The real reasons behind our stagflation predicament

Currencies / opinion

Roger J Kerr struggles to make sense of the Reserve Bank's latest 'stringent' message

4th Dec 23, 8:02am by Roger J Kerr

A man walks past the Reserve Bank on Wellington's The Terrace

Summary of key points: -

The Kiwi dollar jumps four cents over the last month, can it fly higher still?
Why New Zealand has stagflation and why we will struggle to get out of the rut

The Kiwi dollar jumps four cents over the last month, can it fly higher still?

A combination of a weaker US dollar (due to weaker economic data and tumbling US interest rates) and a stronger Australian dollar (due to additional interest rate hikes from the RBA coming in February) has propelled the NZD/USD exchange sharply higher from 0.5800 to 0.6200 over November.

Investor “risk-on” sentiment pushing US equities higher has also been good news for the Kiwi dollar as it is widely regarded as a risk-on, growth and commodity currency. The USD Index has only dropped by 3.00% over the last month, whereas the NZD/USD exchange rate is up nearly 7.00% from 0.5800. The Kiwi following the Aussie dollar higher has added to the additional upward momentum.

The USD Index followed US 10-year Treasury Bond yields higher through July to September. Both of those gains have reversed very quickly indeed over recent weeks. Bond yields are back sharply from 5.00% to 4.20% and look set to continue to slide back to the 3.80% average level they traded at earlier this year. As a consequence of further reductions in bond yields, the USD Index is likely headed back to the 101.00 level (currently 103.12). The NZD/USD equivalent rate to a 101.00 USD Index point is 0.6500. So, yes, further NZD gains of another three cents are very much on the cards over coming weeks.

The USD was sold by the markets following yet another lower than forecast US inflation result, the PCE measure coming in flat at 0.00% for the month of October. The markets also interpreted Fed Chair Jerome Powell’s latest speech as inching towards the “dovish” side, even though he warned that it would be premature for the markets to be pricing in interest rate cuts in 2024.

Why New Zealand has stagflation and why we will struggle to get out of the rut

What drove the RBNZ to deliver a “more hawkish than anticipated” monetary policy statement last week in the face of slumbering economic growth has a few economists and financial market veterans scratching their heads. We thought he would push-back on the interest rate market’s pricing-in of OCR cuts by May next year, however the message and tone were far more stringent than our expectation. Even more perplexing was the RBNZ reducing their “neutral interest rate” to 2.25% from 2.50% previously. With the OCR projected/required to stay well above 5.00% for at least another 12 months, New Zealand is living with the tightest monetary conditions in the world with interest rates more than 3.00% above the “neutral rate”. Such severely restrictive monetary settings would be justified if the domestic economy was booming with rampant consumer demand and/or inflation was increasing globally. Neither of those two conditions are the case right now. In fact, the opposite is the economic reality.

None of it makes any sense and the only explanation is that Governor Adrian Orr seems to take some mystifying pleasure in “wrong footing” the financial markets at almost every opportunity. The end-purpose of such tactics is also difficult to comprehend. However, what Adrian says today is not that relevant and is quickly dismissed as efficient and liquid interest rate markets will always price-in probabilities of future economic conditions, despite what central bankers may say currently. Still expect interest rate cuts here in NZ towards the end of 2024 (earlier than the current RBNZ signalling). However, that will be some time after the US are cutting their interest rates in mid-2024, therefore US dollar negative and NZ dollar positive from a change in interest rate differentials perspective.

Whilst there was a ton of analysis on New Zealand’s current economic conditions contained within the 58-page Monetary Policy Statement document, some straightforward explanations of how New Zealand got itself into a stagflation environment with high/sticky wage-push inflation, was conspicuous by its absence. The RBNZ always seem very reluctant to point the finger at the culprits who are the root causes of our inflation problem. As the guardians of preserving the value of our savings and spending power of our dollar (i.e. maintaining low inflation) they should have a responsibility to flush-out the root causes of constant price increases and make recommendations as to changes. Currently, they do not do that, they merely shove interest rates up and down and hide behind the fact that it is the only tool they have at their disposal to control inflation. However, the markets and the wider general public deserve an independent and succinct explanation as to how we got ourselves into this stagflation predicament and why the economic/financial pain has to be so harsh to get us out of it.

Perhaps we can help with that explanation by the summary below of the three main causes of the persistent high inflation in 2023: -

Government policy blunder number 1: The decision by the Ardern Labour Government to keep New Zealand’s borders closed for far too long after the Covid pandemic caused a debilitating and chronic labour shortage across the economy in 2021 and 2022. The unsurprising outcome from that ill-judged immigration policy was a massive spiral up in wage levels to retain/attract workers and therefore wage-push inflation that is very difficult to reverse.
Government policy blunder number 2: Another poorly thought-through economic policy change by Ardern/Robertson was to end interest cost deductibility on rental properties. The economic and human consequences of this decision was swift and severe. Owners of investment/rental properties sold the houses to owner-occupiers and the evicted tenants in many cases were forced into motels. The reduced supply of rental properties sent rents skyrocketing, which contributed to the higher inflation. “Own goals” scored by the previous Labour Government on both housing and inflation.
Government/RBNZ joint policy blunder number 3: Both monetary and fiscal policy stimulus was significantly “over-done” in New Zealand compared to other countries in the 2020 and 2021 Covid period. The inevitable consequence of the over-stimulation with too much money printing and willy-nilly Government spending was higher inflation.

The Government and the RBNZ do not have to look too far across the road at each other in Wellington to see the major contributors to our stagflation problem. We now have concentrated high immigration which is continuing to push up housing demand and rents.

Reducing inflation when it is the “wage-push” variety is hard work and takes a long time. It does appear that the RBNZ have finally woken up to that reality. However, that does not necessarily mean that the OCR has to remain above 5.00% until 2025.

To understand what needs to change in the New Zealand economy to address the permanently high domestic/non-tradable core inflation, the RBNZ chart below confirms the prime culprit – continuous price increases in Housing and Household Utilities (red bars in chart). The RBNZ’s MPS last week contained inflation forecasts out to 2026 that indicates that domestic/non-tradable inflation remains at its normal 3.00% annual increase. Therefore, tradable inflation (oil and imported goods) will need to be zero or negative for the RBNZ to achieve its 2.00% target (mid-point of the 1.00% to 3.00% band). Everyone should now see why the RBNZ needs a higher NZ dollar value (lower prices on imported items) to get inflation down to target.

Solving the perma-inflation increases in housing and household utilities is a topic for another day. Competition, regulation, economies of scale, efficiency and city zoning are issues a smart guy like Minister of the Crown, David Seymour can put his mind to.

Daily exchange rates

Select chart tabs

Source: RBNZ

Source: CoinDesk

*Roger J Kerr is Executive Chairman of Barrington Treasury Services NZ Limited. He has written commentaries on the NZ dollar since 1981.

We welcome your comments below. If you are not already registered, please register to comment

Remember we welcome robust, respectful and insightful debate. We don't welcome abusive or defamatory comments and will de-register those repeatedly making such comments. Our current comment policy is here.

16 Comments

by elmoboy12 | 4th Dec 23, 8:23am 1701631400

Excellent article from Roger Kerr, and spot on analysis of the blundering RBNZ. However, I wonder if the 7.6 trillion in U.S. dollars of bond auctions by the U.S. government next year will likely put upward pressure on the value of the U.S. dollar? The U.S. is going to have to pay more in interest if it wants successful auctions for all these bonds.

by AshwinRai1488 | 4th Dec 23, 9:13am 1701634414

The goldilocks scenario assumes 130bps rate cut to Fed funds rate. This will bring yields down in spite of excessive supply (which I think is around 2-3 trillion).

This might very well turn out to be the case as neither Treasury nor the Fed wants higher yields. But let's see.

Edit: forgot to add, this will also cause the USD to depreciate in spite higher debt issuance

by ChrisOfNoFame | 4th Dec 23, 12:00pm 1701644435

Did you mean downwards pressure on the USD and upwards pressure on yields?

by AshwinRai1488 | 4th Dec 23, 8:50am 1701633033

Great analysis from Mr. Kerr yet again. We very much need someone like him in the ear of Luxon and Orr.

by Jefferswood | 4th Dec 23, 8:54am 1701633241

Thank you for the excellent, succinct article Roger. A clean out of the group think at the Reserve Bank/Treasury sorely needed.

by treadlightly | 4th Dec 23, 10:14am 1701638062

High inflation has been a worldwide phenomenon and in many cases higher than our own and so we cannot blame the previous government for it. Covid and the resulting supply issues arising from it have been mostly to blame along with businesses profit gouging.

by ChrisOfNoFame | 4th Dec 23, 11:58am 1701644330

Agreed. Kerr's constant political axe grinding with the benefit of hindsight detracts from message.

by Colonial Viper | 4th Dec 23, 6:06pm 1701666417

It was also a world wide phenomenon that governments both vastly over-spent on the COVID crisis and managed that crisis in a way which severely hit the productive economy by destroying small and medium businesses. So its fully valid that some criticisms are levelled at the previous government, not least of all because they allowed the RBNZ to massively open up the low interest debt sourced money supply spigot and for far too long.

by ChrisOfNoFame | 4th Dec 23, 11:56am 1701644165

Concur that the RBNZ's MPC November announcement is completely weird. And, to me, makes little sense.

Liam Dann picked up on word ‘endogeneity’ on page 30. It's part of the section where the RBNZ jumps through hoops to explain why they believe inflation may need another OCR rise to send it lower. Good read too. It's a "special topic" on OCR transmission lags.

https://www.rbnz.govt.nz/-/media/project/sites/rbnz/files/publications/…

In essence, it almost seems a rebuttal to what Jfoe, myself and others have been saying. Alas, they lay out their logic ... but it flies in the face of empirical evidence. Not the least their bar chart on page 30 that shows between 4 and 8 quarters is all it takes in NZ for a high OCR "peak effect" to be felt.

They even say, "Despite this diversity in results, many empirical studies indicate that it takes about eight quarters for monetary policy to have its peak impact on inflation (figure 4.2). " (Again on page 30.) That statement makes sense only in the context of what it takes in other countries, NZ is almost an outlier.

How did they get to eight quarters when their own bar chart shows between 4 and 8?

That aside, the bar chart is a mash-up from various studies. It's title is: Quarter of peak impact of a monetary policy shock on annual CPI inflation.

Note the words "peak impact".

Now cast your mind back to when the RBNZ signaled rates would need to get painful and they started raising with far-too-small increments. That was October 2021. That's already 8 quarters ago. Remember too that the first rise was accompanied by forceful words from the RBNZ about recessions and unemployment and mortgagee sales and what banks should do to help distressed borrowers.

I would argue the reigning in of consumer purse strings started soon after October 2021. (Businesses with access to non-bank economists would have started even before that.) I would likewise argue that covid cash buffers kept some heads above water for longer than was usual. But we are well and truly past the NZ average of 7 quarters, and the low of 6 quarters.

But when we try to identify "peak impact" of the OCR rises, what's the answer to "Are we there yet?"

That depends on how it is measured. Mortgagee sales? Serious levels of unemployment or mild levels? Peak bankruptcies, or back to normal? Closed shops? Rising crime as people steal to feed their families? Mass protests? Take your pick.

I've picked my measures. My measures are consistently falling inflation and consistently rising signs of economic stress. Thus, to me, peak impact is already here.

Which begs the question, "For how long after peak impact should rates be held high?"

My view is never more than one quarter.

Once economic contraction starts, "friction" (the absence of economic will to do anything new or not absolutely essential) and the "domino effect" takes over and propels the contraction.

Thus, small drops in the OCR simply have no effect at restarting economic activity. But it can and does provide relief for people and businesses with debt. This relief does NOT cause them them to suddenly go out on a spending spree. They still can't. And, it sends the signal to savers (IN BIG LETTERS so the oldies can read them) to lock up their money in TDs as current rates are as good as they're going to get.

(There are many other issues, some of the RBNZ's own making e.g. why banks get away with such high variable rates, that are involved in transmission lags. A huge topic. And one, when the situation presents themselves are worthy of more discussion. But not now. I'm trying to figure out who is benefiting from this jawboning and I already have my suspects.)

by Jonny.Foe | 4th Dec 23, 1:36pm 1701650202

Jeez, I hadn't read that MPS special topic. This paragraph caught my eye:

Indebted households facing low disposable income and credit constraints may find increases in their debt repayment obligations force them to reduce their spending, beyond how they would from the savings and investment channel alone. The opposite effect would be true of net savers, whose interest income is boosted by higher interest rates. Overall, New Zealanders are net borrowers, so the reduction in spending tends to dominate.

The emboldened sentence above is highly misleading. Households actually receive more interest income than they pay out [data is here]. When RBNZ talk about 'New Zealanders' they are talking about households and businesses combined. How businesses respond to higher debt servicing costs is not the same as households. Businesses don't necessarily cut back on 'discretionary spending'. Why would they if they can increase prices? Remember here that most businesses in NZ don't face a great deal of competition and / or their competition is experiencing the same increase in credit costs.

by ChrisOfNoFame | 4th Dec 23, 4:00pm 1701658803

Good point.

Hopefully we see another "special topic" addressing this next MPS. ;-)

by Colonial Viper | 4th Dec 23, 6:09pm 1701666568

Net savers tend to be older people who have already paid off their mortgages. It doesn't matter if they earn more interest income they are not going to be spending to the level that younger people setting up new families and households are.

by Jonny.Foe | 4th Dec 23, 1:24pm 1701649494

Roger, you know you can just look up the number of rentals active at any time right? If you did, you would see that rental capacity has increased notably since the govt changed the interest deductibility rules. I appreciate that this simple fact won't suit your priors, but still...

by Colonial Viper | 4th Dec 23, 6:13pm 1701666830

So instead of selling entry level houses to FHBs who can no longer get credit, those same houses are being rented to them. Is this really some sort of win?

by charlieandme | 4th Dec 23, 2:07pm 1701652022

blunder 1 a real effort to save lives resulted in a massive housing inflation driven by deliberately low interest rates & the banks. A wage/price spiral has not eventuated but freight + imports + NZ price gauging + immigration has pushed inflation high & sticky

blunder 2 long needed & economically sensible but mild reforms to rental rules has not lead to a rush of selling by landlords. Rather rent increases are being driven by immigration and rising incomes

blunder 3 the NZ covid fiscal & monetary response was on a par with other western nations which have all experienced strong inflation in CPI terms & in the housing stock

by cp74 | 5th Dec 23, 8:46am 1701719203

“Owners of investment/rental properties sold the houses to owner-occupiers and the evicted tenants in many cases were forced into motels. The reduced supply of rental properties sent rents skyrocketing, which contributed to the higher inflation.”

But if it’s true all these rentals were sold to FHBs, then the rentals these FHBs moved out of, to buy these apparently suddenly for sale rentals, became available, so the number of houses available to live in is unchanged. ‘Investors’ buying and selling houses doesn’t change the number of houses. And of course interest deductibility was still available for new builds - building new houses is something that does change the number of houses.