The Rankin File: #23

The following graph appeared in the Business Herald recently, as a part of Brian Fallow's article:

The data is from the Reserve Bank, which calculates its own version of the Consumers Price Index (CPI) as a measure of what it calls "underlying inflation".

The significant line in the graph is that for "non­tradeable inflation". In essence, non­tradeable inflation is determined by rises in real costs within New Zealand, whereas "tradeable inflation" is determined mainly by the exchange rate of the NZ dollar.

New Zealand's commodity export prices are directly determined by the exchange rate. The prices of import substitutes - goods that are both made in New Zealand and imported - are regulated by the prices of imports which are directly determined by the exchange rate. When the exchange rate goes up, producers in the tradeable sectors - who face the same cost pressures as those in the non­tradeable sectors - go out of business when they cannot match the prices of foreign goods. In other words, they are obliged to absorb cost increases.

The inflation rate that matters in terms of its impact on New Zealand's living standards is that of New Zealand's domestic costs. The best CPI­based measure of domestic costs is the Reserve Bank's measure for non­tradeables. It shows that domestic costs increased significantly in New Zealand in 1990­91, and 1994­97; at well above the upper limit for inflation set by the Government in accordance with the requirements of the 1989 Reserve Bank Act (RBA).

The real exchange rate is a measure of the nominal exchange rate (the value of the NZ dollar against a "trade­weighted index" [TWI] average of the values of foreign currencies), adjusted by a trade­weighted measure of NZ's domestic inflation rate relative to foreign inflation. If New Zealand has a rising nominal exchange rate, and a higher domestic inflation rate than the countries it trades with, then it's economy is in big trouble; trouble that can be temporarily alleviated by inflows of foreign capital. That happened in 1985, 1987 and 1990. Such inflows aggravate the problem, though, by creating a current account deficit (see The Balance of Payments Deficit).

If we look at the real real exchange rate, which means using the "non­tradeable rate" of inflation rather than the "underlying" rate, then the same problem is clearly apparent in 1994­97. The real real exchange rate has risen significantly in 1994­96, to the detriment of employment in the tradeable sectors, and to the detriment of efficiency in non­tradeable sectors such as Health and Education. This inflation means that, for example, the public health sector is collapsing despite increased funding. Increased funding only goes part of the way to meeting increased transaction costs. Transaction costs include the costs of managing such things as high interest rates and bidding for contracts.

The Australian inflation experience puts NZ's situation in a proper perspective. With no Reserve Bank Act like ours, with low interest rates and a falling exchange rate, the Australian inflation rate is much lower than New Zealand's. Not only does that mean that we cannot attribute New Zealand's supposedly low inflation rate to the RBA, but it means that the RBA is itself an active contributor to inflation in New Zealand.

It works like this. Interest rates - which determine minimum profit rates - represent a major business cost (see Profit, the Profit Motive and Social Profit). Thus any policy­induced increase in interest rates (indeed any increase in interest rates not matched by an increase in the productivity of capital) represents a significant increase in factor costs in any capital­intensive economy; ie in any national economy and in the international economy. At the national level, a proportion of such cost increases can be exported via an exchange rate appreciation.

In the New Zealand case, the above graph shows with incredible clarity just exactly what did happen after the Reserve Bank acted to push interest rates up in mid­1994. Domestic inflation increased dramatically, while tradeable inflation was suppressed by being exported.

What is particularly hard to believe is the lack of recognition of this problem in the business press, despite such data - presented in a clear graphical form - staring our journalists in the face. The theme of the Herald article is that, because inflation is so high, then the Reserve Bank will have little scope to deviate from the high­interest rate stance it has pursued unrelentingly since 1994. Yet it is so obvious that this particular inflation problem is in fact being caused by the very policy that we are being told we cannot afford to drop. It is obvious from the graph, and it is obvious from the Australian data.

The Reserve Bank Act does massive damage to the New Zealand economy. It leads to gross resource misallocation; to a low growth of outputs and an increasing waste of inputs. For what? Rather than giving us a better inflation rate for our trouble, it delivers us a significantly worse rate of domestic inflation than we would have had in the absence of the Act. (Thanks to the 'First Past the Post' electoral system, the 1989 RBA wasn't even controversial; it was passed as a fait accompli supported by both parties in a two­party system.)

There is only one way in which the actions of the Reserve Bank under the RBA reduces the CPI. It exports some of our inflation by way of engineered increases in the exchange rate. This is what happened from 1994 to 1996. What is particularly scary is that, as other countries copy our RBA, as Great Britain has already done, then, with more other countries doing the same thing, then a higher interest rate increase will be needed to get the exchange rate up. The global escalation in interest rates that would follow from other states copying our technique of treating inflation would cause a worldwide increase in unemployment, a massively increased misallocation of resources, and a global increase in inflation.

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