The current account in the balance of payments is seriously out of whack, its deficit headed for eight percent of GDP and worsening, as was discussed here last month. This is an alarming imbalance.
Bank of New Zealand chief economist Tony Alexander talks of inflation as an imbalance, too. It was recorded at an annual 2.8 percent in June after being suppressed by 30 percent rise in the exchange rate and is rearing to bust through the top of the Reserve Bank’s 1-3 percent target zone.
An imbalance? How come? The genial Mr Alexander was happy to elaborate to your columnist. Think of an economy purring along smoothly, he said. In New Zealand, when that happens, the current account deficit will be no worse than 4-5 percent of GDP and inflation will be comfortably contained between 1-3 percent (within the Reserve Bank’s target zone). Trouble is, inflation is headed well above three percent and may not come back quickly.
The imbalance results from growth outpacing the availability of resources. The shortages are not only of skilled labour, but also of raw materials and other inputs. Alexander paused, then carefully summed up: “The sentence should read ‘inflation is imbalance, coming from the imbalance of the rate of growth exceeding growth in our resources and productivity’.”
The Reserve Bank of New Zealand (RBNZ), in its September monetary policy statement (MPS), addressed these issues.
First, the shortage of workers. The labour market remained “very tight” (as evidenced by the near-record low unemployment rate of 3.7 percent), the MPS said. Increasing numbers of people are being brought into paid work and lifting wage growth.
The RBNZ expects the labour market to remain “robust” over the next few years and the shortage of workers “to gradually ease”. But it expects relatively high wage growth over the coming years, too, thanks to the lagged effect of the tight labour market conditions.
Then comes cautionary note: if higher wage increases are not matched by productivity increases, and are simply response to the short-lived spike in inflation, “they will have unhelpful consequences for pricing behaviour and medium-term inflation outcomes”.
Second, capital investment (which influences productivity growth). The RBNZ noted how robust demand from home and abroad, coupled with the high exchange rate, has encouraged strong investment in new capital. But business investment growth is expected to slow over the next few years, in tune with the economic cycle. Plant and machinery investment is expected to weaken in the second half of this year; longer lead times should postpone the cyclical downturn in nonresidential construction until next year.
While investment growth is projected to slow, however, investment should remain high as share of GDP. “The recent period of strong investment is expected to result in an improvement in productivity growth over future years,” the RBNZ said.
Third, the shortage of resources. The RBNZ expects medium-term inflation pressures will cool over the next few years, and slowdown in economic activity will become more widespread within the economy. The flow-on effects of high New Zealand dollar, slower population growth and the lagged effects of previous tightening in monetary policy will increasingly constrain domestic demand. This is expected to reduce the pressure on productive resources that has led to rise in inflation over the past two years.
Tightening monetary policy is the most obvious medicine for dealing with rising inflation. It is administered by the Reserve Bank, but it has its limits. As the MPS points out, rising oil prices have made the future more uncertain. Oil prices have surged in recent months – they were 20 percent higher in September than had been projected in June, and some 60 percent up from the end of 2004.
That’s why the RBNZ is forecasting “headline” consumer price index inflation to approach four percent over the next few quarters before returning below three percent by early 2007.
“Monetary policy will not attempt to offset the unavoidable first-round price effects of the oil price spike,” the MPS declared. “However, it will be used to resist any flow-through to ongoing price and wage inflation.”
Further out, higher oil prices are expected to dampen both world and domestic economic activity. This will take some pressure off monetary policy in the medium-term.
There are policies in the government’s medical kit, too, for encouraging productivity growth and resource availability. But they are not quick fixes.
It will take years to improve the infrastructural resource constraint that puts pressure on inflation, for example. Likewise, it will take years for the government’s tertiary education and training programmes to provide their worth. The raw materials constraint will take time, too – we might have to wait until China’s growth slows down, because China’s huge hunger for materials is causing the shortage.
Bob Edlin is regular contributor to Management.
