KEY POINTS:
Inflation has averaged 2.9 per cent over the past three years and the Reserve Bank forecasts it to stay around that level for a further two.
Five years of nigh on 3 per cent inflation is quite a risk to run with inflation expectations, the all-important confidence on the part of wage and price-setters that we live in a low-inflation economy.
The bank's need to lean against that trend has stuck us with a policy interest rate that matches Indonesia's and a seriously overvalued exchange rate.
So we have a select committee inquiry into whether there is something wrong with the monetary policy framework, and barrels of ink are expended second-guessing the way Alan Bollard has done his job.
But there is another possibility, less nationally egocentric but more troubling: that the global economy is moving from a fundamentally benign inflation environment to one in which inflation is much more of a problem.
It is sometimes called the China effect.
Consumers worldwide have benefited from cheaper goods as millions of people have moved from the rural hinterland to the factories which have made China the new workshop of the world.
At the same time rising incomes in Asia have bid up prices for resources of every kind, including oil and food.
One result is that New Zealand now enjoys the strongest terms of trade for 33 years. That is, the world prices of the kinds of things we export have risen relative to prices of the kinds of things we import.
While this is positive for growth and incomes (at least for those of us not directly competing with foreign workers on low wages), it is a mixed blessing on the inflation front. Cheaper plasma TVs but dearer butter.
The concern is mounting that the upward pressures on global inflation from higher commodity prices may be starting to outweigh the deflationary effects of cheaper manufactured goods.
Former Federal Reserve chairman Alan Greenspan warns in a recent book, The Age of Turbulence, that at some point the flow of people into the global economy in China and elsewhere will slow, leading to stronger pressure on wages and prices. And that may be upon us sooner rather than later, he says.
Inflation in China has hit 6.5 per cent, a 10-year high.
Rodney Jones, former managing director of Soros Fund Management in Hong Kong who now advises British and American hedge funds on Asian economic developments, told MPs on the finance select committee that China's export prices used to decline by 2 or 3 per cent a year but now were increasing by 2 or 3 per cent a year.
And the demand for resources arising from its breakneck growth would remain intense, he said, citing as an indicator of the latter the fact that China's automotive market had grown from less than 2 million vehicles a year five years ago to 10 million now.
"A commitment to low inflation is especially important now," he said. "It is not a time to relax and we shouldn't be looking in the rear-view mirror."
Bollard told the committee that the downward pressure China had exerted on manufacturing prices could not go on forever. "That improvement is slowing now. There's still more to come through, but at a slower rate."
This is a problem because in the past few years it has been low inflation in the tradeables components of the Consumers Price Index which has offset stubbornly high inflation, around 4 per cent, in the non-tradeable ones.
Tradeables are items whose prices are driven by world prices and the exchange rate. In the year ended June tradeables prices collectively fell by 0.5 per cent, offsetting a 4.1 per cent rise in non-tradeables prices so that the overall CPI rose 2 per cent. That reflected a sharp rise in the exchange rate.
But with the dollar at an eye-watering US74c and 70 on the trade-weighted index we had all better hope that source of downward pressure on inflation is only temporary.
While a lower dollar will make imported goods more expensive, that does not automatically flow through to what we pay.
ANZ National Bank economists point to a heartening lack of price increases when the dollar fell over the first half of last year (a fall later reversed with a vengeance). They conclude that competitive pressures among retailers were strong enough to force them to absorb the effects of the dollar's fall.
With consumer demand expected to soften as higher interest rates bite into disposable incomes that competitive discipline should continue. But it is a different story for food prices.
Global grain prices have been bid up by growing demand in the emerging economies and the biofuels industry, with spillover effects on dairy prices.
Based on where commodity prices now sit, ANZ is picking food price inflation to climb from 4 per cent now to 5 or 6 per cent by the end of next year.
Meanwhile at the petrol pump drivers are at risk of a perfect storm from rising world oil prices, a falling exchange rate, regional taxes to fund infrastructure projects and from 2009 a price on the carbon emissions from transport fuels.
Household energy prices (electricity and gas) have risen a cumulative 40 per cent over the past five years. But with cheap Maui gas running out, with the Government adopting a 90 per cent renewables target for electricity generation, and with major national grid upgrades needed - like the $500 million project Transpower announced on Tuesday, little relief can be expected on that front.
About 10 per cent of the CPI consists of prices set by central or local Government, like local body rates, health and education.
In recent years public sector wages have tended to rise faster than private sector ones. The ANZ economists expect inflation in the Government-dominated sectors to run around 4 or 5 per cent over the year ahead.
Perhaps the most unfortunate effect of the big deflationary influence flowing out of China in recent years has been that it has taken the pressure off the tried and true policies for keeping the lid on inflation.
One is to constrain the growth in the money (credit) supply.
The huge 500 basis points easing that Greenspan dispensed in the wake of the tech wreck and September 11 would have had a much bigger effect on consumer price inflation than it did without the offset of imported deflation. Instead it flooded the world with cheap, easy and abundant credit, funding asset price bubbles and setting us up for the current credit crunch. The other old-fashioned preventive for inflation is a commitment to competitive markets.
As a procession of submitters have reminded the select committee, monetary policy needs mates.
And among them its best friend should be good competition policy.
