Although the Reserve Bank is caught between a rock and a hard place, its priority should be not making things worse, Brian Fallow says

By Brian Fallow*

The May monetary policy statement's signals come to us through the fog of war. 

Its forecasts, and forward guidance, should be read as accompanied by; “At least that’s our best guess, but at this stage who knows?” 

The key uncertainty, of course, is how long the Strait of Hormuz will remain closed and therefore how close we are to moving from what is so far a price shock to physical shortages of transport fuels.  

And in that case, how much will access to the inadequate supply be determined by official rationing and how much by the brute force of price and capacity to pay? 

In the mean time as the Reserve Bank nervously watches for signs that the current oil price shock, which it can do nothing about, will lead to persistent, sticky inflation in a year or two, which it would try to pre-empt, there are a couple of dynamics to focus on. 

One is the risk of a wage-price spiral, as employees seek relief from the cut to their real incomes from higher prices at the pump, and eventually for everything that moves, and employers raise their prices to fund the pay increases. 

The risk of that is lower than it would have been in more prosperous times.  

The unemployment rate is already, as of March, at a 10-year high. NZIER’s quarterly survey of business opinion found a net 17 per cent of firms reporting a reduction in staff numbers in the March quarter. 

As for wages, Statistics New Zealand’s quarterly employment survey found average weekly earnings rose 3.1 per cent in the year to March, a year in which businesses were expecting a recovery. But the consumers price index (CPI) also rose 3.1 per cent over the same period, so zero real growth in the average wage. 

It does not look like the sort of labour market where employees will find it easy to get higher wages from employers looking glumly at mounting fuel costs and a highly uncertain outlook generally.  

But if the timing of this oil shock has been fortunate in that respect, alt least from the Reserve Bank’s point of view, it is very unfortunate in the other key dynamic: inflation expectations. 

That is because our record for price stability over the past few years has been pretty bad. In the six years since Covid reached our shores the CPI has risen at a compound annual growth rate of 4.1 per cent. For only one of those six years has it been in the 1 per cent to 3 per cent target range. 

And now there is this new price shock, whose height and length are highly uncertain. 

"Currently, core inflation, wage growth, and medium- to long-term inflation expectations remain consistent with inflation returning to the 2-percent target mid-point over the medium term," the Monetary Policy Statement asserts.

But the surveys of inflation expectations have given mixed results lately. 

The Reserve Bank’s own survey of forecasters was pretty sanguine, perhaps recognizing that the expected falls in private consumption and in business investment and hiring are disinflationary influences, offsetting the impact of oil prices to some degree. Their average pick was 3.41 per cent one year ahead, falling to 2.53 per cent two years out. 

But when the bank surveyed households a month ago it was a different story. Their average expectation for inflation a year from now has jumped to 5.6 per cent, easing only slightly to 4.9 per cent in two years. 

In the end neither forecasters nor consumers set prices, though their expectations might influence businesses, which do. 

ANZ’s April survey of businesses found their average expectation for the inflation rate had jumped to 3.8 per cent in a year's time, from 3.08% in March. But their expectations for wage increases have fallen to 2.53 per cent from 2.74 per cent in March. 

“Overall the inflation news in the survey for the Reserve Bank was about as benign as they could reasonably hope,” ANZ chief economist Sharon Zollner said. 

“It’s early days, of course, but constrained wage-setting intentions and steady pricing intentions provide a small degree of reassurance in the face of rising cost and inflation expectations.” 

The American economist Brad DeLong, in some recent advice to the Federal Reserve, said; “Once expectations un-anchor, the cost of re-anchoring is very high indeed.” 

But he immediately added that a central bank, by raising short-term interest rates, cannot produce more oil or stabilise shipping lanes.

“It can, however, take an already contractionary real income shock and turn it into a full-blown recession," DeLong said.

*Brian Fallow is a former long serving economics editor at The NZ Herald.