Treasury inflation forecasts 'optimistically low', below average over inflation targeting era, BNZ economist says

By Alex Tarrant

Treasury's medium-term inflation forecasts averaging 2.5% are being labled as slightly optimistic by BNZ economist Craig Ebert, who points out CPI inflation has averaged 2.8% over the period of the current inflation targeting framework.

ASB economists agreed with the 'optimistically low' view in their weekly economic outlook as well. ANZ economists gave their doubts on Treasury's fiscal projections, saying cautious household behaviour appeared now to be structural, rather than cyclical as viewed by Treasury.

Inflation of 4.5% in the year to March 2011 is expected to drop in the short-term to 3.1% in the year to March 2012, according to Treasury's forecasts in last week's budget. Into the medium-term outlook, Treasury forecast inflation to fall to 2.4% then 2.5% and 2.6% in the years to March 2013/14/15, respectively.

The Reserve Bank of New Zealand is currently tasked with keeping inflation within a 1-3% target band over the near term

'Inflation forecast optimistically low'

The target band would theoretically have economists pointing to 2% average annual inflation if asked to forecast the CPI over the medium-term, Ebert said.

"However, matters of reality suggest we recommend something closer to 3.0%. The fact is that annual CPI inflation has averaged 2.8% in the era of 1.0 to 3.0% targeting. So those who have budgeted for 2% have lost out," Ebert said.

"And it’s not just historical fact that leaves us wondering what the implied inflation target actually is. So does the approach of the NZ policymakers themselves. The Reserve Bank has grown looser with its numbers over the years, with it being quicker to find excuses for high headline inflation, and to emphasise the medium term averages, than making it clear what point of the band it’s aiming for in the first instance," he said.

"In theory this should be the mid-point. In practice as well, because aiming for the centre best allows one-off price shocks to be dealt with, in the context of the band. But the RBNZ, in giving the impression that anything under 3.0% is good enough, naturally runs the risk of not only upward creep in inflation expectations, but CPI surprises that tend to break above the target band.

"Perhaps this is why the Reserve Bank forecasts, in its March Monetary Policy Statement, annual CPI inflation persisting above 2.0% over the medium term? And why the NZ Treasury does the same. Last week’s Budget, for all its focus on restraint, forecast inflation of around 2.5% in the outer years," Ebert said.

"Then again, medium-term inflation of around 2.5% is what the NZ Debt Management Office is widely perceived to work off, in its dealings of government bonds. This is particularly important for pricing inflation-indexed bonds, on which buyers and sellers need to come to some agreement on forward inflation. Of course, the DMO would prefer to issue bonds at an implied 2% inflation rate. But the market, it would seem, would have none of it," he said.

'Speed of Christchurch rebuild could disappoint'

ASB economists also noted Treasury's inflation forecasts, as well as wage and surplus forecasts, appeared to be on the optimistic side.

"We do see some risk the Government may not achieve such a swift return to surplus. Some of the economic forecasts underpinning Budget assumptions are on the more optimistic side, in particular: the Treasury’s assumptions on the speed of rebuilding; the pace of wage growth; and the (relatively) subdued rate of inflation," ASB economists said.

"However, there is more uncertainty surrounding the economic outlook than usual as a result of the quake. As a result, there is bound to be a wide range of views between forecasters," they said.

Treasury’s assumption about the speed of the increase in rebuilding activity in Christchurch could also prove to disappoint.

"We anticipate capacity constraints will result in a more subdued building pick‐up. However, given the substantial amount of uncertainty around the Christchurch outlook, this is not a major sticking point," the ASB economists said.

"Rather, we were more surprised by the amount of wage growth the Treasury had factored in. It seemed rather optimistic, and boosted the consumer spending outlook (and GST revenue). The risks are the Government will struggle to achieve this revenue projection," they said.

"Furthermore, the inflation outlook was on the low side, particularly given the depreciating exchange rate which tends to boost tradable inflation. In addition, these forecasts are not consistent with the sheer strength in building activity the Treasury have factored in, and the associated inflation pressures it will create in the construction industry. Inflation also tends to result in increased Government expenditure, and adds to our doubts on the Government’s swift return to surplus."

Some 'pretty rosy' forecasts

ANZ economists said the budget included "some pretty rosy fiscal numbers," which included the forecast for a return to surplus in 2014/15, with 4% GDP growth in the coming year and 3% for the following five.

"We agree with the short-term boost but struggle to believe this growth rate will endure given deleveraging and transitional headwinds for the economy," ANZ economists said in their weekly outlook.

"Yes, we all know the boost from Christchurch is massive, but we simply don’t believe the economy has the supply-side capacity to keep expanding at 3 percent per year. And on the demand side, debt run-ups in the scale we’ve seen tend to be followed by up to a decade of lower trend growth. The piper’s bill isn’t paid yet," they said.

The Budget went further than being of the zero variety, with a net NZ$1.2 billion of savings identified.

"On the face of it this is a far tighter fiscal stance than expected a few months ago, and will help keep interest rates lower for longer. However, the NZ$1.2 billion was spread over five years (0.12% of GDP per annum) and these figures excluded some support to Canterbury," ANZ economists said.

"Officially, the Treasury’s calculations show the fiscal stance being far more expansionary in 2011/12 but more contractionary from 2012/13. However, when you eye up reinsurance flows from EQC and the infrastructure bond, which are more capital-related items, we’re not convinced the fiscal stance is as reliable as a proxy for the degree of demand pressure exerted by fiscal policy. Such measures focus on the operational side of Government activities, whereas the real story at present is balance sheet related," they said.

Cautious household behaviour 'structural' rather than cyclical.

"Rating agencies gave the Budget the big tick, but then waved the big stick. As we noted last week, the challenge was to ensure an improvement in the fiscal accounts was not offset by a corresponding deterioration in the external accounts. Treasury’s projections of the current account deficit returning to 7% of GDP (and rise in net external debt from 82 to 85% of GDP) did nothing to allay those concerns," the ANZ economists said. 

"S&P and Fitch will be in no hurry to remove New Zealand from negative outlook, with all eyes on the external position. Implicitly, Treasury views cautious household behaviour as cyclical and temporary as opposed to structural. We tend to lean towards the latter," they said.

"The policy emphasis has gone from looking at fostering a “step-change” for the economy to “tilting” it. In effect this looks to be an acknowledgement that magic potions don’t exist; they tend to be snake oil."

(Updates with ANZ comments, ASB comments.)