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4  Short-Term Inflation

4.1  Introduction

4.1.1 This section describes our methodology for setting the short-term CPI assumption. In this context short-term is up to five years.

4.1.2 The value of outstanding insurance claims liabilities, pension obligations and some provisions in the Government's accounts is determined from the present value of the expected future payments. Expected future payments means nominal amounts in the future and therefore, reflect future price increases.

4.1.3 Determining inflation assumptions that are specific to the obligation is a critical part of accounting valuations. For example, to determine the present value of ACC claims incurred to date, where the settlement is expected sometime in the future, ACC assess the impact of the Consumer Price Index (CPI), wage inflation generally, as well as sector specific inflation for carers and health workers. Rehabilitation, medical, and surgical treatments are subject to specific medical cost inflation on current levels of claims expenditure.

4.1.4 Another example is the Government Superannuation Fund (GSF) pension benefits, which are indexed to CPI. Future nominal pension payments reflect the CPI adjusted amounts before they are discounted. Also, there are members of GSF that are currently employed, but have accrued pension benefits based on their current level of service. An estimate of the final salaries of these employees reflects assumed future salary increases, including impacts of promotion.

4.1.5 In the case of asset valuations, predicted future cash receipts may also need to take account of inflationary impacts. For example, student loan repayments are based on the future income levels of borrowers and these grow as a result of salary increases and job promotions.

4.1.6 Although a variety of inflation assumptions are required by our entities, we have limited this document to determining the CPI assumption for three reasons:

  • Firstly, it is vital that there is a consistency between the CPI and discount rate assumptions because under economic theory inflation rates are an integral component of interest rates.
  • Secondly, forecasting CPI is a common assumption across accounting valuations and as such it is reasonable for Treasury to provide a central view.
  • Thirdly, our reporting entities are in a much better position than the Treasury to determine specific inflation assumptions for the obligations or assets that they manage.

4.1.7 There needs to be a justifiable link between whatever discount rate is adopted and the recommended CPI assumption in order to maintain consistency between the various valuations.

4.1.8 CPI inflation assumptions are predictions of the average price of consumer goods and services purchased by households in the future. Statistics New Zealand determine and report actual CPI.

4.1.9 In New Zealand there are limited sources to assess the market's view of CPI in the future. Therefore, we will rely on a mixture of New Zealand consensus surveys, the RBNZ forecasts and Treasury's forecasts of CPI in the short term. In the longer term, we use a mixture of economic theory and historical analysis to cross-check the CPI assumption implied from our view of the long-term real return and nominal bond yields. Long-term CPI assumptions are discussed in section 7 of this paper.

4.2  Summary

4.2.1 To determine the short-term CPI assumption the proposed process is to:

  • convert the relevant CPI forecasts to a common year definition
  • start with the NZIER and the Aon consensus forecasts for the first 4 years
  • consider whether the Treasury or RBNZ forecasts provide any more up to date information and adjust accordingly, and
  • use the long-term CPI rate for years 5 and onwards, determined as part of the long-term assumptions under this methodology, unless there is any compelling reason not to.

4.2.2 The Treasury and its advisors will make final decisions and apply judgement in relation to any inconsistencies in short-term CPI forecasts.

4.2.3 In applying this methodology we think it’s important to consider the purpose of the rates, which is to value cash flows that are long term in nature and are usually spread over many years, not just for short-term forecasting. Both the ACC and GSF obligations have future cash outflows that extend to 50 years and beyond. Consequently, for these valuations the timing of inflationary pressure or otherwise becomes less important. For example, 3.0% in year one and 2.0% in year two will have a similar outcome to 2.5% for two years. The timing of CPI changes is less important for valuation purposes than for short-term forecasting purposes.

4.2.4 In determining this process we have decided not to rely entirely on the Treasury’s short-term forecast of CPI. NZIER and Aon consensus forecasts incorporate a wider range of forecasts of CPI in New Zealand and to ignore the available views of other credible sources may introduce some bias in our assumptions. Assumptions should be objective, impartial and verifiable under accounting and actuarial standards.

4.2.5 However, a balance must be struck between using numerous sources of objective and unbiased CPI assumptions while recognising that the accounting valuations are for the purposes of Treasury’s financial reporting. As such we expect that the Treasury short-term CPI forecast would have significant weighting, particularly if it is more recent than any of the consensus forecasts and is updated for latest economic conditions.

4.2.6 We are aware that in different countries there are some CPI futures markets operating. For example, in Australia some of the investment banks offer CPI derivatives. However, we are not aware of any derivatives activity for the New Zealand CPI. If such markets were to develop in New Zealand they would be assessed as part of future reviews of this methodology.

4.2.7 There is an index-linked government stock maturing in 2016 that is discussed later in this report. Transpower has recently issued some 10 year CPI indexed stock; however, it is too early to assess how well this is trading. It is likely that adjustments for risk and liquidity would be required. The Transpower’s recent issue of stock is unlikely to be directly applicable unless there are similar nominal stocks to compare it to directly.

4.3  Analysis

4.3.1 The following table summarises the main published forecasts of CPI inflation at the time of writing this paper. The forecasts are published at different times, and consequently may be based on different information. In each case below the forecasts are for March years.

Item Published 2010
%pa
2011
%pa
2012
%pa
2013
%pa
2014
%pa
2015
%pa
2016
%pa
2017
%pa
Treasury
(BEFU, May 2010)
Dec, May 2.2 5.9 2.4 2.4 2.4 - - -
NZIER Quarterly Predictions
(March 2010)
Mar, May, Aug, Nov 2.2 2.9 1.3 1.5 1.9 -   -
NZIER Consensus Forecasts
(March 2010)
Mar, June, Sep, Dec 2.2 2.4 2.4 - - -   -
Reserve Bank of New Zealand
(March 2010)
  2.0 2.3 2.8 2.7 - -   -
Aon Economists Survey
(April 2010)
Feb, May, Aug, Nov - 3.4 -   2.5 -   2.4

4.3.2 The Budget Economic and Fiscal Update 2010 (BEFU 2010) forecast published by Treasury includes the effect of GST rising from 12.5% to 15% and it is likely that the Aon consensus survey includes some expectation of a GST increase as it was signalled by the Government prior to Budget 2010. Note also that the 2010 forecasts above are historic and the first forecast year is actually 2011.

4.4  Consensus Forecasts

4.4.1 Consensus forecasts are produced quarterly by Aon and NZIER. These forecast reflect a survey of a range of economists on the following specific measures:

Aon consensus:

  • CPI in 1, 4 and 7 years
  • AWE in 1, 4 and 7 years
  • Rate of GDP growth in 1, 4 and 7 years
  • Real interest rates in 1, 4 and 7 years.

NZIER consensus:

  • CPI in 1, 2 and 3 years
  • AWE in 1, 2 and 3 years
  • Rate of GDP growth in 1, 2 and 3 years.

4.4.2 Note that the NZIER consensus forecasts are March years with the first one being 31 March 2010. The March consensus consequently has only 2 years of useful forecasts. A summary of the current forecasts is displayed below.

Item 1 year 2 year 4 year 7 year
CPI Aon (April) 3.4%   2.5% 2.4%
CPI NZIER (March) 2.4% 2.4%    
AWE Aon (April) 2.2%   3.4% 3.2%
AWE NZIER (March) 1.9% 2.6%    
GDP Aon (April) 3.1%   2.5% 2.7%
GDP NZIER (March) 3.1% 3.2%    
Real Interest Rates 3.2%   2.5% 2.7%

4.4.3 The two consensus forecasts together provide a reasonable coverage for the first four years. The Aon seven year forecast can be a useful additional piece of information for determining the long-term CPI assumption.

4.4.4 The NZIER is a non-profit incorporated society based in Wellington and is independent of government. NZIER's team of economists is one of the largest in New Zealand outside of government. NZIER provide regular economic forecasts to their members and conduct long-standing surveys of business and economic opinion. Consensus forecasts from NZIER include a range of banks plus NZIER, Treasury and RBNZ.

4.4.5 Aon New Zealand is a part of the international Aon Corporation. Examples of entities that contribute to the Aon Economist survey are ANZ Bank (NZ) Limited, NZIER, Bank of New Zealand Tower Asset Management, BERL UBS NZ Limited, Deutsche Bank (NZ) Limited, Westpac New Zealand and the Business Roundtable. Note the Aon surveys do not include Treasury or RBNZ.

4.4.6 We think it makes sense to start from the consensus forecasts for accounting valuations, as these will incorporate, to some extent, the other published forecasts, are produced regularly and are publicly available. These forecasts are published at different times so inevitably the different consensus views will not exactly align. Also, the figures quoted are an average of the views of different selections of participants and so some differences in the averages are to be expected. As these forecasts are ultimately various commentators' views, there will always be some differences. Therefore, we will need to apply judgment in resolving any inconsistencies between the consensus forecasts.

4.5  The Treasury Forecasts

4.5.1 The Treasury has specific short-term CPI assumptions that are used for the 5 year forecasts. These are updated every six months for the budget (generally published in May) and the half year budget update (generally published in December).

4.6  The Reserve Bank of New Zealand

4.6.1 As the central bank of New Zealand, the RBNZ is responsible for the New Zealand currency and for operating the monetary policy to maintain price stability. The mechanism of this is the Official Cash Rate which affects short-term interest rates. The current Policy Targets Agreement of the RBNZ defines price stability as annual increases in the CPI of between 1 and 3 per cent on average over the medium term.

4.6.2 RBNZ forecasts are another important source. The RBNZ and Treasury forecasts are both included in the NZIER consensus forecasts, so to some extent the process of amalgamating the various sources has already been done for us.

4.7  Adjustments to CPI Forecasts

4.7.1 From time to time there will be one-off effects in the CPI forecasts which will need to be considered, for example the increase in GST announced in May 2010. For the purpose of forecasting the CPI index the GST will need to be included, and the effect due to GST needs to be quantified. This will allow entities to determine the appropriate CPI assumption if the effects of GST on their future cash payments or receipts does not need to be incorporated in the valuation.

4.71.2 For the purposes of applying the inflation assumption the nature of the cash flows needs to be considered on a case by case basis, for example:

  • payments indexed to the CPI but not subject to GST, include the GST effect
  • payments with GST that are deductible, exclude the GST effect, and
  • payments linked to wages or salaries are unlikely to be affected by the GST rise, exclude the GST effect before applying linkage to CPI.

4.8  Results using an Example

4.8.1 As discussed above, determining the CPI is a matter of applying judgment based on the views of New Zealand economic forecasters and commentators. Therefore, we believe the best way to describe our methodology for setting short-term CPI is to illustrate the process by applying the steps of the process at the current date below:

  1. All the forecasts are for March years, so no adjustment is required.
  2. The NZIER consensus forecast is 2.4% for 2011 and 2012; the Aon 2011 survey is likely to include some allowance for anticipated GST changes. The Aon forecast for 2014 is 2.5%. Start with the series 2.4%, 2.4%, 2.4%, and 2.5% for 2011 to 2014.
  3. The Treasury forecast is more recent than the rest and includes the effect of the actual GST changes and other effects of the budget. This forecast indicated the 2011 figure should be changed to 5.9%.
  4. The Aon survey has 2.4% after 7 years and the long-term rate is 2.5% so use 2.5% for year 5 onwards.
  5. The result is the series 5.9%, 2.4%, 2.4%, 2.5%, 2.5% for 2011 to 2015+.

4.8.2 GST is allowed for in the forecasts on the basis that 90% of the CPI basket is subject to GST, so the effect on inflation is 0.9*(1.15/1.125 -1) = 2.0%.

4.8.3 In this example the inflation for the first year for cash-flows related to prices that are exclusive of GST would be 3.9%, and for payments that are linked to CPI or are inclusive of GST the first year inflation would be 5.9%.

4.8.4 These results have been included in the sample table of assumptions as at 31 May 2010 in Appendix 3. The Treasury intends to set the short-term CPI assumptions in time for valuations as at 30 June and 31 December each year. This fits with the timing of Treasury forecasts which are usually released in May and December each year. However we intend to perform a high level view of any new CPI forecasts available at the other key valuation dates eg, the GSF valuations of 28 February and 31 October. This will allow Treasury to assess at these dates if the latest short-term CPI assumption is still appropriate.

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