What is inflation?

It was recently brought to our attention that we talk a lot about inflation, but we’ve never really discussed what it is and whether we need to expend so much energy on keeping it in check.

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To explain just what inflation is and its impact on an economy we have to go back to the 1980s when inflation was a serious serious problem. 

The cost of living was being driven higher by oil shocks, a surging deficit and high debt load. Robert Muldoon, who was Finance Minister and Prime Minister at the time, tried to outlaw inflation. He put a freeze on prices and wages.

It didn't go too well.

One of the consequences was sky high interest rates as people hunted everywhere for finance to buy houses or invest in businesses.

All it really achieved was to bottle up pressures which threatened to do serious economic damage.

This is the point that New Zealand stakes a claim as the architect to one of the most significant economic policies of recent memory. Inflation targeting.

The finance minister of the newly elected Labour government was Roger Douglas who felt there had to be a better way and he delegated the task of finding it to some bright young things in Treasury, one of whom was Arthur Grimes.

Grimes said Douglas told them to “Muldoon-proof monetary policy”. 

“So we were sent away to think about what could that mean, would could monetary policy achieve longer term, what couldn’t it achieve and there was a real consensus in the economic community at the time - and I think there still is - that longer term monetary policy really can only achieve one thing and that is pretty much stable prices or if it does it badly, inflation,” he said.

So they decided to concentrate on stabilising prices. They came up with the catch phrase “Zero to two by 92”

“Oh well, we said, why would we want inflation? Why would we want prices rising? Don’t forget inflation, even at one percent, means that prices are still rising. They’re still rising at 1%. So we said, why would we want inflation? There’s a little bit of a reason that the consumer price index maybe 1% inflation is perhaps true price stability. That maybe there’s some mis-measurement there. I think that’s less the case now than it used to be. And we said roughly 1%, plus or minus 1%.”

“It’s that easy,” said Grimes, “We wanted it quite narrow because we didn’t have any credibility, having had two decades of double-digit inflation or whatever. We wanted to make sure there was a really strict target so that people soon learned what we meant, we set out to do something and we achieved it. And that’s what we did.”

There were a few twists and turns in deciding how to reach the target, such as targeting the amount of money in the banking system. Then there was a thing called the monetary conditions index. That tried to balance the value of the New Zealand dollar against short term interest rates. 

But eventually they ended up doing the same as other central banks were doing, they created a benchmark interest rate - which they called the official cash rate.

Now, when the government wants to tap the brakes on the economy and cool down inflationary pressures, they raised the cash rate to make money more expensive. When they wanted to stimulate the economy, it lowers rates.

Keeping the economy steady is as much about safeguarding against falling prices as it is about surging prices.

Consumers might think they want falling prices, but with deflation short term gain could lead to long term pain.

If prices are dropping, people just hold onto their money. Why would you spend $60,000 on a new Toyota Hilux when you can get a Ford Ranger for the same money next year? 

And if everyone’s sitting on their money - the economy comes to a grinding halt.

“Deflation can be problematic if it’s causing outstanding debt to be going up in actual real terms and it costs more to have debt. So deflation’s not a great property and nor is inflation, which is in the end why we went with price stability,” said Grimes

And in that environment it comes down to educating consumers and businesses, setting inflation expectations.

The thinking is that if people stop expecting to pay higher prices all the time and businesses stop expecting to be able to increase their prices, that will go a long way to achieving price stability and will keep inflation in the target zone.

But it wasn’t easy to get the idea across to people early on.

“I well remember when we said we were targeting inflation at that sort of level,” recalls Grimes, “Going to a group of manufacturers and they said you can’t possibly run inflation this low or interest rates this high, we can’t possibly afford it. And I said, well you’ve just had a wage round - that was in the days when we used to have wage rounds - and I said what did you give for your wage round and the first one said 7% and the next one said 7% and then next 6.5% - and I said well how can you say you can’t afford high interest rates when you’re giving wage increases of 7% while there’s a 2% inflation target.”

“They hadn’t yet come round, they didn’t believe that we were credible and they thought that we would just give way. Once we established our credibility, they came into line.”

And so we arrive at the issue of whether we still need inflation targeting. 

Right now, inflation is so low it could limbo dance under a snake, so does the reserve bank need to chase every last fraction of a percentage point to hit the magic two percent mark.

A recent edition of the Economist magazine reported that of the 43 countries that target inflation, 28 are undershooting. So should we leave the sleeping dragon in peace?

Westpac's local chief economist Dominick Stephens thinks the Reserve Bank has been a bit one eyed about trying to reach that 2 percent magic point by cutting interest rates, but he's not ready to abandon the policy.

“I think those who say we should abandon inflation targeting or lower the target need to consider what alternative are they actually proposing. Because if you just allow inflation to drop further and further and further into deflation, what you actually do is push real interest rates up. 

“You can end up in a deflationary spiral. I think one of the things we need to bear in mind is we’re dealing with a really large supply shock at the moment, basically new technologies are allowing firms to deliver things to consumers more cheaply than they could before. That’s a little bit like the reserves of an oil shock and it probably should have been something the Reserve Bank looked through and focused more on its medium-term target,” he said.

Mary Daly is one of the more powerful economic policy makers around the world. She is president of the San Francisco US Federal Reserve and in the next year she'll be a member of the Fed's rate-setting committee.

At a recent conference on inflation targeting, Daly warned that the more often the banks miss their targets the less able they will cope with a bad economic shock in the future - as well as losing a bit of economic cred with consumers.

“It’s tempting to think these misses on inflation are not really meaningful, just a couple of tenths. But in our new economic environment - every tenth counts. There are many difficulties that could arise with consistent misses on our 2% goal. In very practical terms if inflation expectations are a quarter point below our target when the next downturn arrives, and so are nominal interest rate, that’s one less rate cut at our disposal. One less rate cut we can deploy to help achieve our dual mandate goals.”