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MEI Special Topic: CPI Inflation

Annual Consumers Price Index (CPI) inflation rose from 0.4% to 1.3% in December 2016. This brings inflation back within the RBNZ’s target band (of 1-3%) for the first time since 2014. The sudden rise in inflation was not limited to New Zealand – several of our major trading partners saw similar movements. This month’s Special Topic examines the drivers of the recent pick-up in inflation.

Inflation has been low in most advanced economies since the 2008 global financial crisis. Prices tend to increase when demand is strong relative to supply. Relatively weak demand is therefore one reason why inflation has been low. Inflation is also strongly influenced by seasonal patterns and items with large weights, such as petrol. By the end of 2016, inflation picked up to above 1% in many countries (Figure 1). Is this the result of temporary factors, or a sign of growing price pressures economy-wide?

Figure 1: International comparison of CPI
Figure 1: International comparison of CPI.
Source: Statistics New Zealand

NZ inflation was chiefly driven by a few items...

In New Zealand, inflation in 2016 was largely driven by increases in the cost of a handful of items: housing, rents, cigarettes and tobacco, and petrol. Several items became less expensive; ACC levies fell, as did the cost of international air transport, package holidays, and fruit. Petrol prices had the strongest overall influence – almost three quarters of the increase in inflation from 0.4% to 1.3% in the year to December came from previous petrol price falls falling out of the annual inflation calculation.

...but underlying price pressures appear to be growing from a lower base...

A more informative picture of underlying inflationary pressures can sometimes be gained by stripping out the more volatile items in the CPI. Without food and energy prices (often referred to as ‘core’ inflation), annual inflation was 1.6% in December (Figure 2). Likewise, inflation was 1.7% after excluding the price falls of the transport group. In contrast, inflation less the housing and household utilities group was only 0.7%. Figure 2 indicates price pressures are relatively broad-based, with each series showing rising, but still relatively low, inflation towards the end of 2016.

Figure 2: CPI inflation, less specified items
Figure 2: CPI inflation, less specified items.
Source: Statistics New Zealand

More sophisticated methods of removing particularly volatile price movements emphasise underlying inflation is more robust than the headline figure would suggest. The RBNZ’s Sectoral Factor Model, which aims to isolate common factors driving inflation across its different components, shows underlying inflation has remained at 1.5% for the past year. The weighted median price rise in the year to December was 2.0%, up from 1.7% in September and 1.5% the year prior. After removing the top and bottom 5% largest price movements, inflation was 1.6% in the year to December, up from 0.8% in September and 0.4% the year prior. Just over half (52.3%) of all items included in the CPI saw price rises in the December quarter, compared to just under half (48.7%) the previous year.

...supported by recent surveys

The growing strength in underlying inflation is echoed by recent business surveys. In the December QSBO a net 21.8% of firms expected to raise their selling prices in the next quarter, up from 7.1% in the previous month and above the five-year average of 15.8% for the first time since 2014. The ANZBO paints a similar picture.

Non-tradables inflation represents domestic price pressures...

Inflation is commonly broken into tradable and non-tradable components. Items in the CPI that are not easily traded with other nations are assumed to reflect primarily domestic factors. Figure 3 shows how non-tradables inflation tends to be related to the extent of spare capacity (the ‘output gap’) in the economy. Treasury estimates show the output gap is negative, but expected to rise, implying domestic price pressures will continue to build gradually. This estimate is in line with the evidence of remaining capacity in the labour market, with unemployment at 5.2% and easing average hourly earnings growth.

Figure 3: Non-tradables inflation* and output gap
* Excluding the 2010 GST increase
Sources: Statistics New Zealand, the Treasury

...while tradables inflation reflects international developments

The tradable portion of inflation is influenced by the exchange rate and price pressures in other countries (Figure 4). Low global inflation and a high NZD have meant NZ tradable inflation has been negative on average since 2012. Table 1 shows that after removing the influence of food and energy, the variance of inflation across countries increases. This illustrates the simultaneous rise in inflation in late 2016 partly reflected temporary factors like petrol price movements, and to some degree diverging economic growth and capacity utilisation.

Table 1: December global CPI inflation outturns (annual % change)
  US[2] US[3] JP Euro
area
UK AU NZ
CPI 1.6 2.1 0.3 1.1 1.6 1.5 1.3
Core[4] 1.7 2.2 0.1 0.9 1.3 1.3 1.6

Sources:  Haver Analytics, Statistics New Zealand

Figure 4: Tradables inflation*
Figure 4: Tradables  inflation.
* Excluding the 2010 GST increase
Source: Statistics New Zealand

There are also regional differences in inflation

Annual inflation in December in New Zealand was 1.3%, but in Auckland inflation was only 1.2%, and in Wellington it was 1.6%. Regional variation in prices is starker for specific items. For instance, on an annual basis, the increase in the price of a new house in Auckland remained high at 8.2%. The increase in Canterbury was 3.5%, down from 3.9% in the September quarter, but well below the 2013 peak of 12.2%, reflecting the plateauing of the Canterbury residential rebuild. Annual rental increases were highest in Auckland at 3.2% compared to 1.4% for the rest of New Zealand, but continued to fall in Canterbury (down 0.8%).

Looking ahead...

Inflation is expected to increase moderately in the near-term. Previous oil price declines dropping out of the annual calculation will again provide a boost to annual inflation in the March quarter 2017, as will a further 10% increase in the tobacco excise tax. Domestic activity is forecast to remain robust and will likely add to price pressures, although competition, technological improvements and the high NZD will restrain inflation generally.

Notes

  • [2]PCE inflation, the US Federal Reserve’s preferred measure
  • [3]PCE inflation, the US Federal Reserve’s preferred measure
  • [4]PCE inflation, the US Federal Reserve’s preferred measure
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