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7  Long-Term Inflation

7.1  Introduction

7.1.1 Long-term inflation is the third step in three connected components. The long-term inflation is determined as the long-term risk-free rate less the real risk-free rate. Consequently a single long-term inflation assumption is derived for accounting valuations.

7.1.2 It is also important to validate the long-term CPI assumption by considering economic theory and historical analysis in the context of New Zealand's economic environment.

7.1.3 As already noted in this paper many of the Government's obligations or assets valued using estimated future cash payments and receipts are sensitive to various inflation assumptions including CPI. This is particularly true for estimated future cash flows over long durations, such as ACC claims liabilities and GSF pension obligations. These liabilities are just as sensitive to inflation rates as they are to discount rates, because of the compounding nature of both. Below is a summary and analysis of our view of an appropriate long-term CPI assumption for accounting valuations.

7.2  Summary

7.2.1 In the current, comparatively stable economic environment, we believe that the long-term CPI rate can be set by reference to the long-term nominal risk-free rate less the long-term real risk-free rate.

7.2.2 This assumption is validated by the historic levels of CPI inflation and the historic relationship between CPI inflation and the RBNZ inflation targets.

7.2.3 The current Policy Targets Agreement of the RBNZ defines price stability as annual increases in the CPI of between 1% and 3% on average over the medium term. This inflation target band has changed over time since it was first introduced by the RBNZ in 1989/90. Some commentators suggest that any long-term assumption for accounting valuations should be the rate that is exactly half way between the current target band. For example, this would be 2% based on the current target of between 1% and 3%. However, our historical analysis below indicates that inflation tends to run consistently higher than the mid-point of the Bank's target band.

7.2.4 The historical analysis indicates that over the last 20 years CPI inflation has been comparatively stable and averaged 2.2% pa. It also shows that CPI inflation has exhibited a long term pattern of exceeding the mid-point of the RBNZ's target range by 0.7% pa. These indicate a reasonable range for future CPI is 2.2% pa to 2.7% pa (2.7% pa being 0.7% pa above the mid-point of the RBNZ's current target range).

7.2.5 Overall, a 2.5% pa assumption for accounting valuation purposes seems reasonable ie, 0.5% pa above the mid-point of the RBNZ range. For forecasting the New Zealand economy and the Government's projected debt track Treasury currently uses a mid-point CPI assumption of 2%. The next two paragraphs address the reasons for the two rates being slightly different.

7.2.6 The long-term inflation assumption of 2.5% p.a. is based on historical averages. Since the change to the Policy Target Agreement in September 2002, which set the RBNZ’s targeted inflation band as between 1% and 3%, the average annual CPI-measured inflation has been 2.65%. Consequently, in setting a long-term assumption for an accountancy standard, it is not unreasonable, in the absence of any known policy change that could be assumed to alter the future path of inflation, to base the forward projection on historical data.

7.2.7 The assumptions in the Treasury’s medium-term and long-term fiscal projections are based on more than just historical averages, as they reflect current policy. As the RBNZ is currently required to target achieving inflation between 1% and 3%, the assumption that involves the simplest interpretation of this policy, and no inherent call about a bias in either direction, is 2% p.a. ie, the middle of this band. Furthermore, the inflation assumption is only one of a number required for Treasury’s projections, such as labour productivity growth, the unemployment rate and the Government bond rate. All of these assumptions are reviewed at each official forecast round by the Treasury. Consequently, while 2% p.a. is the current long-term assumption for inflation in the Treasury’s fiscal projections, this could change in the future.

7.2.8 Whilst the rate in this methodology is not exactly the same as the 2% Treasury uses for long-term projections, the difference is understandable. The accounting and actuarial standards put more weight on the observable and verifiable data at valuation date for determining assumptions and less on policy intentions of governments.

7.3  Analysis

Inflation over the Last 20 Years

7.3.1 CPI inflation in New Zealand has been relatively stable since the following events:

  • the introduction of the Reserve Bank Act with inflation targets (1989/90)
  • the introduction of GST in 1986 and subsequent increase from 10% to 12.5% (1989).

7.3.2 The RBNZ inflation targets have been:

  • from March 1990 0% to 2% mid-point 1.0%
  • from Sept 1996 0% to 3% mid-point 1.5%
  • from Dec 2002 1% to 3% mid-point 2.0%

7.3.3 The actual average CPI in periods to March 2010, compared to the mid-point of the RBNZ range, have been:

  5 year 10 year 15 year 20 year
CPI 2.9% 2.7% 2.2% 2.2%
RBNZ mid 2.0% 1.9% 1.7% 1.5%
Difference 0.9% 0.8% 0.5% 0.7%

7.3.4 The table above shows that the average inflation has been within the RBNZ target range for each period but has consistently exceeded the mid-point.

7.3.5 The graph below shows the year-by-year progression of annual CPI plotted next to the target mid-point.

CPI compared to target midpoint
CPI compared to target midpoint.

7.3.6 The actual inflation has more often been above the mid-point than below, being below only five times in the last 20 years.

7.3.7 The following histogram shows the historical inflation rates, as measured by CPI, since March 1991. The inflation rates are annual rates for each quarter during this period. The solid bars represent the number of times the inflation rate was between RBNZ’s current target band of 1% and 3%.

Rolling Annual CPI from March 1991 to March 2010
Rolling Annual CPI from March 1991 to March 2010.

7.3.8 The graph shows the distribution is skewed to the right of the target band block (the target band block of 1%-3% is shown as the solid bars). If the comparison was made to the target band at the time, the “skewness” would be more pronounced.

7.3.9 When doing this analysis the effect of a GST change should be backed out of the analysis, and this should be considered when the analysis is updated. It is generally accepted that GST is a step change and is unlikely to impact on longer term inflation expectations.

7.3.10 We have only reviewed the last 20 years for New Zealand historical CPI rates because this represents the time since the introduction of the Reserve Bank Act with inflation targets (1989/90). Prior to this, especially pre the 1984 economic reforms, the New Zealand’s economy was based on significant interventions compared to the open and market based economy of the last 20 years. New Zealand also experienced very high levels of inflation, particularly in the 1970s. Therefore, in our view, the historical analysis pre 1990 is not applicable for determining the long-term CPI assumptions in the current economic environment.

The Treasury Long-Term Forecasts

7.3.11 The Treasury CPI forecasts are essentially done in three steps:

  • the short-term 5 year budget forecasts, which are updated every six months
  • the medium-term forecasts, which project a further 10 years to get 15 year forecasts
  • the long-term model (LTFM) which extends forecasts to 50 years.

7.3.12 The inflation assumption currently used by the Treasury after five years is the mid-point of the RBNZ target range of 1.0% pa to 3.0% pa, being 2.0% pa.

7.3.13 As previously discussed the accounting and actuarial standards require that assumptions are objective, unbiased and verifiable when valuing liabilities and assets for accounting purposes. Therefore we believe that it is important to consider the asymmetrical nature of the inflation distribution evident in the historical analysis. There has been a consistent pattern of exceeding the target range, so in the long-term, average inflation is likely to be above the mid-point of the RBNZ range.

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