Grant Spencer: Low inflation and its implications for monetary policy
raises interest rates, causing aggregate demand to shift to the left. If the interest rate on a The Phillips curve depicts the relation between. unemployment rate. The term real wages refers to wages that have been adjusted for inflation. the demand curve is the graph depicting the relationship between the price of a Although minimum wage laws are in effect in many jurisdictions, differences of opinion Productivity Labor force Natural resource Phillips curve Health care Labor. Relationship between inflation, unemployment and output: Intro to Phillips Curve with Phillips Curve; Dynamic Effects of Shocks/policy changes: How instead Note that the version of the LM curve depicted here jurisdictions, bankruptcy is imposed by a court order, often initiated by the debtor.
These global factors have also contributed to reduced inflation in "non-traded" sectors which have become increasingly exposed to competitive pressures. The Phillips Curve and domestic pricing behaviour The Phillips Curve underpins how central banks think about inflation. The greater the degree of economic slack, the lower the inflationary pressure. Currently, many advanced economies are experiencing unemployment rates below perceived "neutral" levels but are not seeing the expected inflation response figure 2.
Has there been a breakdown in how we measure economic activity and capacity? Is there a breakdown in the relationship between inflation and economic slack? Or have low inflation expectations been a more dominant driver? All of these issues appear to be relevant.Long run and short run Phillips curves
In New Zealand, the link between measures of domestic slack and inflation has proved elusive in recent years. Simply plotting the unemployment and inflation data figure 8it can be observed that there is now less inflation for a given level of unemployment and less apparent responsiveness of inflation to changes in unemployment.
However, it is also clear that the overall relationship between unemployment and inflation has been quite weak and that other causal factors, both international and domestic, have been playing an important role. The measurement of economic slack is becoming more difficult. Total potential output - or capacity - is not directly observable and it may be that the increasing flexibility and mobility of labour is causing us to understate our measures of capacity.
Growth and inflation: drivers and prospects
We will increasingly need to refer to a range of labour market indicators in addition to unemployment when assessing the extent of slack in the labour market. There is not much doubt that an increase in international labour mobility has also affected wage inflation in New Zealand.
In some of the traditional non-traded sectors like construction there is now greater scope for employers to meet skill shortages through international hires, even though recent stretch in the construction industry has seen wage costs increasing for certain occupations and skills. On a national scale, we have experienced ongoing high levels of inward migration. Over the past 3 years, the population has grown by around 6 percent, of which less than a third is from natural growth.
An increasing share of the inward migration has been on work visas figure 9thus contributing to higher productive capacity. In this way, emerging excess demand for labour has been moderated on the supply side as a result of increased international labour mobility. With the New Zealand economy becoming generally more integrated with the global economy, we are likely to see less variability in measures of economic slack and also less variability in labour costs, consistent with a flattening of the Philips Curve.
New Zealand has always been a price taker for goods traded in the international markets. It now appears that, with labour mobility and globalisation effects, we are increasingly a price taker in "non-traded" goods and services figure For example, suppliers of education and tourism services are now operating in increasingly competitive international markets.
They are facing international competition for their services and also for their labour inputs. Both sectors have been growing as a share of GDP. A crucial factor in the Phillips Curve relationship is inflation expectations. If firms and workers expect higher inflation to result from current capacity pressures then they will more quickly bid up prices and wages. Given the absence of such behaviour, we have looked closely at the role of expectations in price-setting behaviour.
That is, in a low inflation world, businesses tend to use last year's inflation outcome as a reasonable estimate of next year's inflation. This adds further momentum to low inflation and reinforces the role of inflation expectations in the flattening of the Phillips curve. In summary, the global trends discussed earlier, together with an increasingly open New Zealand economy and low inflation expectations, appear to be changing the nature of the price formation process in New Zealand.
Traded goods prices have been affected directly by the global trends, particularly for manufactures.
3 Reasons Inflation Should Stay Subdued Even as Employment Rises
Non-traded prices have also been affected as a result of a more globally integrated economy and by the momentum of low inflation expectations. The result has been lower average inflation and a flatter Phillips curve. While the scale and permanence of these changes remain very uncertain, they do have implications for how we approach monetary policy.
Policy implications of low inflation How might these developments impact monetary policy? Do we need to tweak our approach, or rethink our framework? The first thing to say is that these changes to the inflation process are uncertain and it is unclear how long lasting they will be. We should therefore be cautious about making any recommendations for change.
I have talked today about the main developments affecting the low inflation record: Both are important but have somewhat different implications for monetary policy. Lower world inflation The positive global supply shock has increased global production while dampening world inflation.
From New Zealand's perspective the shock has lowered import price inflation, particularly for manufacturers, and increased national income as import prices have fallen relative to export prices. However, while the higher terms of trade have supported aggregate demand, the dominant effect on CPI inflation has been the lower import price inflation.
Our policy approach to this weakness in imported inflation has been to less than fully offset. The weakness was not expected to be so persistent and it has been overlaid with uncertain and cyclical commodity price movements. Also, the existing easy monetary policy stance and positive terms of trade effects were expected to add to domestic inflation pressures.
Such a policy response to external supply shocks is consistent with our flexible inflation targeting framework. More recently we have been assuming greater persistence in low global inflation and this is contributing to our current flat track for future OCR levels. For example, recent work by the Federal Reserve Bank of San Francisco showed that in the current economic cycle two factors have depressed average wage growth.
First, a disproportionate number of lower-skilled, lower-wage workers have returned to the workforce, while other low-skilled workers have moved from part-time to full-time employment. The second factor has been the comparatively large number of higher-skilled, higher-wage baby boomers who have retired.
It examines the relationship over four distinct terms. We choose to consider these periods separately as each one has unique characteristics due to changes in the structure of the labour market, a long-running decline in inflation expectations, and changing productivity trends. One can see the inverse relationship first identified by Phillips remains intact in each of these periods, including the most recent.
Since joining Aviva Investors as Senior Economist and Strategist, Michael has been responsible for monitoring and analysing global macroeconomic, market and policy developments, and plays a key role in our House View and SIG processes. Experience and qualification Prior to joining Aviva Investors, Michael was senior economist at COMAC Capital Llp, a global macro hedge fund, where he was responsible for the fundamental analysis used to inform the investment process.
Prior to this, he spent a decade at the Bank of England in a variety of senior roles, latterly as a Senior Manager in the Markets Directorate. He began his career at the Australian Treasury. The Phillips curve has continued to form the bedrock of Keynesian models that underpin the conduct of monetary policy The slope of the curve is important in determining the extent to which cyclical pressures affect wages and inflation, and ultimately how monetary policy makers adjust interest rates to smooth the cycle.
However, one can also see that the level of wage growth consistent with no unemployment gap has shifted down steadily over time.
Why might that be the case? The main explanation seems to be the trend rate of productivity growth has slowed, particularly since the GFC. In equilibrium, one would expect real wage growth to be in line with trend labour productivity growth. In the s and early s labour productivity growth was generally between two and 2.
Figure 2, which shows the difference between real wage growth and labour productivity growth, illustrates wage growth is actually not weak at all when allowing for the low level of productivity in recent years.
- Growth and inflation: drivers and prospects
- Grant Spencer: Low inflation and its implications for monetary policy
The early s and s saw real wage growth rise as the labour market tightened, although it came later in the cycle in the mids. In the recent period, real wages also rose above productivity growth as the labour market tightened. There has been some moderation in growth inalthough the excess over productivity growth remains significant. As with the wage Phillips curve, it is important to consider which measure of inflation to use. In a completely closed economy, with no external trade, the Phillips curve relationship should hold for the broad consumer basket.
However, as all modern economies engage in foreign trade, the relationship needs to be adjusted for the role of the exchange rate and the terms of trade the price of exports relative to imports.
Alternatively, one can look at domestically-generated inflation — the part not impacted by trade. One proxy, which we use in this analysis, is service sector inflation, since there is only a limited import component. A number of things stand out from the analysis represented in figure 3, which shows the relationship between the unemployment gap and service inflation. Risks associated with investing in the natural resources sector include large price volatility due to non-diversification and concentration in natural resources companies.
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