Fergus Hodgson: Country does not need more inflation

A car updated with more airbags but no change to price would be interpreted by CPI as a price decline. Photo / File

Reserve Bank is expected to lower its base interest rate again but the target range puts it under undue pressure.

• Fergus Hodgson, originally from Ngaruawahia, is an economic consultant with the Fraser Institute in Canada and a research fellow with the Tax Revolution Institute in Washington, DC. He holds degrees in economics and political science from Boston University and the University of Waikato.

New Zealand has achieved the envy of many nations: stable, near-zero inflation. Yet both prominent commentators and the Reserve Bank's mandate give the false impression that this is "bad news".

The latest consumer price index showed prices rising at 0.4 per cent per year, admittedly low by international standards. Herald business editor Liam Dann soon alerted readers that this meant danger, that low prices were "the biggest problem facing the world economy". In particular, he warned that people might foresee falling prices and delay large purchases.

Moreover, the Reserve Bank's target range for inflation is 1-3 per cent, which implies that very low inflation and deflation are undesirable. The Reserve Bank, therefore, foreshadowed a further cut to the nation's base interest rate, the official cash rate, in an attempt to boost inflation.

Before trying to solve a problem, though, we need to be sure the problem actually exists. Is inflation actually too low?

Two reasons suggest that the CPI doesn't fully account for increases in New Zealand's cost of living. First, Statistics NZ calculates the CPI to replicate the cost of living faced by the typical Kiwi household. The index includes rent and the cost of building a new house. It does not include the value of residential land, which people must pay for if they buy a stand-alone house.

The cost of land for housing is no trivial item to overlook. In fact, according to the Real Estate Institute, the price of the average house has increased five-fold since 1992, with the underlying land as the chief culprit. Ironically, this ballooning of house prices has occurred since the Reserve Bank finally achieved "price stability", after years of high inflation.

The second reason relates to how the CPI is constructed. It is not, as many might imagine, simply a measure of how the prices we pay for goods and services change from quarter to quarter. Statistics NZ applies so-called quality adjustments to the CPI, which reduce the prices of goods in the index if they have increased in quality.

For instance, a car manufacturer might update one of its models with additional airbags, but with no change to the price. The CPI interprets this as a price decline. It may seem far-fetched to expect people purchasing a car to regard new airbags as a reduction in their living costs. Nonetheless, similar "quality adjustments" are applied to many other durable goods, such as home appliances. Thus the CPI becomes disconnected from what a household spends to buy goods and services in the real world.

Assessing the overall effect of this policy on the CPI is difficult, since Statistics NZ does not release the unadjusted numbers. Regardless, the effect of quality adjustments is meaningful and likely increasing, given acceleration in technological change.

All this suggests any further reduction in the OCR, which affects the entire range of interest rates in the economy, would be at best unnecessary and at worst harmful. Lower interest rates would put even more upward pressure on the housing prices - the last thing New Zealand society needs.

There is also growing disquiet among economists internationally regarding the way low official interest rates have artificially boosted asset prices. This inflation, not captured by the targeted CPI, has not only worsened inequality, it has raised the risk of another disastrous financial bubble and economic downturn.

Once we pierce the shortcomings of the CPI measure of inflation, we would also do well to remember that the Reserve Bank is governed by an Act of Parliament. The bank's primary objective is to maintain price stability. The legitimate fear was and remains the destructive impact of inflation as a tax on savers and fixed-income earners, particularly retirees. Inflation also generates expenses as people have to adapt to and avoid rising prices, and it impedes planning and investment.

Price stability was originally defined in the first Policy Targets Agreement between the Reserve Bank Governor and the Minister of Finance as CPI inflation within 0 and 2 per cent. The Government widened that range to 0 to 3 per cent in 1996, before raising it further to 1 to 3 per cent in 2002.

There was little justification for the latest change, beyond the misperception that the Reserve Bank was excessively focused on achieving low inflation to the detriment of economic growth. Serious consideration should be given to lowering the target range back to between 0 and 2 per cent, since the Reserve Bank's current mandate is placing undue pressure on it to cut the OCR.