By Alison Brook*
Inflation in many developed countries has risen to levels not seen in several decades. With it has come calls for central banks to aggressively tighten monetary policy. In New Zealand, the Reserve Bank hiked interest rates in both October and November – with predictions of up to seven further rises over the course of 2022. However, if the past is any guide, rapidly rising interest rates are a blunt instrument to cool an overheated economy.
The latest OECD survey of New Zealand confirmed the economy is showing signs of overheating due to government support measures to counteract the effect of the pandemic. While the government stimulus enabled the country to quickly recover to pre-COVID levels, it also had the effect of driving up household debt to 169% of disposable income and house prices to unsustainable levels. The OECD warned that if the government did not move to open borders and rein in spending, interest rates may have to be raised to levels that risked sending the country into a hard economic landing.
Data source: Reserve Bank of New Zealand
A different kind of inflation
While there are calls to raise rates quickly to quell inflation, a new report from BlackRock Investment warns that this may be misdiagnosing the underlying cause of inflation. Unlike the 1980s, the post-pandemic inflation surge is not being triggered by increases in demand but rather by severe supply constraints which have increased the cost of production.
Inflation only started to take off for some advanced economies when they opened after pandemic lockdowns. Not only was it difficult to get the global supply chain engine started up again, but supply capacity (people and capital) was also in the wrong place at the wrong time. BlackRock argues that when demand drives inflation, increasing rates can stabilise inflation and growth. However, where inflation is caused by supply constraints a very different approach is needed. If central banks move too quickly to dampen inflation, they risk killing off fledgling demand.
The New York Fed has also acknowledged domestic monetary policy may have a “limited effect” on supply-side global inflation.
Source: OECD Economic Outlook: Statistics and Projections
Consumption shift from services to goods
In addition to supply constraints, during the pandemic lockdowns, consumers dramatically shifted their spending away from services to goods. Where households had previously spent their discretionary savings on eating out and travel, they redirected their spending onto things like renovations and buying digital equipment for working from home. This massive shift in purchasing behaviour, coupled with border closures, led to shortages, and ultimately inflationary pressure.
The Bank of International Settlements also points to two further factors that are exacerbating the supply bottlenecks. First, the fact that manufactured goods tend to be more dependent on the smooth operation of supply chains, and secondly the “bullwhip effect” of participants along the supply chain hoarding components due to fears of future shortages.
Long term disinflationary forces
Alex Joiner, chief economist at IFM investors argues that the impact of supply-side factors has been underestimated long before the pandemic. In the decades leading up to the pandemic central banks attempted to combat disinflationary supply-side factors like globalization, technology, and demographics by aggressively lowering interest rates. While it has had a massive effect on asset price inflation it has been less effective in sustainably stimulating demand. Joiner writes it “reinforces that monetary policy has been over-relied upon for far too long, to manage too much in the economy with too few tools.”
Whatever the final course central banks take over the next year BlackRock warns that ongoing supply uncertainties mean we should expect further volatility ahead.
It is still unclear for the New Zealand economy where the balance of inflationary forces lies. However, slamming on the brakes could do real damage for many economies and households dependent on cheap liquidity and still reeling from the lingering effects of the pandemic.
*Alison Brook is from the Knowledge Exchange Hub at the Massey University campus at Albany, Auckland. She is on the GDPLive team. This article is a post from the GDPLive blog, and is here with permission. The New Zealand GDPLive resource can also be accessed here.
53 Comments
And so the argument goes we need to continue to look through inflation, it is only temporary. At what point does inflation need to achieve to become a threat ? 10 %,20% . And what will be the response then , more monetary stimulus, this is how Venezuela and Turkey achieved their outcomes.
ah, no. In both the cases you site, the autocrats decided that the laws of economics were wrong. So they lowered interest rates when inflation was high declaring that high interest rates were the cause of inflation. This type of view made things immeasurably worse. So they then took 'direct action' to fix their inflation problem by direct economic intervention. What was worse became disasters. In both cases, they attempted to fix demand-side issues with radical supply-side solutions. The result has been complete disasters. What the article above is questioning is whether our current supply-side inflation pressures need demand-side responses. That is miles from what you are alluding to.
Turkey and Venezuela are quite different cases. Venezuela had pegged its currency to the dollar and built a heavy reliance on imported food and Govt subsidised consumer goods - all of this was scaffolded by high oil prices, which dropped like a stone in the 2014 - 2019 period... leading to disaster. Crap state craft yes, but not sure they ignored economic 'laws'.
Turkey is really interesting - they are trying to get out from under the thumb of investors who demand a ridiculous rate of return on Govt bonds - but they have a highly dollarised economy with most middle class / wealthy people (and businesses) having savings in dollars. The inward flow of capital to Turkey (attracted by high yields) has artificially inflated the value of their currency, and this is now being unwound. It is not pretty, sure.
Given that our demand is mostly for goods from other countries, adjusting the interest rate is going to have only whatever gains can be made from the carry trade. It's a new world since the days when interest rates were a good idea to control inflation. Interest rates can only impact house prices and business equity. You can't even expect an increase in interest to increase the value of the NZD.
Thanks David, a sensible response. My understanding is that if production had kept pace with the increase in money supply, inflation would have been kept in check. However, with the known issues around supply chain, and the inability of production to keep up with demand, there was only going to be one outcome.
Well, I think this inflation *is* temporary. It's just lasting a bit longer because covid has dragged on a bit.
What's the point in massively hiking the OCR if it only has limited impact on the CPI but generates a lot of downsides?
In my opinion, the two lifts last year plus another 75-100 BPs this year will be more than enough to dampen any demand-side inflation that we are seeing.
Omicron outbreak is going to do a bit of demand-side damage too, and then you also throw in the at least *significant* (if not major) impacts of CCCFA.
Then it's just a matter of time, unfortunately, on the supply-side inflation.
hi House mouse Inflation comes manly from increased money supply the US has printed trillions over last 3 years which has created inflation which is being exported around the world when US fed stop printing in March then start paying back the 9 trillion on balance sheet this is when you will see chaos in markets. Interest rates will go up because of bond market at the moment bond market is loosing around 6% each year because inflation is so high they will not let this go on much longer and bond market is huge around 125 trillion. New Zealand has no chance of controlling their own interest rates or inflation as NZD will be worth nothing unless we just follow the flow.
"households dependent on cheap liquidity"
There in lays the real problem, includes the property and finance sectors that are so dependant/addicted on manipulating the market up since early 2000, that we are so far from sound economic fundamentals that a correction is the realistic solution to bring back affordability to our dysfunctional society to operate properly, equitably again.
Due to political reasons the Government has allowed that on going cheap liquidity and the taxpayer to prop up the ponzi scheme, they are far to late to stop the damage.
The longer this crises is left to grow the worse the consequences will be :(
If NZ doesn’t raise rates with rest of the world NZD will continue falling pushing inflation even higher. The reason rates are so low is because of emergency rates now it’s time to pay the piper it will bring down housing market which is completely over valued at the moment, it will also put a bit of backbone in the savings rates
yes the subsidization of home loans has to end, money is not supposed to grow on trees but it has been.............I think we would be seeing this inflation spiral regardless of covid while the OCR is so low. The cheap money just has to end now, the time has well passed.
I'm opposed and my costs are going up through the roof, so if you increase interest rates it's only another burden. Prices are high here because they are high all over the world it's not because suddenly everyone has extra cash so they are going to splash out on a ton of zinc-sulphate! Some stuff you just can't get, no matter the price, other stuff you have to get no matter the price. Interest rates don't even come into the equation. Blame whatever you will, but there are shortages of 'stuff'. When it's stuff you need, you will realise that increasing interest rates won't make it cheaper, just harder to afford.
I'm not sure how any sane person could believe that Bugger. What about all the first home buyers, in many cases youngsters who have saved hard to buy a house? Are they "property ticket clippers"? What about the costs to businesses? More expensive money means less investment, potentially lower production, possibly lower employment. When businesses contract, the economy contracts. It's not a great thing. The only conclusion I can draw from your comment is that you don't own a house and are pissed off with everyone who does. That's a you problem, not anyone elses problem. And as an old CEO of mine once told me, don't make your problem, my problem.
I disagree that raising interest rates will not lower inflation. It doesn't matter if the cause of inflation is high consumption or supply constriction, in a time of high debt, higher interest rates will take a significant amount of disposable income out many consumer's pockets and hence indeed lower inflation.
yvil
Yes, I agree, this article is just another chant of the mantra which we all know by now.
So what is the solution to supply-side rampant inflation? As yet no academic or economist has supplied an answer; we now know that economics is a bridge to nowhere in our present situation.
(But I would still like to know if Keith Woodford can propose a solution.....if anybody can come up with the answer he can.)
The only solution I can think of takes me back to the late-1950s when the then Labour Government slapped import tariffs on a range of imported goods to encourage import substitution by manufacturing locally to fill the gap. A particular successful instance of this strategy that I remember well in our South Auckland suburb was an enterprising ordinary bloke starting a clothing manufacturing business. This business thrived and employed a lot of women. The quality of the garments produced was amazing and although they may have been a little more expensive than imported rubbish people didn't mind paying that little extra because the garments lasted longer. This strategy would cut out many of the dysfunctional supply chain causes of inflation in our current global economy
Look how quickly the USA transformed its economic status in under 2 years just before and after the start of WW2. So, perhaps a nudge towards self-sufficiency could be the answer. People might then argue that we can't impose import licensing and tariffs because we have all these free-trade agreements, etc. I would say so what, other countries break them all the time; if China, for instance, was self-sufficient in dairy products do you think they'd be buying them off NZ? Of course not. So China would still import these products off us free-trade agreement or no free-trade agreement.
If we were more self-sufficient in manufacturing we simply wouldn't need to import so much stuff.
Finally, some might argue that we have virtually full employment now, so where would we find the labour to work in these new manufacturing industries come from. I would suggest they would come from the huge internal supply chain and infrastructure that services our current import dependent economy.
Yvil and streetwise
My disagreement with Alison starts with the assumption that the current inflation is supply-led.
Much of the current inflation is demand led - more money chasing the same output.
Ironically, some of the apparent supply factors are themselves the outcome of this demand inflation, here and overseas.
We have dug a hole for ourselves (as have many other developed countries) and there is now no painless way out of this.
Therefore the question is simply a case of which groups in society are going to pay.
Accordingly, my own preference includes removing GST from food - in NZ the accepted wisdom of many is that it is too complex, but most other countries seem to manage it.
I would also zero-rate income tax on the first $14000 of income (it is currently 10.5%). I would also consider replacing that with a compensating surcharge on incomes above say $100,000, but applied in such a way that those on incomes above $100,000 did not pay more tax overall (therefore keeping within the Govt's promise re no further tax increases during this term).
I am a strong believer that inflation must be quickly reduced to a level below post tax returns on 6- month (and similar) fixed deposits.
And I would give strong consideration to separating the buy and sell rates of the OCR, such that the RBNZ would change a higher rate at which it supplies money for bank liquidity than what it pays on settlement accounts.
My current concern is that the latest increase in minimum pay rate will work its way through many other pay rates and this will seriously embed a cycle of inflation. I doubt whether the RBNZ can now bring it under control without creating a recession. That will bring lots of criticism.
What we are seeing now is almost precisely what I feared would happen (and wrote about starting 20 months ago). My current concern is that we are only in the early stages of the current inflationary cycle. I lived through the last big inflationary cycle, which got going around 1970 and took 20 years, including a lot of pain which destroyed many lives, to bring under control. Of course there were some big winners from that cycle, but overall it did a lot of harm.
In among all of this gloom, thank goodness that export prices for pastoral products and kiwifruit are doing so well.
Incidentally, there are multiple other things I would consider doing, but that is enough for starters.
KeithW
Could start with a luxury goods tax. Higher duty whatever on cars SUVs above a certain size/kW/weight.
Who needs a mobile with the orchestra, conductor, monkey and organ grinder. I'd suggest a mobile at $500-$700 is adequate.
Hopefully there is nothing in GATT and the trade agreements that says we can't. If the later then its time to re-negotiate the trade agreements.
Cut the benefits and suspend minimum wage and you will see inflation drops like a rock.
The current inflation is caused by supply chain issues as well as unprecedented and unbridled uplift in welfare payouts.
If people think that demand is a substantial cause of the problem on top of supply, then issue benefits on welfare cards whereby beneficiary can only buy food and limited fuel on them.
The first benefit that needs cutting is the accommodation supplement then rents will find the market price while cutting inflation at the same time as pulling realestate values back to a realistic level . Also taking away interest deductions and implementing a capital gains tax on property outside of own home . All these measures will reduce inflation .
Ahahahha, thanks I needed a laugh!! It won't be landlords (I'm not one) who squeal, my goodness lol; there will be 1,000 beneficiaries who squeal for every 1 landlord who complains if you drop the accommodation supplement. You have a crazy perspective if you think landlords will be the hardest hit.
Accommodation supplement goes. Tenant cannot afford to pay. Tenant leaves rental and finds a way to make it work (move back in with family, friends etc). Landlord advertises the place, but after a few weeks on the market starts lowering the rent. They eventually find a tenant, at the old rent price less the equivalent amount of the accommodation supplement.
The Government should also legislate that all rents should be a maximum of 25% of a tenants net income. This will have a huge reduction in the cost of living for many, and then we can reverse the minimum wage and welfare increases.
I reckon it's a genius idea. As minimum wage drops, the rent drops as well, then we can keep unwinding past minimum wage increases as their disposable income increases astronomically. Along with it the accommodation supplement could cease to exist. Then businesses will see their wage bill drop, and can either drop prices or hire more people!
CWBW,
You would have been right at home as a Victorian mill owner. Dickens would have loved you. But your total lack of compassion is matched by the stupidity of your 'answers' to inflation.
The minimum wage has in fact been rising for years without any inflationary effect and much the same is true of benefits. Your idea of issuing welfare cards is just cruel.
Of course linklater, only people that believe in the Government paying for everything have compassion. One of the lefts catch cries. All the left does is take unearned moral high ground, "we are the only ones that care". Lol. Why is it then, that when the left are Government, the rich really do get richer? The less fortunate get screwed over? It is actually hilarious. And even better, leftists keep voting to be screwed over.
Nice piece - this needs saying over and over again.
The domestic drivers of inflation (non-tradable) are dominated by increasing housing costs, rents, rates, and reno costs, with a dose of takeaway / restaurant price pressure as well (see below). It is beyond daft to think that reducing demand (by increasing interest rates) will address domestic inflation.
Tackling domestic drivers of inflation requires action on the supply-side. - doing something about profiteering duopolies (e.g. Fletchers / Carters, Woolworths / Foodstuffs), scrapping the perverse electricity market structure, introducing free public transport - starting with children and expanding out to everyone, and, yes, rent controls.
The CPI non-tradable subgroups account for just under 90% of the domestic inflation over the last 12 months. The percentages show how much each subgroup has contributed to domestic CPI (not the actual price increase!)
- Home ownership 43%
- Actual rentals for housing 12%
- Restaurant meals and ready-to-eat food 8%
- Property rates and related services 7%
- Other misc services (mostly Real Estate fees) 6%
- Property maintenance 3%
- Out-patient services 3%
- Insurance 3%
- Cigarettes and tobacco 2%
- Passenger Transport 2%
Higher interest rates might slow the growth a bit - but given that the GFC was not enough to make new house pricing fall, I can't see 2022 giving it any trouble. Also worth noting that the futures price for building materials (what big companies pay in advance for things delivered later in the year) are calculated using interest rates. So, when interest rates go up, futures prices go up.
Indeed. I struggle with economics because I am an engineer and a scientist. It is obvious that the economy is a complex system with lots of moving parts. The idea that changing a single variable within that system (e.g. OCR) and expecting a predictable impact on another variable (e.g. the general price level) is hopefully naive. Look at the US now - where Govt debt is very high. Higher interest rates will mean billions of dollars of extra govt investment (interest payments). Will that be inflationary - yes? Will all the thousands of deflationary impacts outweight the thousands of inflationary impacts - who bloody knows?
Good article, exactly the sort of thing I have been saying.
Most of the inflation is supply side, the OCR is a blunt tool and will only have limited impact in quelling inflation, but with some nasty side effects. It's a bit like a pretty average drug treatment.
Having said that I think there's a case for it to be raised another 75-100 BPs, once that is done it will have had some demand-side impact.
Good article. A nuanced approach is needed.
If some of the main drivers are increased petrol prices, increased rents, increased rates, increased food prices then action could be taken to alleviate a part of the effects.
The govt could remove the petrol tax for a period of six months. Rents - I don't know what you can do to prevent the slow departure of small scale rental investors ( the govt has really botched that up) and the decrease in available rentals, increased rates- govt has the power to subsidise the councils and in exchange limit the scale of rates increases. Increased food prices - the govt could increase the amount of seasonal workers and even allow in some backpackers to limit the increase in fruit and vegetable prices.
It's all micro policy that needs to be introduced without agendas being attached and I'm afraid that that isn't possible with the current govt.
So we will continue to see inflation being touted as due to 'printing money' because it's easier to point the finger at the RBNZ than at your own govt's policy failings.
I'm no fan of the Morrison govt in Australia, but the Australians are doing something right. On the graph above they are predicted to keep below 4% before they fall back to 2 %. Is it that Australians are a practical people who don't let ideology get in the way of sensible economic management?
What you seem to be saying is " you cannot bring down imported inflation with domestic interest rate increases" .
That statement is wrong - higher interest rates move the exchange rate , reducing prices of imported goods in domestic currency - and bringing the inflation down.
OCR is far too low & is a major cause of cpi & house price inflation - This is a Reserve Bank & Government failure.
House prices need to fall to increase affordability. It is as simple as that.
Government policies have created too many classes of residential property owner, some can claim interest some can’t, some will need to pay Brightline tax, others don’t. Result is smart money diverted to property with less tax burden eg improve own house for tax free gain.
Reducing rental supply by penalising landlords that supply most of the rental properties is the dumbest thing the government has done. Rents will increase much faster rate than they would have otherwise done because there are more renters fighting over fewer rentals. Any caps on rent increases would only exacerbate the rental supply problem & lead to poorer quality rental properties as there would be no incentive to improve them.
NZ will become a 2nd class holiday destination as more motels & private rentals are used for emergency accommodation. Where will tourists be able to stay without being impacted by antisocial behaviour of beneficiaries at motels etc?
How can the country afford to pay $1200 per night (or more) for an increasing number of homeless people? 24,000 people or more on the waiting list for a home?
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