ASB economists say tackling labour shortages looks to be the key to mitigating inflationary pressure

Unless there's a "material" loosening in New Zealand's tight labour market, inflation could remain above 3% for "considerably longer" than the Reserve Bank (RBNZ) is forecasting, ASB economists believe.

ASB senior economist Mark Smith has undertaken a very detailed crunch of inflation and the potential causes of it and says that developments in the labour market play a pivotal role in impacting inflation, "although many of the factors influencing labour market conditions are outside of the RBNZ’s control".

According to Statistics New Zealand figures, the country had an unemployment rate of just 3.2% as of the March 2022 quarter. But annual inflation at the same time was 6.9%. The next Consumers Price Index (inflation) figures for the June quarter are due to be released on July 18, while the next batch of labour market official statistics is not due till August 3.

In the meantime the RBNZ's got its next review of the Official Cash Rate (currently sitting on 2.0%) next Wednesday (July 13) and is widely expected to lift the OCR to 2.5%. The RBNZ is charged with maintaining inflation in a range from 1% to 3%. However, in its most recent Monetary Policy Statement in May it forecast that inflation would only get back down under 3% by the fourth quarter of next year.

However, ASB's Smith says his work suggests that inflation in NZ looks to have become more persistent compared with the strict inflation targeting regime of the 1990s.

Tackling labour shortages looks to be the key to mitigating inflationary pressure, he says. 

“If this does not happen, our analysis suggests annual CPI inflation will remain above 3% for considerably longer than the late 2023 timeframe signalled in the May 2022 MPS forecasts,” he says.

Protracted high rates of inflation are “economic and social poison”, Smith says, being extremely costly to firms, households and the economy in general.

The ‘baseline scenario’ of the ASB economists is for the economy to manage to pull off a soft economic landing, “but risks are building”, Smith says.

“With inflation looking to be persistent, the labour market tight, but with an increasingly wobbly economic outlook, the trade-offs facing the RBNZ look stark.

“It could ultimately mean a more pronounced or sharper period of monetary tightening that could likely exacerbate the slowdown already under way, eventually resulting in sizeable job losses.”

Alternatively, the RBNZ could apply a “lighter touch” to the monetary policy brakes in the hope labour market conditions normalise,” Smith says.

“If they don’t, however, this runs the risk of a prolonged inflation overshoot and higher longer term costs to the economy. For now, we are sticking to our view of a 3.50% OCR peak and cuts from 2024 but we will be closely scrutinising labour market developments going forward.”

Smith draws several conclusions from his analysis, including:

• The inflation process looks to have become more persistent. Once inflation has been high for a period it could be more difficult to lower it.

• Developments in the labour market clearly matter for inflation. Labour market variables (labour costs and labour as a limiting factor) directly impact headline inflation, core and non-tradable inflation. They also indirectly impact inflation via their influence on the output gap and other inflation determinants.

• There is no longer conclusive evidence that prices lead labour costs. In fact, the relationship is stronger the other way around, consistent with what is commonly observed overseas.

• Moreover, headline inflation rates can provide more information over future readings for inflation expectations and not the other way around. This suggests inflation expectations are likely to be more adaptive (based on past inflation rates) than purely forward-looking and it could prove trickier for policymakers to lower inflation if it is well above the target band.

• Labour costs look to have a persistent impact on headline inflation but are not set to peak until mid-2023 according to the RBNZ’s own projections. This and the likelihood that labour shortages will stick around for a while yet suggests it could take a while before inflation falls towards 3%.

Smith says it “is sensible” that the RBNZ is paying more attention to the labour market even if this was driven more by changes to the monetary policy mandate [now including maintaining maximum sustainable employment] than a realisation that labour market conditions clearly matter for inflation.

“However, it highlights the importance of not letting the labour market get too tight and the potential labour market trade-offs that may have to be made if high inflation appears ingrained.”

Factors like immigration settings, skills training and gaps, global labour market conditions and the relative attractiveness of NZ as a place to live and work clearly matter, Smith says.

“Alleviating pressures in the labour market could provide a circuit breaker reducing the need for tighter policy settings that would ultimately crunch the economy and labour demand.”

Ultimately, however, the RBNZ has to play the cards it has been dealt, Smith says, reiterating that with inflation looking to be persistent and with the economy already wobbling, the trade-offs facing the central bank are likely to be stark.

“They can either continue to front load policy tightening to try to get inflation under control, potentially crunching the economy in the process with many people losing their jobs until inflation cools. Alternatively, they could move in smaller steps, hoping high inflation will eventually subside.

“If, however, the current situation of widespread and significant labour shortages is not resolved, this runs the risk of a concerted overshoot of the inflation target and the associated longer-term costs to the economy. Not a nice place to be.”

Separately, in an ASB review of Tuesday's NZIER Quarterly Survey of Business Opinion, Smith said "recession looms" but ensuring inflation will eventually settle to generally acceptable levels (i.e. around 1-3%) should be the RBNZ’s key priority.

"With inflation showing few signs of cooling and capacity pressures intense the path of least regrets for the RBNZ is still to swiftly move to restrictive monetary settings.

"... A cooling in capacity pressures (particularly in the labour market) will pave the way for the OCR to eventually to be moved back to more neutral levels (circa 2-2.5%, but now drifting up)."