Listener19 November 1994, republished in Inflation: A Sixth Form Resource, Reserve Bank of New Zealand).

Keywords: Macroeconomics & Money; Statistics;

The Reserve Bank Act requires the Bank to attain and maintain price stability, but it does not define “price stability”. Practically that is defined in the Policy Targets Agreement (PTA) between the Minister of Finance and its Governor. Currently the PTA requires monetary policy to be managed so that the Consumer Price Index (CPI), with modifications discussed below, remains in a 0 to 2 percent p.a. range.

It is not obvious that the CPI is an appropriate measure of inflation. Its importance arises from when the Arbitration Court had to consider changes in consumer prices as the most significant determinant of setting wages. But that Court and the economy in which it operated are long gone. Today many more sectors are exposed to external pressures. It does not always make sense to consider only the costs of the goods and services the worker purchases.

Consider a worker facing consumer prices which have risen 5 percent, while the competitor’s price for the worker’s product has fallen 5 percent (perhaps from being sourced overseas). Which is the more important price change? If I were the worker I would be more concerned about the production price fall. It might mean no wage increase, but at least there was a chance of holding onto the job. If workers insist their wages should be increased in line with rising consumer prices, they could find themselves redundant.

The proponents of the Reserve Bank Act did not intend that there should be no change in price levels. In an ideal world some prices will go up and others down. The objective is prices should “on average” stay at the same level. But what do we mean by “average”? The CPI measures the average change in the prices of the goods and services the average consumer purchases. Since most of us are not average, most experience changes in our personal prices indexes differ slightly from the CPI.

Statistics New Zealand calculates many more price indexes. The accompanying graph shows the year on year changes for the Producer Price Index (PPI), which measures the price of industry output, as well as the CPI. The PPI has been increasing recently at around 3 percent a year (comparable to the OECD average), while the CPI increases were nearer to 1 percent p.a. From the perspective of the inflationary past, they are both very low. From the perspective of recent years, the divergence might be important. What is clear is there is no unique price index which precisely defines inflation.

From this perspective it is unfortunate that the PTA gives the impression that the CPI is the measure of inflation. Recently the Reserve Bank has compounded the confusion by distinguishing what it calls the “headline” rate of inflation with the “underlying” rate of inflation. Behind their rhetoric, the headline rate is that measured by the CPI, which affects the average consumer’s spending power. It is the actual rate. The Bank’s so-called underlying rate is no such thing, but that set down by the PTA. For the agreement recognized that targeting on the CPI could lead to inappropriate outcomes.

Suppose GST were to be increased. It would be crazy to try to squeeze that hike out of the economy using monetary policy. Similarly if there was some surprise shock – say an oil price rise – the best response might not be to disinflate. Excluding interest changes from the PTA measure arises because of the direct impact monetary policy has on interest rates.

We should be mature enough to recognize that different price indexes are needed for different purposes. Despite their odd terminology the Reserve Bank is doing just this. If it were targeting on the actual CPI, it would have to markedly tighten its monetary stance to try to keep that index within the target range. Instead it is focusing on another price index, which does not require as repressive a response.

That does not mean that we should ignore the CPI when considering inflation. That it is rising faster means some people are going to suffer reductions in their standard of living. (But interest recipients are going to be better off.) No doubt the Reserve Bank would worry if everyone started demanding full compensation for their price rises, for then inflation rate would start rising on every measure.

This column has argued that it would be better if the PTA inflation target was in terms of production prices rather than consumer ones. The CPI would still be relevant as a transmitter of inflation, and for its impact on welfare. But the Reserve Bank and the public should not be obsessed by it.

Recently I have been wondering if there is any suitable measure at all. Just as there is no single stock of money that the Reserve Bank can target as an indicator of its monetary policy, neither is there any single price index. Targeting a set of price indexes would reduce the precision of the PTA, but it would shift the framework from the idealised world of textbooks to the real world in which unsatisfactory targets for the Reserve Bank can damage all our welfare.