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A Bernanke-Blanchard model decomposition of New Zealand inflation: The pandemic and beyond

This Note assesses inflation in New Zealand through the lens of the Bernanke-Blanchard (2023) model. 

Gerelmaa Bayarmagnai and Punnoose Jacob

Key findings

  • This Note assesses inflation in New Zealand through the lens of the Bernanke-Blanchard (2023) model. The framework decomposes price and wage inflation to the individual contributions of supply shortages, labour market pressures, food and energy prices and productivity.
  • The historical decomposition of headline inflation over the past four years suggests that supply shortages and labour market tightness have contributed significantly to inflation. The contributions of more direct factors such as the prices of food and energy have been lower and less persistent.
  • In the absence of pandemic-related shocks, and supply disruptions due to war and weather events, annual headline inflation in New Zealand would have remained just below 2%, the mid-point of the RBNZ’s target band, by early 2024.
  • The sizable contributions of labour market tightness to inflation distinguishes the New Zealand economy from its peers in the advanced world. In most other countries, supply shortages and food and energy prices have contributed more materially to inflation. 

Why we did this research

More than four years since the arrival of COVID-19, annual headline inflation remains above levels targeted by central banks across advanced economies. The excess of aggregate demand over aggregate supply that induces high inflation has been supported by expansionary fiscal and monetary policy on the demand side. In addition, the supply side of the global economy was impeded initially by pandemic-related public health restrictions, and later by the Russian invasion of Ukraine.

It is important for monetary policy-makers to understand the nature of the factors influencing inflation, as they can draw the implications for the inflation outlook, and calibrate the appropriate monetary policy response. This Note views the trajectory of New Zealand inflation since the start of the pandemic through the lens of the model of Bernanke and Blanchard (2023). The empirical model, first developed for the United States, features dynamic interactions between price inflation, wage inflation, and short- and long-term inflation expectations. Headline inflation can be influenced by more ‘direct’ factors such as relative prices of food and fuel as well as indirect factors such as supply shortages and overheated labour markets. The estimated model as well as several variants are used to decompose New Zealand inflation into the individual contributions of the models’ driving forces.

The research presented in this Note is aligned with the monetary policy research agenda of the Reserve Bank of New Zealand - Te Pūtea Matua (themes: inflation, labour market, small open economy macroeconomics).

What data have we used?

The New Zealand version of the empirical model of Bernanke-Blanchard (2023) is estimated using quarterly data over the period 1997Q1-2024Q1. The table below lists all the data series and the data transformations that are used to estimate the model.

Data series used to estimate the Bernanke-Blanchard model for New Zealand

Model variable Description Source Alternatives
Price inflation Annual percent change (APC) in ex-GST CPI Stats NZ APC in ex-GST non-tradables CPI; Annualised quarterly percent changes in ex-GST CPI
Wage inflation APC in Labour Cost Index (LCI) Stats NZ -
Short-term inflation expectations RBNZ survey of expectations (business) – annual CPI inflation - 1 year ahead (mean) RBNZ -
Long-term inflation expectations RBNZ survey of expectations (business) – annual CPI inflation - 10 years ahead (mean) RBNZ -
Change in the price of energy relative to wages APC in CPI (petrol and other vehicle fuels) less APC in LCI Stats NZ Annualised quarterly percent changes
Change in the price of food relative to wages APC in CPI (Food) less APC in LCI Stats NZ Annualised quarterly percent changes
Supply shortage indicator Quarterly Survey of Business Opinion (QSBO) indicator for the net number of New Zealand firms reporting materials as the factor most limiting production NZIER -
Productivity 8-quarter moving average of production GDP/total hours worked Stats NZ -
Labour market tightness indicator Vacancies to unemployment ratio MBIE; Stats NZ Unemployment rate; RBNZ unemployment rate gap; QSBO labour as the factor most limiting production indicator