Brian Fallow: Reserve Bank gets down to the brutal business of stamping out inflation


The Reserve Bank has opted to turn up the volume in its message to businesses setting prices: if you are thinking of raising them, think twice.

Central banks know how to deal with inflation that threatens to become an entrenched, widespread, chronic condition. They have done it before.

The treatment is to drive interest rates up, and asset prices down, so as to drain enough spending power from the economy that firms are deterred from passing on their increased costs, for fear of the damage that would do to their top lines. It is a brutal and indiscriminate business.

Right now, when both businesses and consumers are already distinctly down in the mouth, the question for the Reserve Bank’s monetary policy committee was whether they needed to send that stern message to price- and wage-setters even louder than they already had.

They have decided they do. They have chosen to raise the official cash rate by 50 basis points to 1.5 per cent, calling it a “stitch in time” approach.

Moving the OCR to a more neutral stance sooner than they had foreshadowed in February would reduce the risk of rising inflation expectations, they said, and would give them more flexibility in light of the highly uncertain international environment.

The decision follows Tuesday’s release of the latest quarterly survey of business opinion from the New Zealand Institute of Economic Research, whose inflation indicators were downright menacing.

A net 77 per cent of firms say they expect to raise their selling prices over the next three months.

The survey’s measure of capacity utilisation hit a record high of 97 per cent, indicating very little spare capacity left to meet any increase in demand.

Despite that, firms’ intentions to invest in plant and machinery have weakened — not a surprise, though, when expected profitability has lurched deep into negative territory.

Hiring intentions by contrast have improved, but are liable to be frustrated, with the reported difficulty of finding both skilled and unskilled labour at extreme levels. Labour is now cited as the main factor constraining output.

The monetary policy committee believes that even with the border reopening, in stages, net immigration will increase only slowly, eventually leading to a gradual easing in skill shortages.

Before yesterday’s decision, the Reserve Bank had already engineered a serious tightening of financial conditions, in particular in the most important interest rate curve, that for mortgage rates.

In its February monetary policy statement, when it delivered the third OCR increase of this cycle, the bank foreshadowed an intention to raise it by a further 2.25 or 2.5 percentage points by the end of next year. That would be an exceptionally steep and rapid increase by historical standards.

Even so, the financial markets priced in an even faster increase to an even higher end-point around 4 per cent, well above the bank’s central estimate of a neutral OCR — neither stimulatory nor contractionary — which is around 2 per cent.

The committee said consumer price inflation is expected to peak around 7 per cent in the first half of this year and that the risk of more persistent high inflation expectations has increased.

BNZ’s head of research, Stephen Toplis, argues that the only way interest rate increases can remove the inflationary pulse from the severe supply-side pressures businesses face is to get interest rates so high, so fast that demand is reduced to the level of supply.

“In other words push them so aggressively as to create a major recession soon. We simply do not believe this is warranted.” Toplis said the mortgage interest curve was already high enough to be putting downward pressure on house prices, household wealth, consumer spending and even, at the margin, construction activity. But the increases in mortgage rates are still less than the Reserve Bank has already signalled that it expects to raise its policy rate.

It has nonetheless reined in runaway house price inflation and in the process likely turned off one of the main ways easy money has boosted demand, namely the wealth effect where people spend a few cents in every additional dollar of wealth, even if they have to borrow to do so.

Westpac’s Michael Gordon points out that the REINZ house price index fell for the third month in a row in February.

“This is important as housing is the biggest channel through which monetary policy works to dampen inflation pressures. The sharp rises in mortgage rates in recent months are clearly having their intended impact,” Gordon said.

This can be expected to continue as a large proportion of households’ swollen mortgage debt comes up for an interest rate reset in the year ahead.

“This will, however, take time and patience,” he said. “However what we have seen so far doesn’t point to the RBNZ falling behind the curve.”

Rampant inflation is a global phenomenon. New Zealand is among the majority of advanced economies to have an inflation rate north of 5 per cent and heading higher. Hopefully not as high as the 8.5 per cent just recorded by the United States.

The OECD’s preliminary estimate is that the war in Ukraine will add another 2 percentage points to baseline inflation rates across the advanced economies.

Meanwhile, Covid-related disruptions to supply chains will worsen and China locks down major cities while it persists in its zero-Covid policy in the face of the highly infectious prevailing variant.

In a sobering speech last week, Agustin Carstens, general manager of the Bank for International Settlements, the central banks’ bank, warned that “we may be on the cusp of a new inflationary era”.

“The forces behind high inflation could persist for some time. New pressures are emerging, not least from labour markets as workers look to make up for inflation-induced reductions in real income. And the structural factors which have kept inflation low in recent decades may wane, as globalisation retreats.”

For many years central banks, having conquered inflation, could focus on growth and employment, Carstens said. “But this is no longer possible, since low and stable inflation must remain the priority.”

The new challenge for policymakers generally is to recognise that boosting long-term growth cannot rely on repeated macro-economic stimulus, be it monetary or fiscal. “It can only be achieved through structural policies that strengthen the productive capacity of the economy.”

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