It is widely recognised that inflation can be either cost-push or demand-pull. It is also widely accepted that inflation expectations influence both purchase and pricing decisions, with this feeding back at a macro level to self-fulfilment of the expectations.
These explanations, despite being correct, are superficial.
Simply knowing that the above explanations are true, in itself does very little to help policymakers prevent inflation. If the solutions were simple, we would not be in our present New Zealand situation with inflation at three percent per annum despite a stagnant economy.
Three percent per annum of compounding inflation does not necessarily sound very much. However, it means prices double every 24 years. In 100 years, prices increase 19-fold.
In the last five years since September 2020, our inflation rate, using official CPI data (Reserve Bank series M1), has actually averaged 4.6 percent per annum. This is despite the Reserve Bank mandate to keep inflation between one and three percent in the medium term, with a specific focus on the midpoint of two percent.
During this latest five-year period, non-tradable inflation has averaged 5.2 percent and tradable inflation has averaged 3.8 percent. This difference, particularly given that it has been a period when the exchange rates were overall in decline, tells us very firmly that we cannot blame our problems on the rest of the world. We have been creating most of the inflation problems ourselves through domestic inflation for items in which there is no international trade.
Looking back over the two preceding decades, a similar picture emerges. Non-tradable inflation averaged 3.2 percent while tradable inflation averaged only 0.8 percent.
During those two earlier decades, overall inflation at 2.2 percent was close to the target midpoint but it was only because tradable inflation was exceptionally low. A lot of that low tradable inflation was thanks to what was happening in China, our most important trading partner.
Out of curiosity, I used the RBNZ inflation calculator to tell me the extent of consumer price increases in New Zealand between the start of Year 1900 and the latest price levels in 2025. I found that consumer prices have increased by a factor of 123 over that time. In other words, what could be bought with New Zealand’s one-pound note in 1900, would now, in 2025, cost $246. That works out to a compound rate of inflation of 4.3 percent annum.
Given that our rate for the last five years through to September 2025 averages 4.6 percent per annum (as reported above), compared to this longer 125-year rate of 4.3 percent, we don’t seem to have got any better at inflation control!
We can call it ‘money creation’ or some other term, but the bottom line is that one way or another a lot of money has been and still is being created. Of course, in recent and current times there is no need to print physical money. Instead, it can be done with digital key-strokes.
I have no argument against the need to create money in the presence of a growing population in a growing economy. That would be a silly argument. But have we consistently overdone it as short-term political expediency?
In recent months, I have spent considerable time bringing myself up to date on monetary economics- thinking, searching for a path forward. This journey reflects that although I have at times been using macro-economics in my work, it has been a long time since I studied monetary economics in a formal setting. In the meantime, monetary economics has got a lot more complex.
Currently, conventional economic wisdom says that inflation is best controlled by adjusting interest rates. In New Zealand, we use what is called the official cash rate, better known as the OCR, as the key tool. The OCR was first introduced in 1999.
This current focus on interest rates is in direct contrast to most of the last two decades of the 20th century, when the dominant theory influencing macro-economic policy across the Western World was that the answer lay in directly controlling the supply of money.
My own conclusion is that neither of the above two approaches as applied in the past, nor the preceding mantra of Keynesian thinking, by themselves provide a sufficient pathway to the ever-changing future.
What became very clear during my recent investigations is that what works during one period of history does not necessarily work at other times. There are very few absolutes in relation to monetary theory. Macro-economic theory-building is a pragmatic journey of what seems to work within changing institutional frameworks and changing behaviours. More on that later.
The first question to put to rest is the notion that inflation does not matter very much as long as incomes rise at no less than the rate of inflation. The answer is that inflation, even at rates of around three percent per annum, is distortionary. It leads to bad investment decisions. More too on that later.
Of course, there are both winners and losers from inflation. That is part of the reason why it is so hard to control. Many individual fortunes have been made on the back of inflation, with property ownership and associated financial leverage from borrowing being of fundamental importance.
Conversely, I am confident that there has never been a billionaire who got there by saving money in the bank.
Failure to get on the first step of the property ladder, often linked to an inability to access a Bank of Mum and Dad to get started, lies at the core of the increasing inequality that we have seen in New Zealand.
Some History
If we go right back to the 19th century, there was minimal inflation in those times. The key western countries used a gold standard. The world economy was growing but so was the quantity of gold, and hence the quantity of money was increasing.
It may have been a matter of chance rather than purposeful policy, but in those days, prices did stay relatively stable. At times prices did increase a little, and at other times they decreased a little. This linked to the specifics of what was happening with gold supply relative to innovation-led economic growth.
Then everything started to change with military mobilisation across Europe preceding the First World War. Britain left the gold standard in 1914. This allowed the printing presses to churn and fund the War effort. Similar events happened in many parts of Europe, with Europe at that time the centre of the World economy.
Once the First World War was over, the additional money was available for consumables in what became known as the Roaring Twenties. German hyper-inflation in an environment of war reparations was the ultimate illustration at that time of what could go wrong with money-printing.
Then came the Great Depression starting in 1929. The key insight from those depression days was that full employment does not occur naturally in a capitalist economy. It needs help from the Government to reduce oscillations in the business cycle.
Keynesian Thinking
The solution that then took hold across the Western World was underpinned by Keynesian thinking with the English Lord Keynes leading the charge. He enunciated and popularised the importance of fiscal policy together with direct creation of employment by Government.
Keynes argued that job creation, funded by Government borrowing of money, would shift the economy to a higher level. The increased economic activity would provide the necessary income to repay the borrowed money.
Keynes was less forthcoming about where the borrowed money should come from, but he clearly understood that simply printing money was highly inflationary, and that an unconstrained ‘money- printing’ policy did not provide a long-term pathway. At times he was specific that funding should come from increased taxes. At other times he argued for reduced taxes.
So-called Keynesian thinking had fully taken root across the Western World by the time of the Second World War and it lasted as the dominant economic paradigm through until the 1970s.
In New Zealand, Keynesian policies were de facto used as the dominant economic paradigm through until the mid-1980s and the arrival of Roger Douglas as Finance Minister in the Lange Government.
However, I doubt if Keynes himself, who died in 1946 at age 62 from a heart attack, would have agreed with a lot of what subsequently became known as Keynesian economics. Keynes’ focus was on business cycles and how to minimise recessions and avoid depressions. Long-term priming of the pump is another matter.
The term ‘money printing’ had yet to develop as a pejorative term in Keynes’ time. The euphemistic term was ‘deficit funding’. Although some of this deficit funding could come by borrowing from the private sector, a government could also borrow from its own central bank.
The consequent assets and liabilities from governments borrowing from central banks sat on the balance sheets of these governments and central banks, but did not necessarily have to be repaid. Governments could, if they chose, simply wipe off the debt, given that in those days they were the full legal custodians of their central banks and hence operated on both side of the transaction.
To clarify the point, in those times there was no such thing as central bank operational independence. Central banks did whatever the Government told them to do. More too on that later.
Coming back to the years of big deficit funding by politicians in New Zealand, it was the Muldoon years of 1975 to 1984 when inflation really took off. The compound rate of inflation in those years averaged 13 percent per annum. This caused prices to treble over the nine-year period. However, it could well be argued that the pump priming was already well under way in the preceding three years of Norman Kirk and Bill Rowling.
It was a global phenomenon but New Zealand fared worse than many other OECD countries.
1984 and Beyond
Everything changed within the New Zealand economic scene following the election of the Lange Government and the appointment of Roger Douglas as Minister of Finance in 1984. It was a time of tough economic medicine. There were six years of neo-liberalism under Douglas, with policies known colloquially as ‘Rogernomics’, followed by three years with Ruth Richardson as Minister of Finance, with similar policies known colloquially as ‘Ruthanesia’.
Starting in late 1984, the dollar was floated, import restrictions were removed, tariffs were removed, and union power was constrained.
By late 1991, inflation was down to one percent per annum. However, unemployment reached a peak of 11.2 percent in September 1991, which tells something of the cost of bringing inflation under control.
Whereas Keynes had been the international economic standard bearer from the late 1930s through to the 1970s, for much of the next 20 years it was Milton Friedman’s monetarist polices that represented dominant economic thinking.
Fundamental to Friedman’s monetarist thinking was the notion that, if inflation were to be prevented, then creation of money needed to be constrained tightly and in balance with real levels of economic growth.
To achieve long-term economic stability, Friedman was explicit that this growth in money supply should itself be stable and not chasing short-term business cycles. Key mechanisms could include key-stroke money creation, or various credit controls imposed on banks. However, these mechanisms had to be tightly constrained and set in accordance with long-term growth prospects for real economic growth.
One of Friedman’s enduring quotes is that inflation is always a monetary phenomenon. He pointed to the classic quantity of money identity that:
MV = PY,
where M is quantity of money,
V is velocity of circulation,
P is prices (nominal), and
Y is production of goods and services.
This relationship, being an identity relationship that can be considered a truism, had been known for several hundred years. I recall being introduced to it in Stage 1 Economics in the late 1960s.
It follows that if both V and Y are fixed at any point in time, then prices must be directly determined by M, the money supply. Accordingly, Friedman’s focus was on M, the quantity of money, with this being something governments and their central banks could supposedly control through a mix of regulations and direct control of money creation.
In practice, it did not work out quite as simply as what Friedman suggested. As the financial world got more complex, it became harder and harder to decide exactly what was and what was not money. Aligned to this, the velocity at which money circulated, for example whether consumers spent money or saved money, was clearly not constant. International money flows were another complicating factor.
This highlights that an identity relationship that holds by definition does not necessarily lead to simple equations. In the case of money, all four terms in the identity relationship are variables with complex interactions. None is a constant.
Specific Inflation Targets
New Zealand was at the forefront in the late 1980s of setting a specific inflation target, which was initially proclaimed by Finance Minister Roger Douglas as ideally being between zero and one percent, but then set at zero to two percent. Then in 1996 it was reset at zero to three percent, and in 2002 constrained to between one and three percent. That is where it currently sits, although with a specific goal of averaging around two percent over the medium term.
Although these targets were and are set by Government, the task of achieving them was delegated in 1990 to the Reserve Bank, which from 1990 has had operational independence from the Government.
By the late 1990s, Western governments were increasingly becoming non-enamoured with trying to directly control money supply as the key tool to control inflation. The Friedman approach was considered to be inadequate. Instead, the new idea was to place increasing weight on interest rates as the tool.
Accordingly, the old idea of managing inflation by a ‘fractional reserve’ system, whereby the trading-bank reserves required by the Reserve Bank relative to trading-bank borrowings were adjusted, became less important.
Interest Rates as the Inflation-Controlling Tool
In New Zealand, the key change to using interest rates occurred in March 1999, and appears to have been led by the Reserve Bank itself rather than directed by politicians. That was when the Official Cash Rate (OCR) was first introduced.
This is still the same system that New Zealand currently uses some 26 years later, with the Reserve Bank’s Monetary Policy Group meeting on seven occasions per year, and at each meeting determining whether there should be a change to the OCR.
This OCR determines the rate of interest which the Reserve Bank pays to the trading banks on the deposits they hold at the Reserve Bank. More important, it provides ‘guidance’ to the banks as to what is appropriate within the broader economy.
Note that I use the word ‘guidance’. The OCR does not actually control what the banks pay citizens for their deposits, nor what borrowers have to pay on their borrowings.
I recall a seminar in the relatively early years of the OCR system, where a very senior official of the Reserve Bank, speaking under Chatham House Rules, acknowledged, to use his own words, that there was an element of ‘con in the system’ such that the Reserve Bank had to be careful that it did not stray too far from where the financial markets were heading of their own accord.
If the Reserve Bank did stray too far from where the markets wanted to go, then the Reserve Bank’s OCR system would lose credibility. Chatham House rules preclude me from saying who that high official might have been.
The idea of low interest rates is that people who have home mortgages will have more money to spend on other things when interest rates are low. As to the proportion of adults who have mortgages, this can be confusing, but it is less than 40 percent. The remaining 60 percent or slightly more either rent or are mortgage-free owners.
Investors might also be more likely to take on new business projects and borrow more if interest rates are low. This means more money is created via credit creation.
The counter effect is that when interest rates are low, then earnings on savings are less. Those who rely on savings have less to spend.
However, the empirical evidence is strong that lower interest rates do increase overall expenditure. There is then an expenditure multiplier affecting both M and V as increased spending works its way through the economy, albeit with delays. Typically, this increased expenditure then leads to inflationary pressures.
Here in New Zealand, the experience over the last 25 years has been that all of the major banks do take close guidance from the Reserve Bank via the OCR.
The Last Five years
Although the OCR is currently the month-to-month tool used by the Reserve Bank to control inflation, it is not the only tool in the toolbox. In 2020, in the early days of the COVID pandemic, the Reserve Bank initiated two schemes of quantitative easing to provide more liquidity into the financial system and to specifically lower interest rates.
The first of these schemes was the Large Scale Asset Programme (LSAP) which in 2020 and 2021 injected $53 billion into the economy through the Reserve Bank purchasing government and local body bonds using created money. These bonds are currently being withdrawn from the market, with the winding down expected to be complete by mid-2027.
The second programme was the Funding for Lending Programme (FLP) which provided the banks with $19 billion of cheap funding at the OCR from the Reserve Bank. These FLP funds will have been repaid to the Reserve Bank by the end of 2025.
A key consequence of the LSAP and FLP was that the markets were flooded with liquidity and cheap money. It was the presence of this money in the market that set off the property boom of 2021 and through into early 2022. The subsequent reversal of this property boom has been painful.
The combined excessive level of the LSAP and FLP also drove the inflationary boom through to 7.3 percent in June 2023. Bringing that under control has also been painful.
Both the property boom and the inflation take-off should have been predictable to the Reserve Bank but apparently that was not the case. I was a lonely voice when I first wrote about the forthcoming monetary flooding back in June 2020, and followed that up with further articles throughout 2021.
Whereas the Reserve Bank was working from models built on historical behaviour, I based my assessments on expected behaviours, recognising that we were in a ‘new world’.
Despite the current quantitative tightening associated with the current withdrawal of the LSAP and FLP funds, New Zealand’s ‘broad money supply’ as calculated by the Reserve Bank’s C50 series, continues to increase rapidly. This ‘broad money’ is essentially what is known internationally as ‘M3’ money although the Reserve Bank no longer uses that term.
In the year to October 2025, both broad money supply and domestic credit increased by just over five percent. In the six years from October 2019 the supply of broad money has increased 37 percent. Where is this money coming from?
The answer is that apart from the excessive use of the LSAP and FLP, the remainder has been coming from credit created by the trading banks to willing borrowers, within rules set by the Reserve Bank. However, the Reserve Bank takes what is essentially a ‘hands-off approach’ within a framework of relying on the OCR to influence behaviours, plus a focus on ensuring that there is sufficient liquidity in the system to avoid instability.
This means that the combination of citizen savings, spending and investment behaviours, combined with banks willingness to lend, is currently the fundamental determinant of growth in the money supply, with a consequent effect on inflation. I emphasise that monetary economics is very much a study of human behaviour.
Yes, there are fancy econometric models but they are all built on historical human behaviour patterns. Historical behaviour patterns change as time goes by and this makes prediction difficult. There is a famous quote from economic modeller George Box from some decades ago that ‘all models are wrong but some are useful’.
The Reserve Bank influences human behaviours by interest rates, but there are lags in the system. For example, most house loans are fixed for between one and three years by decisions of the borrowers. Hence, changes in the OCR can take well over a year to have their full effect.
My own opinion is that the Reserve Bank in the last six years has consistently adjusted interest rates with too great a range and been too slow to find the turning points. Ever since COVID they have taken us on a crazy ride. This crazy ride continues.
The Future
I am writing this just days after the arrival of Dr Anna Breman from Sweden as the new Governor of the Reserve Bank. However, Breman has already made it clear in her initial meeting with the parliamentary Finance and Expenditure Committee (FEC) on December 2 that she will be strictly following, “with a laser focus”, the single mandate given by the Government to the Reserve Bank, which is to manage and control inflation.
This idea of a single mandate was traditional in New Zealand from the start of the Reserve Bank’s operational dependence in 1990. However, in 2018 the Labour/NZ First coalition brought in a dual mandate whereby the RBNZ was also responsible for maximising sustainable employment. This second mandate was then removed by the current Government in late 2023.
My reading between the lines is that the new Governor of the Reserve Bank, in explaining her ideas to the parliamentary Finance and Expenditure Committee on December 2, has implied rather strongly that the RBNZ has been distracted from its current single mandate and that this ‘won't happen on her watch’. I happen to agree with her stance.
This laser focus on inflation does not mean that maximising sustainable employment is not critically important. But it does mean that maximising sustainable employment is the role of the Government, using fiscal policies, and not the role of the Reserve Bank, which has a sole focus on monetary policy.
I hope Breman will use the OCR with more skill than her last two predecessors, using both less brake and less accelerator, and identifying turning points at an earlier stage. We need a much smoother OCR journey.
I note that Breman has also indicated that she will be encouraging diversity of thinking in relation to monetary decisions. That is encouraging. There seem to have been elements of groupthink within the present system.
As well as damping down the overuse of the interest rate tool, we have to ask again as to whether there are other tools that can contribute to controlling inflation.
There also needs to be a new discussion as to whether New Zealand should revert to a lower target than the current one to three percent. Why not a range of zero to two percent and a mid-point of one percent, as laid out in the Reserve Bank Act of 1990?
One way or another we need a society where property plus financial leverage is not the main avenue to wealth and where money in the bank does not get destroyed by inflation.
*Keith Woodford was Professor of Farm Management and Agribusiness at Lincoln University for 15 years through to 2015. He is now Principal Consultant at AgriFood Systems Ltd. You can contact him directly here.
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