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Special Topic: Non-tradables Inflation

The Consumers Price Index (CPI) measures changes in the price of goods and services purchased by New Zealand households. The CPI can be split into tradables and non-tradables components. The tradables component comprises the prices of goods and services that are imported or in competition with foreign goods. The non-tradables component comprises goods and services that face little foreign competition, reflecting changes in domestic demand and supply. In this special topic, we look at the non-tradables component, currently accounting for 54% of the CPI.

Non-tradables inflation and domestic demand

Figure 7 shows the relationship between non-tradables inflation and Gross National Expenditure (GNE – a measure of domestic demand) is relatively strong over time, with non-tradables inflation following the profile of activity with a one year lag. For the past seven years, non-tradables inflation has averaged 4%, mirroring a period of strength in the economy. The current recession has seen non-tradables inflation begin to ease, falling to 3.3% in June 2009.

Figure 7 – Non-tradables inflation and GNE
Figure 7 - Non-tradables  inflation and GNE.
Source: Statistics NZ

Housing and utilities group drove non-tradables inflation over the past seven years

As well as having the highest weighting (38%), the housing and household utilities group has increased strongly, contributing to more than half of the increase in non-tradable prices between June 2002 and June 2009 (Figure 8). Within the housing and household utilities group, three of the five subgroups have increased particularly rapidly – home ownership (the cost of building a new house), property rates and related services, and household energy. Out of all the subgroups in the CPI, these three have been the top contributors to non-tradables inflation over the past seven years.

Figure 8 – Contributions to non-tradables inflation
Figure 8 - Contributions  to non-tradables inflation.
Source: Statistics NZ, Treasury

The housing boom placed pressure on housing construction costs…

Average prices for existing houses rose 102% in the five years between June 2002 and June 2007, according to Quotable Value New Zealand. Low mortgage interest rates in the initial few years (together with high job security and relatively easy lending criteria), had a direct impact on demand, pushing house prices up. High population growth also placed upward pressure on prices, with net migration - which tends to be a swing variable in population growth rates - increasing to historic highs following the September 11 terrorist attacks.

While existing house prices do not feed directly into the CPI, higher demand was reflected in construction costs, with the home ownership subgroup rising at more than twice the rate of the CPI between June 2002 and June 2009 (Figure 9). The large increase in costs reflected significant price rises in electrical, carpentry and plumbing materials for construction of housing. In addition, wages and salaries for construction workers rose at a faster rate than for the whole economy.

The impact of significant increases in the home ownership subgroup was particularly strong, given it averaged the highest weighting in the CPI over the seven years to June 2009, accounting for 13% of the non-tradables index. In fact, the rapid and sustained increase in home ownership costs was the chief reason for non-tradables inflation remaining elevated over the seven years to June 2009, contributing 19% of the total increase in non-tradables inflation over the period.

Figure 9 – House prices and construction costs
Figure 9 - House prices  and construction costs.
Source: Statistics NZ, QVNZ

Electricity prices have also risen substantially over the past seven years…

Another key component of the housing and household utilities group is household energy, of which electricity is the main contributor. Electricity prices rose 60% in the seven years to June 2009, contributing approximately 11% of the total increase in non-tradables inflation over this period, despite its weighting being only 6%. Higher-than-usual generation costs were recorded over this period, particularly during 2008 when low lake levels led to generators switching from hydro to costlier sources of power. Price increases have been driven by underlying increases in the cost of generating electricity, particularly with the run-down of the Maui gas field. The cost of building new capacity to meet increasing demand for electricity has also risen sharply.

Property rates and related services – another part of the housing and household utilities group – also rose rapidly in the seven years to June 2009 (up 58%), contributing approximately 8% of the total increase in non-tradables inflation over the period.

Weak non-tradables inflation in the near term  

Non-tradables inflation is closely correlated with the output gap, ie, the extent to which the economy is above or below its long-term potential. Spare capacity has opened up since the onset of the recession in early 2008 leading to an easing in non-tradables inflation. The Budget Forecasts incorporate a persistent negative output gap, suggesting non-tradables inflation will continue to ease and remain at low levels throughout the forecast period (Figure 10).

Figure 10 – Non-tradables inflation and output gap
Figure 10 - Non-tradables  inflation and output gap.
Source: Statistics NZ, Treasury

The housing and household utilities group has been the key component of non-tradables inflation over the past seven years. The strong correlation between house prices and home ownership costs is important, as large swings in home ownership costs have the potential to affect the trajectory of non-tradables inflation. The Budget Forecasts incorporate a weak housing market, primarily owing to a higher household saving rate and a weak labour market. This factor will also serve to limit non-tradables inflation.

The weak labour market incorporates low wage pressures, which are a key component of input costs for firms, particularly those in residential construction (mentioned earlier). The global financial crisis has had a strong positive effect on net migration, posing some upside risk to housing activity in the near term. However, as the global economy recovers, we expect this trend to ease, with a generally weak economy keeping non-tradables inflation lower in the medium term.
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