Inflation has reached its highest level in 30 years. So how did we get here — and what awaits us?
First: definitions. Inflation describes the general increase in the prices of goods and services in the economy. Everything from food and fuel to health and housing. And the Consumer price index this is how we measure inflation. Every quarter, Stats NZ minions take a field trip to sample the prices of a representative basket of goods and services. The (weighted) average price of the basket of the day is compared to the basket of another moment. A positive change means a rise in prices – inflation. A negative change means lower prices – deflation.
The story of inflation in New Zealand over the past 50 years resembles a trilogy. And it starts in the 1970s. The 70s will be remembered for its flared jeans, high-heeled boots and even higher prices. Inflation averaged 11.5% between 1970 and 1980, largely supported by soaring oil prices. OPEC-sanctioned oil embargoes have seen oil prices more than quadruple. And as an economy heavily dependent on imported oil, New Zealand’s consumer prices have risen at the same pace. Inflation peaked at 18.4% in 1980.
In an attempt to control the upward spiral in prices, Prime Minister Robert Muldoon introduced a wage and price freeze in 1982. The policy certainly did the job and inflation fell below 5%. But the freeze was hugely unpopular. Profit margins were squeezed with sticky prices and workers wanted to take home more bacon. In 1984 the new Labor government was introduced and the policy freeze was lifted. But inflation returned to the highs of the 1970s. As many had feared and warned, the policy had simply suppressed inflation, not banished it.
Across the street, the Reserve Bank of New Zealand was also working hard to rein in inflation. And in the 1990s, all eyes were on our island nation. The RBNZ had introduced a revolutionary approach to monetary policy known as “inflation targeting” – later adopted by central banks around the world. Initially, the target band was set between 0 and 2%. Soon after, inflation was successfully brought under control. And the credibility of the RBNZ in fighting inflation has been established.
Over time, adjustments have been made to the definition of the target. Eventually, a target range of 1-3% with an emphasis on the 2% midpoint was decided. And in 2018, an additional policy objective was added to the RBNZ mandate: to support as many sustainable jobs as possible. But the 2018 amendment was just a formality. Employment has always been taken into account when defining monetary policy. And that’s thanks to the work of pioneering New Zealand economist, Bill Phillips. The Phillips curve describes the inverse relationship between unemployment and wages. In other words, when unemployment is low, wages tend to rise. And rising wages put upward pressure on costs, which businesses pass on to consumers through higher prices, creating inflation. Central bankers have used the Phillips curve to predict inflation and set monetary policy accordingly. To curb inflation, central banks would raise interest rates. To generate inflation, central banks would lower interest rates.
The GFC and post-GFC
In the post-inflation targeting era, prices have held up well, with inflation averaging around 2%. But the second part of New Zealand’s inflation saga was relatively brief, cut short by the global financial crisis. Financial markets were in disarray and economies were under significant pressure. Inflation in New Zealand peaked at 5.1% with sharp increases in the price of petrol, food and cigarettes. The unemployment rate rose sharply from 3.4% in 2007 to 6.2% at the end of 2010. The RBNZ cut the cash rate in response. In the space of just nine months, the cash rate fell from 8% to 2.5%. Inflation fell below 2%. But even as the economy recovered and the unemployment rate fell to 4%, inflation remained mysteriously low. Part III saw the Phillips curve inverted in New Zealand and textbooks thrown out the window.
After the GFC, inflation had remained consistently below target, averaging 1.5%. Several theories have emerged in an attempt to explain this economic conundrum. One theory points to globalization and the influx of imports of cheap manufactured goods from emerging economies. Another to aging populations and the global savings glut. Technological advancement is also to blame: a TV today with “smart” technology selling for the same price as last year’s version is deflationary. These developments exerted downward pressure on prices. But with interest rates pushed to historic lows, central banks had little room to cut rates further to generate inflation.
The Return of the Beast
At the turn of the decade came the Covid-19 pandemic. And a new chapter in our inflation story begins, but one that sounds familiar. Because just like bell bottoms and waders, 1970s inflation is back. At 6%, inflation is at its fastest pace in 30 years. And there are several reasons for this.
First, base effects are in play. The 2020 lockdown has depressed demand, especially for oil, as economies have been turned off. The New Zealand economy even experienced a period of deflation. But in 2021, the recovery took hold and demand rebounded strongly. The annual percentage changes are therefore slightly exaggerated given that prices started at a low “base”. But we can’t hide behind math forever. Especially since inflation is expected to remain high for some time.
High imported inflation explains the initial peak in headline inflation. The price of oil has rebounded and Covid-related restrictions have disrupted supply chains. Shipping costs have skyrocketed and there have been considerable delays in sourcing goods overseas. Overall, it has become more expensive to move goods from ports to stores. But this cost pressure comes at a time when demand has been surprisingly strong. Job security has been well supported by fiscal policy. Easy monetary policy has made money cheap. And a closed border has left many households with cash in the travel jar. Spending on everything from swimming pools to pets was not lacking in demand. But a shortage of supply and resilient demand is a powerful cocktail for higher prices.
Inflation has yet to peak, with imported inflation continuing to rise. The omicron outbreak is adding pressure to already strained supply chains. Russia’s invasion of Ukraine has pushed up commodity prices, with global oil prices up 60% year-to-date. And a weaker New Zealand currency offers little compensation. An inflation rate starting with a 7 seems more likely every day.
But cost inflation should eventually run out of steam – although predicting exactly when is nothing short of a guessing game. What is more concerning is the dynamics of domestic inflation, as domestically generated inflation is more difficult to control. We have already seen non-tradable (domestic) inflation hit its highest level on record. And that’s three-fifths of all items in the CPI basket. So it’s not just about used cars and fruits and vegetables with more expensive price tags. The New Zealand economy is enjoying a rapid recovery and is now exceeding its potential. Demand continues to outstrip supply and this imbalance pushes prices up.
The job market is no exception. A capacity-constrained economy pushed the unemployment rate to 3.2%, a new record high. The pool of available talent is rapidly evaporating. Employers must pay to attract and retain workers. Wages are expected to rise, which means higher costs for businesses and therefore higher consumer prices. The triggering of this price-wage spiral risks making transitory price peaks more persistent.
Another concern is rising inflation expectations, as these have the potential to be self-fulfilling. If businesses and households expect prices to rise, which would erode expected profit margins and the purchasing power of a hard-earned dollar, then prices and wages should adjust now. Over the past decade, medium-term expectations have remained relatively well anchored at the target midpoint of 2%. But five-year expectations have since risen to 2.3%. The recent upward slide certainly calls into question the credibility of the RBNZ when it comes to fighting inflation.
Is inflation bad?
Reading this far, it might seem like inflation is the big bad bogeyman that needs to stay hidden. But high inflation can be a good thing. Especially coming out of a recession. It signals a strong and growing economy. What we don’t want is the bogeyman of inflation spending too much time outside the closet. High inflation for an extended period is what concerns us. Especially when wage growth does not follow the rise in the cost of living. At 2.8%, wages are progressing at a snail’s pace and households are seeing their real incomes erode. And low-income or fixed-income households are disproportionately affected, as food and fuel typically take up a larger share of the household budget for low-income households. And inflation hurts those who don’t have as much leeway.
Can we tame the beast again?
With the threat of inflation lingering, the RBNZ began to scale back the monetary stimulus it injected at the start of the pandemic. Last October, the RBNZ raised the policy rate for the first time in seven years. The cash rate was increased two more times in successive moves to 1%. And we still see eight hikes underway to reach 2.5% by the end of the year and 3% in 2023. The RBNZ has a lot of work to do to contain inflation and better balance the economy.
A rising cash rate means that interest rates in the economy have risen further. The days of a two-year fixed mortgage rate of 2% are long in the rear-view mirror, and a rate close to 6% is inevitable. Tighter monetary conditions should pull the brakes on economic activity – particularly in the housing market – and ease inflationary pressures. But only time will tell if we can tame the beast of inflation again.