Free Exchange in The Economist had an article which looked at the change in terminology used by Janet Yellen chairman of the Federal Reserve. In a recent statement she alluded to the US economy near maximum employment and that rate rises could ensue. However only 69% of American adults have a job.
Full employment has normally been the concept that has been used to describe a situation where there is no cyclical or deficient-demand unemployment, but unemployment does exist as allowances must be made for frictional unemployment and seasonal factors – also referred to as the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU). If a central bank wishes to stimulate demand below this level there is the concern that inflation will increase therefore they take a guess as to what is the natural rate of unemployment – the lowest rate of unemployment where prices don’t accelerate. Maximum unemployment is the same in that it refers to the labour market being as tight as it can be without increasing prices. Natural rates in the US have varied – around 5.3% in 1950 and then peaking at 6.3% in the stagflation period before falling 4.9% in 2008 and then rising to 5.1% after the GFC, see graph below.
NRU and its causes
The NRU mainly depends on the level of frictional unemployment – defined as those who are in between jobs. This number can vary as at different times of the business cycle as there can be a delay in matching those looking for work with the vacancies themselves – a mismatch sometimes referred to as Structural Unemployment. The increase in frictional unemployment in the 1970’s and 80’s was largely due to the decline in manufacturing jobs with the advent of automation and more right wing policies (Reagan and Thatcher). Workers would stay unemployed in the hope that good high paid manufacturing jobs would reappear.
Unions can also influence the NRU with protecting workers jobs and pushing up wages so that employers find it too costly to employ more labour. However the fall in the 1990’s could be due to the advent of technology in the hiring process and the growth of part-time jobs which assisted those workers facing a career change.
Another influence on the NRU is wage growth as with the higher wages you attract more of the labour force to engage in actively looking for work.
A central bank will have to use trial and error to make a decision on how much spare capacity there is in an economy. Only when prices start to increase do they have an idea how capacity is running.
Quality not Quantity
As alluded to by The Economist the goal of full employment must consider the quality of jobs as well. With the acceleration of technology over labour, maximum employment should consider more than capacity constraints or inflationary pressure.
Rather, governments need to consider the options available to workers: not just how easily they can find jobs they want, but also how readily they can refuse jobs they do not. By lifting obstacles to job changes and giving workers a social safety net that enables them to refuse the crummiest jobs, societies can foster employment that is not just full, but fulfilling.
Sources: The Economist 28th January 2017, St Louis Federal Reserve – Natural Rate of Unemployment
Inflation is predicted to increase in the global economy in 2017 which is a welcoming thought when you consider the threat of deflation. The Economist identified 3 areas that are behind the increase.
1. Imported inflation – producer prices in China are increasing as prices at the factory gate rose by 5.5% and the spare capacity in the economy is getting smaller. Furthermore there has been an improvement in demand especially in Asia. Additionally oil prices have increased to over $50 per barrel up from $30. Therefore a lot the above imports have become more expensive which could lead to higher prices. However a lot will depend on the exchange rate – lower value exchange rate means that imports will be more expensive
2. Capacity pressures – with a reduction in spare capacity goods become more scarce so the price of them should increase. The USA economy is close to full capacity with 4.7% unemployment and US Fed chairman Janet Yellen recently indicated that a further increase in interest rates might be necessary to cool increasing pressure on inflation. In the Euro area there is more spare capacity with the unemployment rate of 9.8% – this is especially prevalent in Italy and Spain. Therefore if the inflation rate is to increase in the Euro area it will need countries like Germany, with a 4.1% unemployment rate, to generate it.
3. Inflationary expectations – expectations of further inflation in the future can lead workers to demand higher wages in anticipation of price increases or lead producers to set higher prices in anticipation of increased costs of production. Inflationary expectations have reached their highest level in 12 years according to a survey of fund managers. But it has also raised fears the world is heading for a period of low growth, higher unemployment and accompanied by high inflation leads to stagflation.
Sources: The Economist, FT
Below is a useful graph from the National Australia Bank’s 2017 Outlook. It shows the inflation relative to the central target rate – so for New Zealand the current inflation rate is 0.4% but the policy target agreement is 1 – 3% with a target of 2%. Therefore NZ is 1.6% short of their inflation target.
Inflation globally has been a record lows and according to the IMF “cyclical unemployment and weaker import (commodity) prices can account for the bulk of the deviation of inflation from (central bank) targets …..but other unexplained factors have been playing an increasingly larger role”
In 2017 it is predicted that higher commodity prices and wages will lift global inflation. With the US Fed raising interest rates there is the sense that inflation could be on its way up. Also spare capacity is forecast to reduce in most advantage countries with the US already at full employment.
A Trump policy of protectionism and expansionary fiscal policy would definitely mean a more hawkish US Fed. If he does follow this agenda the US will initially experience some kind of stagnation environment, but given the chance for trade retaliation this could quickly lead to a global recession which could eventually push the world close to a secular stagnation scenario of low growth, low inflation, and low productivity. Below is a very informative matrix from NN Investment Partners.
The Economist has a graph showing the change in price of commodities from 5th January 2016 to 18th October 2016. The change in price is purely reflected in simple supply and demand theory. In 2015 raw material price dropped mainly because of over-supply. The main points from the graph are:
- Oil – $50 per barrel – expectations that supply might decrease by OPEC countries
- Sugar – price up by 56% – unfavorable weather therefore supply decreases
- Grain – prices down by 9% – bumper harvests in the USA
- Beef – prices down by 24% – oversupply of beef
Although the attention this morning was on the election of Donald Trump as US President the RBNZ cut the OCR to 1.75% with a mild easing bias of “numerous uncertainties remain, particularly in respect of the international outlook, and policy may need to adjust accordingly”.
It is expected that the OCR will remain at this level in the near future with inflation expected to be back within the 1-3% Policy Target Agreement (PTA) by the end of January next year – see graph from ASB Bank. The reason for this is that:
- Dairy prices have recovered considerably.
- The labour market is tightening.
- Growth is running at an above-trend pace.
- The OCR is already at an expansionary rate and the economy.
Could there be another cut in the OCR? There would be pressure if the following eventuated:
- there is a strengthening of the NZ dollar,
- increasing bank funding costs,
- any further weakness in inflation expectations,
- any deterioration in the global growth outlook.
The change of US Presidency will also be a wildcard over the longer term, with its mix of potential fiscal stimulus and trade protectionism. Trump has already signaled that he is not keen to sign TPP and he wants to reopen the NAFTA – North America Free Trade Agreement. Furthermore, he might take umbrage on the Chinese with their manipulation of the Yuan to advantage its exports and put a large tariff on its goods coming into the US. For New Zealand it may mean that they have to go down the bi-lateral agreement option in order to increase trade.
Other than the US election, Graeme Wheeler needs to be aware of the following:
- Theresa May has indicated she wants to trigger Article 50 by May 2017 – it is very unclear what the process will be and the negotiating strategy of both the UK and the EU. This could have implications for NZ trade.
- In China the increasing of centalised power of the President.
- China has a huge amount of corporate debt relative to GDP – see graph below.
- Brazil is still in recession
- Russia still has issues in the Middle East
What is the consumers price index?
The consumers price index (CPI), New Zealand’s best known measure of inflation, measures the rate of price change of goods and services purchased by households. The CPI consists of a basket of goods and services that represent purchases made by households. The goods and services in the basket, and their relative importance, are reviewed every three years to ensure the basket remains up to date.
There are about 690 goods and services included in the basket. They are classified into 11 groups. The table below shows the CPI in NZ for the September Quarter 2016 with the 11 groups and the final calculation (All groups) being 0.2% for the Quarterly and Annual change.
These groups are then broken down further into 45 subgroups and then into 107 classes. The CPI is reported each quarter down to the class level.
Each good or service in the basket is assigned an expenditure weight (see definitions under ‘Statistical calculations’) that represents its relative importance in household spending patterns. Goods and services that are more important to households are given higher weights and have a greater influence on the CPI. The weight assigned determines how much impact a price movement for a particular good has on the overall CPI. For example, if households spend more on petrol than on milk, a 5 percent increase in the price of petrol would have a greater impact on the CPI than a 5 percent increase in the price of milk.
What is a Price Index?
A price index is a single figure that shows how a whole set of prices has changed over time. A price index uses one number to represent the prices being charged for various goods and services at the wide range of outlets and locations where they are being purchased. The average price level of goods and services in the expression base period are assigned an index number of 1000. This is the benchmark to which average prices in other periods are compared. Thus, if the index number for a period is 1150, prices have increased by 15.0 percent since the base period. Workings below:
Increase in index number = 1150 – 1000 = 150
150/1000 x 100 = 15%
The population coverage of the CPI relates to the expenditure of private, New Zealand-resident households living in permanent dwellings. The reference population covers approximately 98 percent of the usually-resident population. There are no exclusions based on income source or geographic location.
The target population for the Household Economic Survey (HES) mirrors the reference population for the CPI. The HES excludes residents of temporary dwellings and households in very remote parts of the North and South Islands and on offshore islands, including Great Barrier, Kawau, Stewart and the Chatham Islands. Some types of expenditure are also excluded because their price movements cannot be satisfactorily measured nor can they be related to the price movements of items which are price-surveyed. These include works of arts, illicit drugs, pets and other livestock, gambling, most legal services etc.
All prices are surveyed at least quarterly, though many prices are surveyed more frequently due to their price volatility (for example fruit and vegetables are surveyed weekly). The types of outlets surveyed reflect the places indicated as typical in the Household Economic Survey.
Expenditure weight – The measure of the relative importance of an item in the index basket, based on the expenditure of the item relative to expenditure on all items in the basket.
Index number series – A series of numbers measuring movement over time from the index reference period value.
Index reference period – The period in which the average price level of goods and services is an index number of 1000. This number is chosen to represent the reference period, but the interest is only in the relationship of the other index numbers to it. The index reference period for the CPI is currently the June 2006 quarter.
It is important that you are aware of current issues to do with the New Zealand and the World Economy. Examiners always like students to relate current issues to the economic theory as it gives a good impression of being well read in the subject. Only use these indicators if it is applicable to the question.
Indicators that you might want to mention are below. Notice how low global interest rates are as economic conditions have warranted greater borrowing and spending in the world economy.
The New Zealand economy expanded by 2.8 percent over the year ended in the June quarter driven mainly by an increase in household consumption of 1.9 percent over the quarter, while exports of goods and services rose by four percent. The construction industry expanded by a further five percent in the quarter, while the retail, hiring, and real estate services industry expanded by 1.3 percent. The annual current account deficit totalled $7,383 million in the year ended June 2016, equivalent to 2.9 percent of gross domestic product (GDP).
The OECD in its September Interim Economic Outlook commented that the world economy remained “in a low-growth trap”, with GDP growth of 2.9 percent predicted for 2016, before rising slightly to 3.2 percent in 2017. Subdued economic growth is forecast for the major advanced economies, with growth for the United Kingdom expected to drop from 1.8 percent in 2016 to one percent in 2017. The Chinese economy is expected to grow by 6.5 percent in 2016, easing to 6.2 percent in 2017 as it moves from an investment-led to a consumption-led growth model. In mid-2009, the unemployment rate for both the Euro area and the United States was approximately ten percent. Since then the unemployment rate for the United States has fallen to 4.9 percent, while the unemployment rate for the Euro area peaked at over 12 percent in 2013, and currently sits just above 10 percent.
Low interest rates internationally have resulted in asset price inflation, particularly in share and house prices. Monetary policy can only do so much but with global interest rates at approximately zero there needs to be the support of the politicians to enlist a much more stimulatory fiscal policy.
Source: Monthly Economic Review: New Zealand Parliamentary Library