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The credibility of the Reserve Bank of New Zealand (RBNZ), as well as its counterparts around the world, has taken a hit.
Its failure to maintain price stability has seen it flung into both
the news headlines and the boxing ring that is the political arena.
Conversations around monetary policy are now taking place around the barbecue, not just in the boardroom. The cost of putting food on the barbie is through the roof, as is the cost of borrowing to buy that roof.
This has created a problem for the Government and an opportunity for the Opposition going into an election year.
Of course, we could’ve been in a much worse position if the RBNZ didn’t support the economy in 2020 and 2021. But it’s partly responsible for getting us into this mess.
Will it be able to put inflation back in its box? Can it kill inflation without inflicting too much pain on certain pockets of society?
The slashing of interest rates in response to the pandemic highlighted the fact that the tools at the RBNZ’s disposal can have perverse effects.
As ANZ chief economist Sharon Zollner put it, the OCR is not only a “blunt” instrument but can be “blatantly unfair”.
So, does the Government need to do more to help the RBNZ?
These are the multi-billion-dollar questions. The answers are not clear cut nor apolitical.
Defining the problem is difficult
Part of the reason there’s no easy way out of the pickle we’re in is because it’s difficult to define the problem.
Yes, we face a “cost of living crisis”. Annual consumer inflation came in at 7.2 percent in the September quarter. This was way above the RBNZ’s 1 to 3 percent target range.
There isn’t enough capacity in the economy to absorb all the demand.
The Government and RBNZ introduced policies in response to Covid-19 to encourage people to borrow and spend. Meanwhile, the pandemic constrained supply. Lockdowns, travel restrictions and illness made it difficult to move goods and people around the world.
To make matters much worse, Russia is trying to invade Ukraine. This is further disrupting global trade, pumping up the prices of fuel, grain, and fertilizer.
The difficulty is figuring out how much of New Zealand’s inflation can be put down to these external supply-side shocks versus local demand-side factors, as well as businesses pre-emptively hiking prices and employees asking for pay rises based on their expectations inflation will remain high.
The RBNZ’s best guess is 50:50, but even it admits it’s difficult to untangle all the factors that influence the prices in a “basket of goods”.
Two schools of thought
People who see a lot of inflation coming from excess demand, believe the RBNZ needs to continue aggressively hiking the OCR, as it is.
They recognize asset owners’ wealth increased so much during 2020 and 2021 (on top of the decade before), they can borrow a lot and feel confident spending.
Furthermore, because our lifestyles were so constrained during 2020 and 2021, households’ savings rates hit three-decade highs.
So, there’s a view, shared by the RBNZ and the likes of Zollner, that the central bank has a lot of work to do to unwind the wealth effect that accompanied loose monetary conditions.
The argument is that a lot of people have a fair bit of savings to eat through before they will tighten their belts enough to help cool inflation.
The difficulty is that wealth isn’t evenly distributed. So, while high interest rates will prompt some households to completely slash their spending, others won’t bat an eyelid.
Another school of thought, shared by the likes of BNZ head of research Stephen Toplis, is that the RBNZ has already hiked interest rates enough to quash excess demand in the economy.
We just need to wait for more people to refix their mortgages at higher rates to see the dampening effect come through.
Some of those in this camp put more weight on the supply-side constraints in the economy.
They fear aggressive interest rate hikes will kill growth and create job losses, without actually addressing the root causes of inflation.
There is, of course, a spectrum of views. But people will arrive at solutions based on their definitions of the problem.
A limited toolkit
Here’s the next issue for the RBNZ – the legislation it operates under doesn’t have a caveat that excuses it from keeping prices stable in the event of unforeseen circumstances like war.
While its requirement to meet its inflation target in the “medium term” gives it some wriggle room, there’s a risk (especially in the eyes of the second camp described above) that the RBNZ just keeps hammering away at the economy, even though other tools would help get the job done.
A case for lots of government involvement
This is where the Government comes in.
There’s almost unanimous agreement among economists that the Government could make the RBNZ’s fight against inflation easier by ensuring immigration and tertiary education/training policy settings help plug labor shortages.
But making changes in these spaces is bureaucratic and takes time.
Also, opinion is divided over how far the Government should go, setting policies based on where we are in the economic cycle.
Australian modern monetary theorist and university lecturer Steven Hail takes a particularly strident view, arguing governments could implement price controls and ramp up renewable energy production, so they’re less reliant on fossil fuels from offshore that are a key source of inflation.
He stops short of suggesting governments hike taxes to try to withdraw money from economies, because he’s firmly in the camp that sees a shortage of supply, rather than an excess of demand, as the problem.
Indeed, Hail believes it’s good New Zealand households, which typically don’t save much, have some reserves.
A case for a more balanced approach
Former RBNZ deputy governor Grant Spencer takes a more orthodox view.
He believes governments could help fight inflation by implementing policies that improve competition in sectors dominated by a few big companies.
He also maintains any upward adjustments to income tax brackets (as National is proposing) should only be made once inflation has cooled.
However, more generally, Spencer doesn’t believe governments should fixate on creating policies based on the economic cycle.
Sean Keane of Triple T Consulting, on the other hand, believes income tax thresholds desperately need adjusting for inflation.
But he maintains governments could do more to help central banks, whose policies can impact society beyond their mandate.
Keane recognizes the RBNZ’s efforts to cool the economy will spur job losses, but says failing to tame inflation would leave us with both high inflation and high unemployment.
For example, if a business owner must keep paying more for inputs required to make whatever they sell, they may be forced to reduce production and staff numbers to control cashflows and costs.
While Keane firmly supports central banks’ independence, he believes governments could’ve done more, particularly when the OCR was nearing zero.
This would’ve taken some of the pressure off central banks to “dream up the alphabet soup of unconventional monetary policies that have landed so many of them in trouble”, he says.
The difficulty of governments doing more, and the reason maintaining price stability has been outsourced to independent central banks, is that politicians need votes and are obliged to deliver what they’ve promised.
It’s usually also good for governments to take long-term views that look beyond fluctuations in the economic cycle.
While the Government has been criticized by some for allocating hefty sums of money to health reforms, infrastructure, and climate change, it would’ve been punished by its supporters if it didn’t invest in what it said it would.
Governments can’t of course swim completely against the tide of central banks.
A tantrum thrown by financial markets recently prevented former United Kingdom prime minister Liz Truss from implementing major tax cuts that would have countered the Bank of England’s efforts to cool inflation.
Coming back to the debate over identifying the causes of inflation, even those who believe the RBNZ should do more to cool economic demand acknowledge the pain will be felt more by some than others.
Indeed, Zollner admits the RBNZ taking a sledgehammer to the economy is not only “blunt”, but “blatantly unfair”.
She acknowledges millennials have had a raw deal. Those who did not own property in 2020 and 2021 did not benefit from the RBNZ’s slashing of interest rates boosting home values.
Those who managed to secure large mortgages at the time now face eye-watering repayments.
Meanwhile, those looking to buy a home face an uphill battle, as rising mortgage rates are making cheaper houses less affordable.
The fact monetary policy can affect different groups in society so differently is an issue that’s been on Keane’s mind for some time.
The RBNZ looks at the state of the economy as a whole when it sets the OCR.
It doesn’t have the tools nor the mandate to consider fairness or promote certain types of investment for example.
It’s always the vulnerable who take the hit first.
Looming job losses are what really gets Hail.
He suggests central banks could start restricting bank lending to cool inflation.
He even goes so far as to suggest the Government creates minimum wage jobs to keep those made redundant in work.
But again, the concept of the Government stepping in to soften the edges of monetary policy can be counterproductive and distortionary.
While the Government felt compelled to help ease the pain of inflation, by temporarily reducing fuel taxes and giving low-income earners cash via the Cost of Living Payment, it’s wary support needs to be temporary and targeted enough to avoid exacerbating inflation.
Where does this leave us?
Monetary policy will continue to be political because it involves trade-offs and is affected by politicians’ policymaking.
It’s possible that during this pandemic period, governments have learned that while outsourcing economic problems to central banks is quick and effective, it could cause greater headaches further down the track.
Whether they pick up the mantle to reduce the need for such drastic changes in monetary policy again, is yet to be seen.