Is the Reserve Bank in danger of being caught between a rock and a hard place in its inflation fight?
I pose this question because of the Reserve Bank's apparent determination to see the life squeezed out of stubbornly high non-tradeable domestic inflation, and its new political masters' reverting the central bank's monetary policy to just inflation targeting.
This government move ramps up pressure and expectation on the Reserve Bank to force inflation back below 3% at a time when key inflation drivers may not be things the Reserve Bank's actions can really influence.
Both the Government and Reserve Bank's determination to win the inflation war are welcome. The high inflation of the past couple of years has been a salutary reminder of the harm it can cause.
The questions now, however, are; at what cost and just how dogmatic should our policymakers be in their inflation fight, and is the Reserve Bank maintaining the Official Cash Rate (OCR) at 5.50%, or increasing it, really the way to rein in that non-tradeable inflation?
The OCR was lifted from just 0.25% in October 2021, with monetary policy having been kept too loose for too long by the Reserve Bank's own admission, reaching its current level in May 2023. This has resulted in a startling spike in interest rates for both home loan and business borrowers. The weighted average yield on the total of all business loans with registered banks rose to 7.86% from 3.36% in the two years to November 2023, Reserve Bank figures show. The weighted average for home loans rose to 5.72% from 2.86%.
Over the year to December 2023, households faced a 31% increase in interest costs, according to Statistics NZ, and the annual interest bill for NZ's mortgage holders rose 47.5% to $17.694 billion.
Add on the high prices experienced for the likes of food over the past couple of years, where annual inflation peaked at 12.5% in mid-2023, and times have certainly got quite a bit tougher for many New Zealanders.
Meanwhile, the latest Reserve Bank forecast has unemployment reaching 5.2% by June 2025, up from 3.9% as of the September 2023 quarter.
Tradeable v non-tradeable inflation
The latest Statistics NZ Consumers Price Index (CPI), remember, had annual inflation at 4.7% in the December quarter. Breaking that down, tradeable inflation, featuring imported goods such as petrol, was down to 3%, with domestic non-tradeable inflation at 5.9%.
In a speech last month Reserve Bank Chief Economist Paul Conway noted annual non-tradeable inflation came in higher than the 5.7% expected by the Reserve Bank.
"To sum up, monetary policy is working, with the economy slowing and inflation falling. But we still have a way to go to get inflation back to the target midpoint [2%]. We will have much more to say on this in the February [Monetary Policy] Statement, which will be based on an assessment of all incoming data," Conway said.
That Monetary Policy Statement is due on February 28.
Questions raised
BNZ Head of Research Stephen Toplis raised some serious questions about the Reserve Bank's battle with non-tradeable inflation last week.
Given the drivers of non-tradeables inflation, "it's highly unlikely monetary policy will be able to get it anywhere near 2% in the foreseeable future," Toplis said. Over the past year Toplis noted the major contributions have come from cigarettes and tobacco, property rates and related services, household energy, out-patient services, hospital services, education and insurance.
Whilst the Reserve Bank maintains its modelling shows non-tradeables inflation is interest sensitive, Toplis argues while this may have been so in the past, a significant amount of today’s inflationary pressure is not.
That's because the key drivers of non-tradeable inflation are local and central government charges, New Zealand’s infrastructure deficit, the impact of climate change and, rising insurance premiums following natural disasters. Add to that population growth, with net migration growth at record highs, and its impact on housing and local government costs.
"Monetary policy will not quickly address global warming issues - It won’t improve the weather. It won’t fix Wellington's, or anyone else’s, water problems. It won’t curtail population growth," Toplis said.
The central bank can warn government about its policy impacts on inflation, but it can’t direct policy.
"The Reserve Bank’s actions can do little in this space but act as a barrier to second-round effects."
Toplis went as far as saying he hadn't yet heard a good argument proving 2%, the mid-point of the Reserve Bank's 1% to 3% inflation target band, is the optimal number.
A second bank economist, Kiwibank's Chief Economist Jarrod Kerr, also recently queried the ongoing feasibility of the 2% target. Speaking in interest.co.nz's Of Interest Podcast, Kerr said more extreme weather events, moves to decarbonise the economy, improving insufficient infrastructure, wars and geo-political tensions are all inflationary.
"If we do wake up in a few years time and realise keeping inflation between 1% and 3% in a world where climate events and the transition to different energy sources proves to be quite inflationary and quite persistent, then the argument will move from getting inflation back down to 2% and averaging it there, so maybe we soften that stance a little bit and allow inflation to run slightly higher. From the Reserve Bank's point of view, I could imagine that they could relax it from say 2% to 2.5%, maybe as high as 3%," Kerr said.
Little option but to dig its toes in
This, however, doesn't appear to be on the Reserve Bank's agenda. Governor Adrian Orr is set to make a speech on February 16 when, among other things, he'll discuss; "why - despite these challenging years - we continue to believe that a flexible inflation target centred on 2% still makes sense."
Speaking in Interest.co.nz's Of Interest Podcast in December, Orr said monetary policy was an important part of why inflation was declining, but supported the view of having "some humility around what monetary policy can or can't achieve." He also acknowledged profit-led inflation had played a role in NZ's high inflation.
However, it appears we should expect a strong defence of 2% inflation targeting on February 16.
Orr's new political masters, heavily critical of him and the Reserve Bank's performance over recent years when in opposition, have made much of changing the central bank's monetary policy mandate to remove any questions that inflation targeting is its game.
On December 13 new Finance Minister Nicola Willis trumpeted the removal of the requirement to support maximum sustainable employment from the Reserve Bank's monetary policy remit, which was added by her predecessor Grant Robertson in 2018.
"With no hierarchy of objectives, the introduction of a dual mandate heightened the risk of a future policy error – with monetary policy led in multiple directions, even as inflation embedded itself in the economy," Willis said.
“Risking higher inflation in the pursuit of unsustainably high employment, just creates the conditions for a more severe hike in interest rates later on to bring inflation back under control."
And after the release of the latest CPI data Willis said; "our government understands that inflation is the thief that erodes the real values of people's incomes and savings. We are focused on removing excessive inflation from our economy and won't be satisfied until we have."
So we have a government that's talking tough about fighting inflation. Whilst that's welcome, putting too many eggs in the Reserve Bank's inflation targeting basket may not be. I'm not calling the removal of support for maximum sustainable employment a mistake. Rather, as Toplis and Kerr have argued, and Orr has acknowledged, monetary policy has its limits.
Who will be monetary policy's mates?
With the Reserve Bank's sole monetary policy focus on price stability, we've now moved back to the regime established under the Labour government in the 1980s when it outsourced monetary policy to the Reserve Bank. This followed the domineering rein of National's dual Prime Minister and Finance Minister, Rob Muldoon.
Is this a case of back to the future, with NZ recommitting to a 1980s-era monetary policy recipe, assuming it's still the best approach in the 2020s?
As Toplis explained, some of the inflationary challenges we're facing - think council rates, insurance premiums, rents and energy costs - are unlikely to be affected much by the Reserve Bank increasing or lowering the OCR.
There's an old saying that monetary policy needs mates. And if we're to tackle the key causes of our current non-tradeable inflation, it seems likely monetary policy will require some long-term mates.
And the key one probably needs to be the Government. Tackling some of our problems, think housing, decarbonisation and infrastructure, requires investment and long-term thinking. This may even require flexible thinking on how we target inflation and the inflation level we're prepared to live with.
Being clear and honest about the sources of inflation, and having an open mind to potential solutions in a world of overlapping emergencies as German economist Isabella Weber puts it, could be useful.
The Coalition Government is still in its infancy. It remains to be seen to what extent it's prepared to allow the use of government funding tools such as bond issuance to help fund NZ's key long-term challenges, remembering it can borrow money cheaper than local government and the private sector. And to what extent it's prepared to assist with the facilitation of workers and resources to tackle those challenges.
Good starts from the Government could be moving NZ away from its ad hoc immigration policy, disconnected from other public policy settings, to a long-term policy on immigration to help with housing and other infrastructure that benefits from long-term planning. And developing long-term funding, alongside local government, to tackle inadequate infrastructure and address climate resilience, might also be useful.
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