Opinion: Inflation hasn’t peaked yet. The financial pain being felt by New Zealand households and businesses is not set to ease anytime soon, and judging by the global outlook, we can expect that pain to get worse.
Recent economic figures are not encouraging, as shown by the consumer price index (CPI) increase by 1.7 percent for the three months ended June, pushing the annual rate from 6.9 percent to 7.3 percent.
Prices across all sectors are increasing. Both tradable (8.7 percent) and non-tradable (6.3 percent) inflation rates are very high.
In a small open economy such as New Zealand, the basket of goods and services consumed by households can be divided into two categories, tradable and non-tradable. Non-tradable items are exposed to a low degree of international competition, and hence non-tradable inflation refers to the increase in prices of goods and services whose prices are largely determined domestically.
Tradable items, however, are much more exposed to international competition, and hence tradable inflation refers to the increase in prices of goods and services we either import for our own consumption or as components in our own manufacturing and exporting processes.
“Working with allies and partners through friend-shoring is an important element of strengthening economic resilience while sustaining the dynamism and productivity growth that comes with economic integration.”
– Janet Yellen, US Treasury
Food prices were 6.6 percent higher in June 2022 compared with June 2021. Rental housing prices increased 4.3 percent and petrol prices increased 32 percent in the year to the June 2022 quarter.
Low-income households in New Zealand need support beyond a minimum wage increase, to keep up with the rapidly accelerating cost of living. This is also true for other countries. In the EU, for example, on average, spending on food, electricity, and gas accounts for around 22 percent of total expenditure of the poorest quintile of households, compared to 15 percent for the highest-income quintile.
A global snapshot of inflation woes
In Australia, over the twelve months to the March 2022 quarter, the CPI rose 5.1 percent. The Australian Bureau of Statistics will release CPI data for Australia’s June quarter next week, and Westpac forecasts inflation to reach 6.1 percent.
In the United Kingdom, the CPI rose by 9.1 percent in the 12 months to May 2022, up from 9.0 percent in April. The Bank of England projects it to increase further to slightly above 11 percent by October.
Inflation has reached 9.1 percent in the United States, while the Euro area faced annual inflation of 8.6 percent in June 2022, up from 8.1 percent in May 2022.
Global inflation forecasts, 2018-23 (OECD)
Inflation is also rising in many developing countries, with some concerning statistics. In Sri Lanka, inflation touched a year-on-year record of 54.6 percent in June. In Argentina, consumer prices rose 64 percent in June from a year earlier. Annual inflation in Turkey surged to 78.62 percent in June.
For balance, it is worth noting the point that inflation is not so high in some other countries. In April 2022, inflation in annual terms in Japan hit 2.5 percent and it stayed at that level in May 2022. China’s inflation rate is lower than in Western countries. In June 2022, the Chinese CPI rose by 2.5 percent year-on-year. Yi Gang, Governor of the People’s Bank of China, emphasises that as long as grain production and energy supply remain stable in China, inflation will be kept within a reasonable range.
The lowest annual inflation rates in the euro area were recorded by Malta (6.1 percent), France (6.5 percent), and Finland (8.1 percent) in June 2022.
How do we get inflation under control?
Many central banks are tightening monetary policy and raising interest rates to combat inflation.
Last week the Reserve Bank's monetary policy committee raised the official cash rate to 2.5 percent from a record low 0.25 percent in October last year. There will be three more OCR announcements in 2022, in August, October and November. If the committee raises the official cash rate by 50 basis points at each meeting, then the OCR will increase to 4 percent in November.
The central bank of Norway raised the policy rate from 0.75 to 1.25 percent in June 2022, the country’s largest single increase since 2002, and announced that a further rate hike to 1.5 percent is likely in August.
The US Federal Reserve, known as the Fed, raised the target range for the federal funds rate by 75 basis points to 1.50 to 1.75 percent. A further rise of 75 basis points is expected next week.
The Bank of England raised its main interest rate from 1 per cent to 1.25 percent in June, and a 50 basis points rise is one of the options for the August meeting. Bank of Canada increased its policy interest rate by 100 basis points in July 2022.
Rising interest rates have the potential of being effective at addressing demand-pull inflation. Rising interest rate will contribute to a slowdown in domestic demand.
The main global problem we face, however, is the ongoing supply disruptions, which are driven by several major events, such as Covid-19 persistence and Russia’s invasion of Ukraine.
Supply chain resilience is key
The war in Ukraine, soon to enter its sixth month, has placed natural gas supply in Europe at risk. Following recent cuts in deliveries, Russian pipeline exports to the European Union are now down roughly 60 percent compared to June 2021.
China’s zero-Covid policy has also created a supply chain shock for the global technology market. Output from China’s integrated circuit industry, which became the world’s largest and fastest-growing before the outbreak of global pandemic, dropped 4.2 percent in the first three months in 2022.
Suggestions to improve global supply chains include boosting domestic production through on-shoring (bringing production back to your own country where it is safe from foreign adversaries) and near-shoring (bringing production back to friendly countries not far from your own country).
In a speech this week, US Treasury Secretary Janet Yellen uses the term friend-shoring, an idea about “deepening relationships and diversifying our supply chains with a greater number of trusted trading partners to lower risks for our economy and theirs”.
New Zealand heavily relies on supply chains. About 90 percent of New Zealand’s building materials and products are imported. Supply chain disruptions cause delays and price increases in construction. Prices for the construction of new dwellings increased 18 percent in the June 2022 quarter compared with the June 2021 quarter. Developing best practices on supply chain resilience will help reduce inflation.
Considering New Zealand’s geographical isolation, it is particularly important that we sign a variety of trade and partnership agreements. India, Japan and Australia formally launched the Supply Chain Resilience Initiative in 2021 to build resilient supply chains and to promote supply chain principles in the region.
New Zealand should actively search for regional supply chain partnerships within the Asia-Pacific region and prioritise the achievable supply chain resilience targets.
Managing public expectations is important
Inflation is strongly affected by the expectations of future inflation, making the management of expectations a crucial part of monetary policy.
In May, the RBNZ released the latest Household Expectations Survey and the Business Survey of Expectations. Households’ future inflation expectations continue to rise, and business forecasters expect the OCR to continue rising over the course of the next 12 months.
Central bank policy communication, such as monetary policy statements, speeches, presentations or interviews with policymakers will be important to manage the household and private sector inflation expectations.
American economist Christopher J Waller, a member of the Federal Reserve Board of Governors, emphasised this point:
“Inflation has to be our focus, every meeting and every day, because the spending and pricing decisions people and businesses make every day depend on their expectations of future inflation, which in turn depend on whether they believe the Fed is sufficiently committed to its inflation target.”
Recent research findings from Germany suggest central banks should communicate with the assumption that distinct information channels are used by different types of households. For example, younger individuals are mostly likely to receive monetary policy-related news if it is covered in social media.
The Reserve Bank has a YouTube site, and although it has created some short videos to explain concepts such as inflation, senior officials as well as economic analysts should be more active communicating the pressing issues regarding both domestic and global inflation.
Although it seems trivial, such an initiative could help the Reserve Bank manage expectations and provide financial and economic literacy to different age groups in New Zealand.
Fiscal policy also matters
Monetary policy and fiscal policy are the two most widely recognised policies for influencing a nation’s economic activity. A government’s choice of spending and taxes is known as fiscal policy, whereas actions taken by the central banks (such as the Reserve Bank of New Zealand) to influence interest rates are known as monetary policy.
It is important to get the right combination of the two policies at a given time, that is, the monetary-fiscal policy mix.
Two great macroeconomists, Thomas J Sargent and Neil Wallace published a very important paper in 1981, with a central message that a central bank may not have the power to determine the long-run rate of inflation without fiscal support.
Good monetary policy requires good fiscal policy and because of that interdependence, price levels are determined by fiscal policy as well as central bank policy.
Higher interest rates reduce demand and lower inflation. This is the reasoning why central banks are hiking interest rates. According to a January 2022 poll, 54 percent of Americans see inflation figures as the best measure of how economy is doing.
The current inflationary surge will not be short-lived. If the significant portion of the New Zealand society also considers the pace of price increases as the best indicator of the economy, then some will suggest expansionary fiscal policies by raising spending to increase the popularity of the Government.
That is a trap. Such populist policies will boost demand and increase inflation.
In the lead-up to the 2023 general election the Government should stay away from populist policies.
To be clear, this does not mean policymakers should stop providing targeted relief for low-income households.
As Waller also states, “high inflation is the biggest challenge to sustaining our employment goal, and the greatest burden for individuals and families, especially lower and moderate-income households that dedicate a larger share of their spending to necessities”.