New Zealand Digest: The 'lowflation' conundrum

New Zealand Digest: The 'lowflation' conundrum

• Despite strong economic growth, New Zealand’s inflation has remained low and is currently running at 1.0% y-o-y, which is at the bottom of the RBNZ’s target band
• This may reflect the on-going effect of the high NZD and that there may be more spare capacity than previously thought, partly due to recent strong inward migration
• Nonetheless, our estimates suggest that spare capacity is continuing to be absorbed and, along with a lower NZD, we expect this should push inflation higher in 2015

How long will inflation keep undershooting?
New Zealand’s economy continues to outperform the rest of the OECD, with y-o-y growth running at +3.9% through to the middle of the year. Ordinarily, such strong growth would generate additional inflationary pressures and, indeed, this was expected to occur in New Zealand in 2014. However, inflation has confounded the forecasts, falling back to 1.0% y-o-y, which is the lower edge of the RBNZ’s 1-3% target band. As a result, we need to reassess the inflation picture. There may also be lessons for other economies from this exercise, given that many countries are seeing inflation surprises on the downside.

In New Zealand, there are a number of factors that have kept the lid on inflation recently. Goods and services that have their prices set in international markets have seen little price growth, with weak global demand producing widespread ‘lowflation’. At the same time, the high NZD has pushed down the cost of these imports in local currency terms.

Meanwhile, the domestic economy has exhibited more spare capacity than was expected. This may partly be due to a sudden upswing in net migration, to record highs, that has helped address skill shortages in some sectors. Our estimates also show that there may have been a general underestimation of how much capacity was added in the pre-recession years and, therefore, how high potential output and spare capacity have been in recent years.

These factors help to explain the recent ‘lowflation’ experience, but they do not suggest that inflation will remain permanently low. The NZD has already fallen, which will raise the cost of imported goods, and even with higher estimates of potential output, it is likely that spare capacity has largely been absorbed over the past year. We expect inflation to rise gradually in 2015, prompting the RBNZ to resume its tightening cycle in the second half of 2015.

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ENDS

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