An inflation primer

Dr Eric Crampton
27 September, 2022

Hard times make for bad thinking.

Inflation has been running at 7.3%, or at 7.8% if you remember how the petrol excise holiday works. That’s more than double the top of the RBNZ’s target band.

There’s been a lot of woeful thinking about inflation and how to rein it in. The government’s blamed the supermarkets. Unions blame high profits. And some blame wage increases.

Getting it back under control is not likely to be painless. Unfortunately, from where we are, no painless paths are obvious.

When economists point to the higher unemployment rates likely to result from getting inflation back on track, it isn’t because they like unemployment. Unemployment causes misery. But failing to get inflation back on track will also result in higher unemployment than we have now, plus all the harms of higher inflation.

An inflation primer may be in order.

The Reserve Bank’s Remit requires that it maintain future annual inflation between one and three precent over the medium term, focusing on the two percent midpoint of the band. At the same time, the Bank is instructed to consider employment levels relative to their maximum sustainable levels.

The Bank’s mandate isn’t about the current inflation rate, though the current inflation rate can suggest that the Bank made errors in the past. It’s about inflation rates going forward. Monetary policy takes a long time to feed through into the real economy. Decisions made by the Bank today can have immediate effects on expectations. But investment and employment effects will not be obvious until next year.

So monetary policy winds up targeting what the Bank thinks inflation will be in the future, and its inflation forecast will depend on where the Bank thinks employment will be relative to its maximum sustainable rate. If the forecasts suggest that inflation will wind up being too high over the next few years, then the Bank adjusts monetary policy to put forecast inflation back on track.

All going well, there is no conflict at all between the Bank’s inflation target, and the Bank’s consideration of maximum sustainable employment.

No perfect central bank exists, but if monetary policy could be set perfectly, unemployment rates would have nothing to do with monetary policy. Unemployment would instead be determined by everything other than monetary policy: structural change in the economy, ease of mobility from places with fewer jobs to places with more jobs, levels and duration of unemployment benefits, retraining opportunities and more. Not monetary policy.

Suppose that the Bank erred, sent far too much money out into the economy, and did not reverse course quickly enough – the simplest short explanation of what happened in 2020 and 2021.

Whoever first received that hot money would use it to buy goods and services.

Businesses would start seeing their inventories run down because demand for their goods went up. So they would do two things. They would increase the price they charge for goods to ration what goods they had until they could increase production. And they would start buying more inputs.

That’s one reason why business profits increase before wages increase in this kind of process. Increased profits are the signal that tells businesses to expand. When they start expanding, they increase their demand for labour.

Businesses competing for workers bid up wages. But until that happens, workers are effectively trading at a discount. Prices for businesses’ products go up first. That also means that workers’ wages, measured against the value of outputs and against the prices of things that they purchase, have gone down.

The first phase of the inflationary push sees real wages go down, even if nominal wages have started to rise. Because workers are cheap, relative to the value of output, firms want to hire even more.

And here we start seeing what maximum sustainable employment means. Employment levels, during this early phase, are not sustainable unless inflation continues to increase. In the same way that you or I might buy more of anything we like when it’s on sale, and more than we would normally purchase, firms want to hire more workers than they otherwise would when inflation pushes real wages down.

It isn’t sustainable in a very obvious sense: labour demand is only as high as it is because prices for firms’ outputs rose more quickly than wages. But firms are competing for workers and want more of them when wages are low relative to the prices they can receive for their products. That competition pushes workers’ wages up.

Once wages catch up, then labour is no longer on sale. Companies that had wanted to do lots of hiring when workers were effectively on special stop wanting to staff up and some even contract. Employment rates go down again – even if the Reserve Bank has done nothing to tighten monetary policy.

And that’s the spot the Reserve Bank has gotten us into. Monetary policy errors driven by incorrect forecasts back in 2020, followed by failures in correcting the errors quickly enough, mean we now have an awful mess to get out of. All paths out are painful.

If the Reserve Bank declared that its new inflation target were 7.8% forever, we would still wind up with higher unemployment rates than we have now. Everyone would work higher inflation expectations into their wage bargaining and real wages would come back up – reducing employers’ demand for workers.

But we would be stuck with the costs of high inflation forever.

And the only way of using monetary policy to maintain the levels of employment enjoyed during that first phase would be by pushing inflation ever higher, so workers keep being surprised that their real wages are lower than they had expected. That is obviously even worse. And it is unsustainable in a different way – that path winds up in economic collapse.

The story is obviously constrained by the limits of a short column and misses out a lot of the complexity you’d find in a decent macroeconomics course. But when economists point to employment rates being unsustainably high, it isn’t because they like unemployment or want to cause misery. It would be wonderful if policymakers could find ways of increasing the maximum sustainable employment rate. But monetary policy isn’t the way to do it.

Getting inflation back within bounds will be costly. But alternatives are worse.

A few simple lessons then.

High profits don’t cause inflation, but they can be a temporary consequence of it. Those increased profits aren’t a bad thing. They signal which sectors should be expanding relative to others.

Wage increases don’t cause inflation either. And they aren’t something to lament. Reduced real wages have their own harms – that’s the essence of current cost of living pressures. But central banks can infer things about inflation expectations from wage settlements and those expectations can matter when targeting inflation.

Supermarkets causing inflation is right out.

The Reserve Bank targets its inflation forecast and forecasting in April 2020 was far from simple. Covid provided a complicated mix of shocks.

But I’m not sure that forecasting in September 2022 is a whole lot easier.

The consequences of Europe’s massive rise in energy prices will be large and hard to predict. It will affect European demand for New Zealand’s goods and Europe’s ability to supply parts and materials critical for many New Zealand firms.

Let’s hope that the Reserve Bank can maintain a sharp focus on monetary policy, its one big job, during the difficult forecasting times ahead. Hard times will be even worse if they can’t.

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