The Reserve Bank could have limited inflation peak to 6.4% but could not have prevented the spike without breaching its mandate, new analysis suggests

The Reserve Bank (RBNZ) could have prevented the post-pandemic inflation surge by hiking the Official Cash Rate (OCR) to 6% before the end of 2021, inducing a deeper recession than the Global Financial Crisis.

This analysis is based on a purely mechanical model of what policy settings would have kept consumer price index (CPI) rises below 3% after the Covid-19 pandemic and response. 

An analytical note published by the central bank on Monday simulated the effect of two different monetary policy settings in the aftermath of 2020. These scenarios were described as “illustrative rather than definitive” as the economy may respond differently to extreme policy settings.

“Most importantly, the models that we use for this analysis are calibrated to typical policy responses, and it is likely that the transmission of policy would be materially different if monetary policy was set differently from those typical patterns,” it said.

“On balance, we view the simulations as providing a useful ‘ballpark estimate’ of what economic outcomes may have looked like with different monetary policy responses.”

With those caveats out of the way, the RBNZ essentially found it could have cooled overall inflation a little by reacting sooner (after the initial stimulus) but only unrealistic policy moves could’ve kept it in the target range. 

The note did not look at alternative reactions to the initial pandemic shock, but the bank has previously acknowledged its bond buying and bank funding stimulus contributed to the inflation pressure.

Keeping annual inflation below 3% would have required the OCR to rise 500 basis points in the first nine months of 2021, reaching 6% two years earlier than the actual 5.5% peak that eventuated in May 2023.

This would have crashed the economy. An output gap of -3.8% would’ve opened up (instead of -1.6%) and unemployment is estimated to have peaked at 6.2% instead of about 5.2%. Roughly 120,000 fewer people would have had jobs and mortgage rates would have hit 8%, instead of 7.4%. 

But this trouble may have been short-lived. The RBNZ’s mechanical model showed a faster recovery than New Zealand has experienced, with the output gap and employment ending up in much better shape than today.

It's hard to say whether it would have worked in practice. And the question is moot, anyway, as the scenario would have breached the central bank’s monetary policy remit.

The RBNZ is tasked with keeping CPI within a 1% to 3% range but only over “the medium term” and it has to achieve it while avoiding “unnecessary instability” in economic output, interest rates, and employment.

At the time, the bank was also asked to “support maximum sustainable employment”. The Monetary Policy Committee could only have taken such a drastic path if it felt there was no alternative. 

“A rapid and unexpected tightening would have been well out of step with the global monetary policy cycle and market expectations at the time. This may have constituted a significant shock to financial markets, increasing interest rate and exchange rate volatility if expectations adjusted abruptly”.

“The policy shock would also have tested the resilience of household, corporate and banking balance sheets, heightening risk to financial system soundness,” the RBNZ said in the note.

A more plausible scenario involved tightening policy two or three months sooner and getting to 5.5% six months earlier. This would have lowered the inflation peak to 6.4% from 7.3% in 2022 and caused a more moderate recession.

“These results suggest that while an earlier and steeper tightening cycle would have delivered a lower inflation peak and reduced labour market pressure, the counterfactual path would not have prevented a sustained period of above-target inflation,” the RBNZ said. 

The monetary policy committee planned to raise interest rates in August 2021 but opted to delay as a second nationwide lockdown was announced during their policy meeting. This scenario imagines them going ahead with a 50 basis point rate hike, having already raised 25 points in July.

New Zealand’s OCR would have been sitting at 4% in May 2022, while Australia was still at 0.35% and the Bank of England and US Federal Reserve were at or below 1%.

Getting better

The analytical note was released as a wider update on the RBNZ’s response to a monetary policy review published in 2022. 

Chief Economist Paul Conway said the RBNZ had made progress implementing the various recommendations made in the review. 

These included developing a better understanding of supply shocks, neutral interest rates, and fiscal policy instruments; and monitoring the economy with more high frequency data. 

Conway said the period of high inflation and economic volatility had provided valuable insights into how economic activity, price setting by businesses, and inflation expectations can evolve.

“We now have a deeper understanding of supply shocks and structural drivers of inflation and have expanded our use of high-frequency data for more timely and granular monitoring. We have developed new tools to estimate neutral interest rates and run scenario analysis. These improvements ensure the MPC [Monetary Policy Committee] is well equipped to navigate future shocks while maintaining price stability.”

Responding to the scenario analysis, Conway said an earlier or more aggressive tightening might have reduced inflation sooner.

“But this would have been difficult given the data available at the time and could have conflicted with the MPC’s mandate back then, which included maintaining maximum sustainable employment."

All four analytical notes and bulletins published on Monday can be found on RBNZ’s website.