example of a restructuring exercise which turned out to have unforeseen consequences for the CPI.
While the macroeconomic influences of the exchange rate, interest rates the budget deficit etc may be favourable to lowering inflation there are still plenty of such price shocks possible. Under the rigid policy setting structure now in place there are limits to the extent the Reserve Bank can allow for these in setting policy. The only outs it has come from natural disasters, commodity price effects home ownership costs and a rise in GST or a major change in another indirect tax. That’s it. A price shock from some other cause will force a monetary tightening even if we are already on the ropes screaming for mercy.