New Zealand and indeed many parts of the Western World have got themselves in a bind with inflation. To some of us it is puzzling that the central banks did not see that coming. Getting out of the current mess will be painful.
The final precipitating factor that has created the current situation is the specific monetary response to COVID-19, but the underlying flawed thinking was firmly in place prior to that.
For those who think the current inflation is primarily a consequence of logistics constraints rather than monetary policy, I will take up that issue further down. First, we have to understand monetary policy.
In essence, central banks have operated for a long time aligned to the theory that interest rates can be used to stimulate or dampen the economy when, in their opinion, economic demand is unnecessarily constrained.
Supposedly, there are multiple behavioural pathways to explain why this monetary stimulation should work. First, conventional theory has said for a very long time that low interest rates can be used to stimulate productive investment decisions by reducing the cost of debt. There is an obvious logic to that.
Second, low interest rates cause asset capitalisation rates to decline and this can be used to increase asset values. The consequent wealth feeling then encourages economic activity, with people deciding they can afford to spend more.
Standard economic theory recognises that low interest rates have potential to create inflation in consumer prices as well as in asset values. This arises when the demand induced by low interest rates exceeds the supply of goods. When companies are competing for labour, then not only do costs rise, but companies find they can increase their prices. This in turn leads to more wage demands. And so, an inflationary cycle is then in place.
Over the last 30 years, there has been a developing consensus within conventional economic wisdom that rampant inflation and the associated risk of stagflation were historical conditions relating to another time. In particular, an open global economy combined with digital technologies supposedly meant that those conditions were not particularly relevant to the conditions of the 21st century.
Somehow, it also became embedded in economic thinking that modest inflation was actually a good thing. Not only did economic growth tend to precipitate inflation, but supposedly there was reverse causation in that modest inflation could generate ongoing economic growth, well beyond short-term stimulation of economic activity. The evidence for that was always scanty, and arguably non-existent, but the notion took root.
Accordingly, the notion of increasing the money supply through quantitative easing gradually shifted, particularly since the so-called Great Financial Crisis (GFC) of 2008, from unconventional to conventional monetary theory. This paralleled a drift away from the notion that monetary policy was primarily a short-term fix to dampen economic cycles by letting air into and out of the economy, to a long-term pumping of the economy.
Some 18 months ago, I wrote here about the risks of too much quantitative easing. I am sure I was not alone in foreseeing an inflationary outcome that would become embedded in the system, but it was not mainstream thinking.
One of the weaknesses exhibited by economists is that they rely on models that encapsulate a rear vision perspective. The models may be sophisticated but the mathematics therein encapsulate historical behaviours.
When behaviours change, the models no longer work. And that is where we have been for the last 18 months, in large part hidden initially by lags between decisions and outcomes.
A key tipping point with asset inflation occurred when an increasing proportion of savers recognised that interest earned on money in the bank was providing a negative return after inflation. It wasn’t inflation by itself that was crucial, but the relationship between interest rates and inflation.
Many people came to the conclusion that they had to find another home for their savings. I was one of them. The options were the share market, crypto, or houses. And for many people, houses looked like being the least risky alternative.
If the economists had only put away their models and spent more time in the real world, observing and analysing what consumers and investors were actually doing, then they could have viewed the last 18 months with foresight rather than hindsight. Now we have to sort out the mess.
Here in New Zealand the key flaw was not the COVID-19 economic support provided by Government and funded through Treasury bonds. That support was fundamental in keeping society functioning during the COVID-19 crises of 2020 and 2021. The key flaw was the way the Reserve Bank stepped into the picture with monetary policy.
Treasury bonds were the obvious way to fund the fiscal deficit created by the COVID-19 support measures. If those bonds had been left in the market, with lesser amounts purchased from the market by the Reserve Bank, then that would have soaked up some of the plentiful liquidity.
If liquidity had become an issue, as it did for a period during the GFC, then the Reserve Bank could have supplied necessary funding. But alas, the Reserve Bank, with its models designed for another time, swamped the system.
Where has the inflation come from?
There has been a tendency within the current Government to claim that the current inflation is caused by logistical constraints in getting supplies to New Zealand, and that it is therefore transitory. If that were the case then it would be showing up primarily in the ‘tradables’ component of the consumer price index rather than the ‘non-tradables’. But that is not what the data show.
First a reminder of the definition of ‘tradables’ versus ‘non-tradables’.
Tradables are items that can be traded internationally, for which the prices in New Zealand are determined by international prices. Many physical products fit in this category unless they have a very short life. Accordingly, steel, aluminium, meat, butter, cheese, computers and pharmaceuticals are in this category.
In contrast, non-tradables are items that are not easily traded across international borders. Many services are in this category. Restaurant services are one example.
Also, some physical products like houses are essentially non-tradable, although some of the resources from which they are built are tradable. Accordingly, many items have both a tradable and non-tradable component within the CPI. For example, telecommunication services are 18 percent tradable relating to the imported equipment and 82 percent non-tradable relating to the internal servicing cost.
Overall, tradables comprise 40 percent of the CPI and non-tradables comprise 60%.
In early 2021, I wrote here as to how most of New Zealand’s inflation in the last 20 years has been in non-tradables. That means that it was generated primarily through New Zealand’s economic policies rather than a consequence of overseas events.
I reported how for the 20-year period from Quarter 4 (Q4) of 2000 through to Q4 of 2020, the prices of non-tradables increased by 84 percent whereas tradables increased by only 49 percent.
Over a ten-year period from Q4 2010, the non-tradables increased in price by 29 percent whereas the tradables increased by only 14 percent.
Over a five-year period from 2015 through to Q4 2020, the non-tradable inflation totalled 14.2% (average annual inflation of 2.7%) whereas tradable inflation totalled only 0.1 percent in total over the five years - effectively a big zero. Tradable inflation in 2020 was actually negative at minus 0.3 percent.
In 2021 the story has changed somewhat. First, non-tradable inflation over the nine months through to the end of September was 3.7 percent, with year-on-year tradable inflation of 4.5 percent. So internally generated non-tradable inflation has been increasing. That is a direct effect of Reserve Bank monetary policy providing excessive internal stimulation.
The other part of the story is that tradable inflation has also now taken off, increasing by 5.4 percent over the first nine months of 2021 and 5.7 percent year-on year. The three contributors to this are the international prices of products that are imported, plus transport costs, and with both of these mediated by exchange rates.
There is little that New Zealand can do about the tradable inflation that is now arriving. To a large extent, it will be imposed by events elsewhere in the world, where inflation is now at the highest rates in more than 30 years. Transport costs may decline but this will not be enough to change the upward direction.
The key mediating factor will be exchange rates, which themselves are influenced by interest rates. However, the recent decline in the USD relative to the NZD is yet to work its way through the system, so the overall likelihood is for exchange rate issues to drive further increases in import prices in coming months.
That means that non-tradable inflation, which is under the control of monetary policy, will have to be tightly squeezed to bring down the overall inflation rate. Even if the non-tradable inflation were to drop to zero, which would be remarkable, there is going to be considerable imported inflation.
The wicked problem
The current problem is what can be called a wicked problem, meaning that there is no painless solution. If inflation is to be reined in, then interest rates have to rise. That has potential to take the heat out of inflation, but it is also likely to slow down the overall economy. I see storm clouds ahead.
The alternative is to let inflation run. That will simply fuel the desire to get savings out of fiat currency. The options will remain as shares, crypto and housing.
There are two big costs of inflation, both of which become much worse when that inflation exceeds the post-tax interest return on fiat currency; i.e., the return on term deposits.
The first cost is that it distorts investment decisions. When these conditions are in place, the pathway to prosperity travels through leveraged land assets on which the debt is inflated away. Wealth generation arises from capital gain rather than income. This pathway is particularly attractive in New Zealand where, unlike in Britain, the USA, Canada and Australia, most capital gains are not taxed.
The second cost of inflation is that it leads to a transfer of wealth from savers to borrowers. Once on the property ladder, there are seldom any snakes to take one back down the slippery slide. The exceptions are the ultra-leveraged who think the sun never stops shining.
In contrast, those trying to get on the property ladder keep having their feet taken out from under them by savings that depreciate.
I often read how the younger generation need to be taught the rules of compounding and how to use those rules to lift themselves up. Well, those rules no longer apply. Here in New Zealand, for those who lack access to the bank of Mum and Dad, there is no longer a bridge across to the promised land. And there lies the seed, now flourishing greatly, of an increasingly polarised society.
So what is the solution?
Well as I said earlier in this article, all solutions are in the wicked category. People are going to get hurt.
Those who are young and qualified but lack access to the Bank of Mum and Dad will head off elsewhere. Those who are young and unqualified will have to stay and become more bitter.
It won’t be the first diaspora from New Zealand. I was myself part of the early 1980s diaspora in search of challenges elsewhere. It was a mix of push and pull, influenced by New Zealand’s pump-priming economic policies of the time that were destined to fail, but also pulled to some exciting challenges elsewhere.
Twenty years later, when an interesting opportunity to return to New Zealand arose, I had to think very carefully about rejoining an already polarised society with high wealth-earning disparities.
I did come back with my family, influenced by what we considered to be some outstanding compensating factors. But if I were still young, with those disparities now much greater, and if I had no access to a Bank of Mum and Dad, then I would now be heading off.
Putting off the medicine is no solution. We must get inflation below the post-tax interest return on fiat currency. Until then, the disease will simply get worse.
The starting point has to be to drop the target inflation to a range of no more than zero to two percent, or arguably even less. That is where it was set from 1990, then raised to a three percent maximum in 1996.
In 2002, the minimum rate was raised to one percent, implying that some inflation was always good. Thereafter, apart from making a two percent mid-point an explicit medium-term target, the only explicit change was to create a dual mandate with maximum sustainable employment now an additional requirement, albeit with no definition of what that rate might be.
My own preference would be a target range of zero to one percent. We do not need an economy with embedded inflation. Of course, inflation does create wealth for some people, but it is always at the expense of others. It does not create real wealth. And it definitely takes away from those who cannot get on the property ladder.
It is important to note that the target inflation rates are set by the Government and not by the Reserve Bank. The Reserve Bank has indeed played their hand badly over the last 18 months with excessive priming of the pump, but it is the Government that sets the overarching rules.
What will happen now?
There is considerable uncertainty as to what will happen now, in part because the Reserve Bank has a conflicting mandate covering both inflation and employment. How the Reserve Bank deals with that conflicting mandate requires insight into the specific thinking of Reserve Bank Governor Adrian Orr.
Bringing employment levels into the Reserve Bank mandate has conflated the role of monetary and fiscal policy. We need to go back to the old days when the Reserve Bank had a single role of maintaining the value of New Zealand’s fiat currency.
This is not in any way to diminish to importance of maximising employment levels. Every government needs to have a social contract to achieve this. But trying to get there through an inflationary monetary policy is flawed. Fiscal policy combined with infrastructure development where that is appropriate, is the pathway to maximise employment.
The bottom line is that we are indeed in a bind, with much of it self-created both internationally and in New Zealand by economists locked into models that inevitably build from a rear-vision mirror.
Here in New Zealand, it is particularly fortunate that primary industry exports are booming with dairy, lamb, beef, and kiwifruit at the forefront. Log exports to China have also been doing exceptionally well over the last 18 months, although that industry has hit some significant speed wobbles in recent weeks.
Overall, we are now in an environment of great uncertainty. Conventional wisdom from Treasury says that the economy will speed along in 2022. That may or may not happen given that the treasury models inevitably reflect how people used to behave in very different times. The one certainty is that many groups in society will continue to be left behind as inflation does its damage.
There is also very little evidence of productive income-earning investment, with housing having become the only game in town. This follows massive underbuilding during the years of big immigration. Alas, things could get quite rough in the broader economy over coming years, regardless of the medicine that we take.
*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.