Why inflation looks here to stay

NZ Herald
1 February, 2022

Last week’s announcement that inflation is at its highest level in more than 30 years was a shock.

Consumer prices rose by 5.9% last year, the largest increase since June 1990. Petrol and housing contributed the most to the rise. Inflation here is higher than Australia (3.5%), Britain (4.8%) and Europe (5%). The United States is worse at 7%, a 40-year high.

The result sent markets tumbling. The New Zealand dollar fell more than a cent against the US dollar. Shares dropped 1.6%.

Meanwhile, the Reserve Bank, the agency responsible for price stability, was busy with other things. On the same day as the inflation update, it announced the appointment of Karen Silk as a new Assistant Governor.

Silk has had an impressive career as a banking executive. But she has no relevant economics qualifications and no previous experience in central banking or monetary policy. The Reserve Bank Governor, Adrian Orr, noted Silk’s role as co-chair of the Sustainability Council and that she is “steeped in climate change.”

So, on the day we learned inflation is at its worst level in three decades, the Reserve Bank Governor was talking about climate change. Again.

The Reserve Bank has no statutory mandate for climate change. Yet, since Orr’s arrival in 2018, the Reserve Bank has become virtually fixated on the issue. Its most recent annual report has three times more references to climate change than inflation. Last November’s monetary policy statement referred to climate more than 30 times. Despite a 60% increase in staff numbers since 2018, the Bank’s research output has almost come to a standstill. The Bank has developed a habit of giving senior positions to people without relevant skills or experience.

All of this seems to be occurring at the expense of the Reserve Bank’s core business. Particular monetary policy.

The Reserve Bank’s response to COVID has been nothing short of a catastrophe.

Once the scale of the threat from COVID became clear in March 2020, the Reserve Bank responded with “quantitative easing.” It printed money.

Between March 2020 and July 2021, the Bank used its Large-Scale Asset Purchase programme to buy $54 billion of government bonds. It poured tens of billions of dollars into the economy.

The Bank ran the programme for too long. When it finally switched off the printing presses, unemployment had been depressed to record lows, wages and consumer prices soared, and inflation expectations increased. Already-high property prices soared by more than 30 percent in a single year.

The Reserve Bank overcooked the economy, and now inflation is nearly triple the target inflation rate of 2%.

It is not just more money that is driving inflation. Supply chain problems and government spending are contributing, too.

The supply chain will, one hopes, recover as governments wind down their responses to COVID later this year.

The government has spent $62 billion due to COVID. Some of that spending will go into an already-tight economy, adding more fuel to the fire. The government has run large deficits which will double public debt from 20% of GDP before the pandemic to 40% of GDP next year.

Between supply constraints, and the vast stimulus from more money and spending, it is no wonder that inflation has come roaring back after a thirty year absence.

The question now is whether the Reserve Bank will do what it takes to get inflation back under control.

To put a lid on inflation, the Reserve Bank must raise interest rates. Higher interest rates will encourage more saving and raise the cost of borrowing.

If history is any guide, the required correction to interest rates could be brutal.

Back in the 1990s, a newly-independent Reserve Bank had to set interest on overnight cash settlements – roughly today’s Official Cash Rate – well above the inflation rate in order to bring down inflation.

For the decade as a whole, inflation averaged 2% while interest on settlement cash averaged 8%. So it required an interest rate 6% above the inflation rate to achieve price stability.

Today, the Official Cash Rate is 5% below inflation, an unprecedented position since at least 1985 and probably in this country’s history.

This 11% gap – the difference between interest rates 6% above historic inflation versus 5% below current inflation – suggests there is a real possibility that it will take a drastic increase in interest rates to curb inflation. Either that, or inflation is here to stay.

History also tells us that it will take a sharp recession to get rid of inflation. Recessions tend to be unpopular things, so to win the fight over inflation the Reserve Bank will have to stare down popular discontent and unhappy Ministers. The Reserve Bank’s independence will be tested to its limits.

The crucial factor in the Reserve Bank’s favour is that New Zealand still has relatively modest public debt.

Putting up interest rates raises the cost of borrowing for the government. In countries running fiscal deficits and with public debt above 100% of GDP, a higher cost of borrowing is a serious problem. Fighting inflation can lead to financial instability.

Spare a thought for the European Central Bank. For the ECB, inflation is nothing less than an existential threat to the European Union.

Italy, the third-largest economy in the Union, is in trouble. It has public debts worth 156% of GDP, a fiscal deficit equal to 6% of GDP, and government spending a whopping 57% of GDP (for comparison, New Zealand is 44%).

That places the ECB in an impossible position. Raising interest rates to bring down inflation could trigger a run on Italian debt, then default, followed by the break up of the European Union as Italy and other countries exit.

Perhaps that is why the ECB has been so quiet about the need to raise interest rates. The ECB President Christine Lagarde insists inflation is only transitory, a supply chain issue. Let us hope her theory is correct. The future of Europe depends on it.

New Zealand’s debt is at manageable levels, so the Reserve Bank can raise interest rates without worrying about instability. Another reminder, as if any were needed, of the value of fiscal prudence.

Other factors will lean against the Reserve Bank’s efforts to bring down inflation.

High land and house prices will multiply the pain of rising interest rates. Average house prices across the country recently passed $1 million, an incredible figure. The average Auckland home now costs $1.7 million. For anyone with a $1 million mortgage, each 1% rise in interest rates will cost $200 per week. Higher interest rates will send some households and businesses to the wall.

Another problem for the Reserve Bank is credibility. It takes more than just higher interest rates to bring down inflation. To persuade businesses to stop putting up prices each month, they must believe the Bank is serious about stopping inflation.

Two things hurt the credibility of the Bank’s commitment to stop inflation. In 2018, the government gave monetary policy a second job. As well as price stability, the Reserve Bank has to deliver “maximum sustainable employment”.

The problem is that price stability and maximum employment conflict. Raising interest rates to fight inflation tends to cost jobs, at least in the short term. If the Bank must choose between competing goals, that makes it harder for the Bank to look credible on inflation.

The other factor hurting the Reserve Bank’s credibility is that it looks distracted.

Which brings me back to last week’s announcement of the new Assistant Governor. It is hard to look like a hawk on inflation when on the day the country learns inflation has reached historic highs, the central bank is talking about climate change. It is as if the Reserve Bank is going out of its way to signal it is disinterested in core business.

So far, the Bank’s lukewarm actions have matched its words. Since June 2021, annual inflation has leapt by 4.4%. In response, the Bank has raised the OCR by just 0.5%. Even if the Reserve Bank decides inflation is a problem, it will start its battle firmly on the back foot.

Inflation looks here to stay.

Stay in the loop: Subscribe to updates