Returning inflation to target could be made more difficult if businesses and workers try to push up their real profit margins and real wages, the Reserve Bank’s Chief Economist says.
Speaking at the KangaNews-ANZ Capital Markets Forum on Thursday afternoon, Paul Conway said inflation was “high and widespread” because strong demand had outstripped supply.
“Businesses passed on higher costs and workers sought higher pay to compensate for higher prices. Fiscal and monetary responses to the pandemic supported demand while health measures and other shocks reduced the supply of labour and products,” he said.
Monetary policy was working to lower inflation but would need to be more contractionary for longer if businesses and workers continued to chase higher prices and wages.
“We remain deeply committed in our work of bringing inflation down and keeping it low and stable in future. Quite simply, that’s our job”.
Conway said high inflation created economic costs and distortions, such as making it more difficult to see price changes and increasing the likelihood of poor decisions being made.
“People devote more time and effort to minimising inflation risks, rather than more productive endeavours. Overall, inflation leads to misallocated resources and lower living standards. Less wealthy and less financially sophisticated people are more likely to lose out.”
Spreading inflation
In 2021, inflation increased mainly because of a relatively small number of large price increases in a few specific products. But in 2022, there were small price increases across a large number of products as inflation spread throughout the economy, Conway said.
Businesses were trying to pass on higher input costs and workers were leveraging a tight labour market to negotiate higher pay and maintain their spending power.
“These second-round effects create ongoing inflation, even after the original stimulus – a relative price shock for specific products like petrol or plasterboard – has died away”.
Inflation can also spread through the economy because it is easier for firms to increase prices when other firms are. Customers may not question price increases when there is inflation in the economy.
Expectations matter
How high interest rates have to go depends on how “realistic and pragmatic New Zealanders” are in accepting they are worse off because of the pandemic, war in Ukraine, and recent storms, he said.
Quoting RBNZ Governor Adrian Orr, Conway said “the people of planet earth are poorer because of the pandemic and war”.
If businesses and workers try to push profit margins and real wages to where they would have been, then inflationary pressures will linger for longer and deepen an eventual recession.
He said it was unclear whether inflation expectations were falling fast enough to mean Official Cash Rate forecasts were sufficiently disinflationary.
US Fed meeting
Earlier Thursday, the US Federal Reserve went ahead with a 25 basis point increase to its Federal Funds Rate – now between 4.75% and 5% – despite trouble in the US and Swiss banking sectors.
While undeterred from tightening monetary policy, the US central bank said; “some additional policy firming may be appropriate” to tame inflation, which was softer than its usual line about “ongoing increases” to rates.
At the press conference, Fed Chair Jerome Powell said the committee had considered a pause due to the banking crises but decided its impact was still unknown.
“Before the recent events, we were clearly on track to continue with ongoing rate hikes. In fact, as of a couple of weeks ago it looked like we’d have to raise rates over the course of the year more than we’d expected [at the December meeting]”.
Credit conditions have tightened following the collapse of Silicon Valley Bank, he said, but whether it was equivalent to an entire rate hike wasn’t clear.
The uncertainty in the banking sector was likely to make an economic ‘soft landing’ more difficult, but not impossible.
“I do still think that there is a pathway to that. I think that pathway still exists and we are certainly trying to find it,” Powell told reporters.
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