The series of relative price shocks coming from successive industries falling under the ETS, the removal of the initially heavily subsidized price of carbon permits, and the likely increase in the world price of emission permits with economic recovery over time can't help but feed into both CPI shocks and expectations of CPI increases. Note that the effective purchase price of permits is currently $12.50/tonne given the government's fixed supply price and two-for-one deal; the world price is currently €15/tonne: roughly double the NZ price.
In my initial post, I worried that the RBNZ position, as characterized by Key that ETS would have no effect on inflation, meant they expected that we wouldn't see the reasonably hefty increases in permit prices post 2012 that would feed CPI expectations. Which would mean either that the permit system would be a bit of a nonsense for not effectively moving to world prices, or that RBNZ wasn't watching inflation expectations. However, as the MPS notes, they will be watching for feed through into inflation expectations; they just don't expect that to happen over the medium term. As I have a hard time telling what the RBNZ ever means by the medium term as it's nowhere defined in the Reserve Bank Act or the Policy Targets Agreement, I suppose that it's tautologically true that it won't happen over the medium term.
But Matt Nolan raises another rather important consideration:
The main thing that makes it “not just relative price shocks” is Kyoto. If we have a net liability under the Kyoto protocol this would be equivalent to a negative terms of trade shock (something I would term a negative supply shock) – so the Bank would optimally want to partially accomodate that (given their implicit quadratic loss function).Yes, if RBNZ cares about more than inflation, I can see this.
The main question has to be how an ETS impacts on inflation expectations (these would be the second round effects). The Bank must believe that the gradual nature of the ETS’s introduction, and the negative direct income effect stemming from any Kyoto liability, will be sufficient factors to prevent them having to do anything – they don’t think inflation expectations will move. If anything, the common belief that we will end up with a liability as a nation (when all the figures are finally together) implies that Bank policy should respond by EVEN LESS than it would in the face of a compensated relative price shock – as it is a negative supply shock.Unfortunately, the RBNZ series on inflation expectations doesn't go beyond end 2011.
Matt's post is good. I worry more than he does that all of this will feed into inflation expectations, but he's the one who's working with that kind of data all the time, so I ought be updating my expectations more than him.
"Yes, if RBNZ cares about more than inflation, I can see this."
ReplyDeleteMinimising a quadratic loss function is a common goal for monetary policy. Inflation targeting is simply there to anchor expectations - in order to minimise any loss from putting in place this sort of stabilisation policy.
This is part of the reason why asking the Bank to target growth makes no sense - inflation targeting is stabilisation policy. Asking it to focus more on growth implies less effective stabilisation policy.
I would note that when I say "partial accommodation" I am saying that the Bank will be willing to let the price level rise - as responding fully to the increase in the price level from a supply side shock would lead to a greater than necessary drop in output. The goal is for output to be at its "potential level" whereby inflation will sit nicely in the middle of the band.
Negative supply side shocks suck generally - and there is no point trying to get output back to its prior level following such a shock. But, in the face of said shock it is also important to make sure we don't overreact.
"I worry more than he does that all of this will feed into inflation expectations"
Which I think it fair enough to be honest.
For me, the primary way to look at inflation expectations comes from quality adjusted wage growth. Quality adjusted wage growth depends on the level of slack in the labour market . The Reserve Bank will react to relative "slack" in the labour market, keeping (trend) quality adjusted wage growth - and thereby inflation expectations - moderate.
In essence, I think our descriptions of policy are equivalent - the only point of difference is our level of concern regarding changes in inflation expectations (as you said).
In regards to this point, I would note that we just experienced two massive negative (albeit temporary) supply shocks (drought, global crisis) and a massive negative demand shock (on the basis of consumer concern and a weakening housing market) and inflation expectations only nudged marginally inside the band.
This implies that either:
1) The Bank was able to perfectly anticipate what was going on and respond appropriately or,
2) Inflation expectations are incredibly strongly anchored.
My impression is that the Bank believes in the second explanation.
Most quadratic loss functions I've seen minimize squared losses between inflation and unemployment; thought you were implying that they might be following such a function and weighing more than just inflation, which I'd thought nicely cheeky.
ReplyDeleteThe anchoring seems to be very strong on the downside, but I'm not so sure on the upside. We'll see.
"Most quadratic loss functions I've seen minimize squared losses between inflation and unemployment; thought you were implying that they might be following such a function and weighing more than just inflation, which I'd thought nicely cheeky."
ReplyDeleteAhh yes, I see what you are saying - I was definitely unclear.
I was viewing it as potential output - which is equivalent to looking at the (natural) unemployment rate for sure.
"The anchoring seems to be very strong on the downside, but I'm not so sure on the upside. We'll see. "
That is also a major question - asymmetry in price setting or inflation expectations are a pain in the ass. In goods markets I've never been entirely convinced there is a definite asymmetry - but in the labour market there likely is, and that is where inflation expectations will get formed.
It is going to be very interesting.