RBNZ chief economist Paul Conway says inflation expectations and price-setting behaviour are ‘critical’ in determining appropriate monetary policy stance

Reserve Bank (RBNZ) chief economist Paul Conway says while near-term inflation pressures have eased as oil prices have fallen, reflecting some progress towards resolution in the Middle East, the conflict has still “delivered another significant inflation shock”.

And the challenge for monetary policy, Conway told the audience at a BusinessNZ event on Tuesday, was to ensure that this doesn’t lead to persistent inflation.

The RBNZ’s six-member Monetary Policy Committee (MPC) raised the Official Cash Rate (OCR) to 2.50% from 2.25% last week. When it came to its decision to increase the OCR, the RBNZ noted that although oil prices have fallen, the effects of the oil shock would linger for some time.

“Future OCR decisions will depend on how incoming data, price-setting behaviour, and the strength of economic activity affect medium-term inflation pressures," the RBNZ noted.

The RBNZ is projecting inflation, as measured by Statistics New Zealand's Consumers Price Index (CPI) to be 3.9% in the June quarter and 3.3% in the current quarter. As of the March quarter, annual inflation was at 3.1%.

The RBNZ is tasked with maintaining inflation between 1% and 3% and it specifically targets 2%.

Conway told the audience understanding how workers and businesses respond to inflation and economic shocks is important in assessing whether “cost shocks fade or become embedded in persistent inflation pressure”.

“When inflation is high, people pay closer attention to it. Research suggests that New Zealand businesses pass on cost increases more readily now than in the past and are less likely to reduce prices when costs ease. All else equal, this raises the risk that temporary shocks becoming persistent inflation.”

Asked why this was the case with businesses, Conway said this was an area where they needed to dig deeper as it was not well explored. 

He said competition in New Zealand could have something to do with it but there was more work to be done in this area.

‘We cannot take anchored inflation expectations for granted’

Conway said monetary policy was about separating signal from noise.

“The signals that matter most can change as the inflation environment changes, so our assessment toolkit must evolve too. When above-target inflation changes expectations and price-setting behaviour, monetary policy may need to respond more firmly to re-anchor inflation expectations.”

Conway said: “There’s nothing monetary policy can do to soften the hit to our national income from higher oil prices. We are collectively worse off but what we can and what we will do is prevent a temporary increase in costs from becoming more generalised inflation."

He said inflation expectations and price-setting behaviour were key to that and critical for determining the appropriate stance of monetary policy.

“The more businesses can pass on higher costs, the more businesses expect inflation to be higher in future, the more persistent inflation becomes, and the harder monetary policy must work to bring it back to target.

“Encouragingly, medium-term inflation expectations remain well anchored, and spare capacity in the economy should help limit pass through, but after several years of above-target inflation, we cannot take anchored inflation expectations for granted.”

RBNZ will respond if inflation pressures are ‘more persistent’

With last week’s OCR decision, the MPC noted that some further reduction in monetary policy stimulus was likely, Conway said.

“We’re not talking about moving to a restrictive stance. We're talking about a calibrated reduction in monetary policy stimulus. Think of it as drifting back to neutral, figuring out where neutral is on the way.”

“But in saying that, we will respond if inflation pressures stemming from the Middle East conflict prove to be relatively more persistent,” he said.

“Because when high inflation expectations become embedded in price-setting behaviour, getting inflation back to target becomes much more difficult and costly.”