Emissions trading scheme and inflation

Inflation is an important issue for everyone in New Zealand at the moment, with rising food and oil prices driving our annual inflation rate has fallen outside the Reserve Bank’s target band (hitting 3.2%pa in December). The fact that inflationary pressures are elevated will make it difficult for monetary policy to respond to any slide in real economic activity – a definite concern for New Zealand.

At the same time there has been a lot of talk about how the emissions trading scheme will impact on inflation. Both the Reserve Bank and Westpac are telling us that it will lead to a higher rate of inflation, and commentators seem to have accepted that it will – but how does this work?

Before answering this, we need to define what inflation is: Inflation is the rate of growth in the general price level. Inflation describes the underlying tendency of prices to grow over time (currently the RBNZ focuses on the ‘medium term’ when looking at inflation, I’d read that as 2-3 years). This is separate to a change in relative prices (where the underlying value of goods relative to each other has changed), or a change in the price level (which is when we have a sudden, one off, jump in prices)

Next we need to say how the ETS will change prices. Currently the implicit price of carbon is zero. The ETS will, in some sense, set a (variable) price for carbon by making firms buy carbon credits for their carbon emissions. If we take for granted that the ETS will increase the price of carbon alone, then we don’t have to worry about inflation as this is a change in the relative price of carbon.

However, the price of carbon also feeds into the price of other goods. As carbon is a byproduct of the creation of many inputs to the creation of many products, this will drive up the price of these products. However, a one-off increase in the price is not inflation, it is a change in the price level – so this is not the inflationary concern we are talking about either (Although, for the medium term outlook, this increase in the general price level is often seen as important to deal with).

The inflationary impact comes from the effect on peoples inflation expectations. If people believe prices are going to rise 5%, they will try to push for higher nominal wage increase, and firms will then push prices up further (or vice-versa, depending on who holds the expectations). If people see the price level being pushed up over and over by ‘shocks’ (first food, then oil, then the ETS) they will begin to revise up their inflation expectations – leading to more inflation.

So people are concerned that the ETS will feed into inflation expectations causing inflation, fair enough.

There is another inflation related issue to be concerned about with the ETS. One of the main reasons we care about inflation is volatility – we assume that the higher the inflation rate the more volatile prices are (given that some products have ‘stickier’ prices than others). The ETS gives us a volatile price for carbon. As carbon is the result of production for many inputs, this scheme could increase the volatility of prices – which is a concern.

A tax on carbon would have removed this potential source of volatility, however this would have come at the cost of an uncertain outcome in terms of the quantity of emissions created.

Ultimately, the link between the ETS and inflation is a fair one to make. Hopefully what I’ve said makes sense – if it doesn’t quiz me on it in the comments.