Opinion: At 2pm the Reserve Bank of New Zealand will decide whether to raise the official cash rate (OCR) and by how much.
The OCR sets the cost of borrowing across the economy, and media coverage of the OCR usually focuses on home loan rates. But the cost of borrowing also influences who has a job, and the kind of wage growth workers are likely to see as we deal with the cost-of-living crisis.
The theory goes that as unemployment gets closer to zero, competition for scarce goods and services pushes up their prices, causing inflation to rise. This relationship, expressed by the Phillips Curve (posited by NZ economist Bill Phillips in the 1950s), is now undergoing a radical rethink as our labour market changes.
Unemployment and inflation
The unemployment rate is 3.3 percent, about as low as it’s been in the past three decades, while the Labour Cost Index – the most accurate measure of wage growth – has now risen to 3.4 percent (it normally sits at 1-2 percent). Wage growth tends to lag behind unemployment data, so this is likely to rise a bit in the next six to 12 months.
At 7.3 percent, the consumer price index – which measures increases in the cost of living – suggests prices are rising twice as fast as wages. While 26 percent of workers got a pay rise over 5 percent in the past 12 months, almost a million workers (34 percent) got no pay rise whatsoever.
The Reserve Bank’s job is to prevent prices from rising too much (to “maintain price stability”), hiking the cost of borrowing to reduce demand for goods and services. Raising interest rates increases the cost of commercial lending for businesses, making it more expensive to maintain existing jobs and create new ones.
In short, this means throwing people out of work to increase competition in the labour market, so businesses no longer have to offer better wages and conditions to attract new staff. The people thrown out of work are almost invariably in low-income, insecure jobs, meaning new costs for the state covering unemployment benefits.
There is now an almost universal consensus that rates will rise, and if the past couple of months are anything to go by, we are looking at another 50bps increase to 3 percent. Over the past 10 months the Reserve Bank has already raised interest rates from 0.25 percent to 2.5 percent – the fastest increase in its history.
In May the Reserve Bank suggested the rate was likely to peak at 3.9 percent next year, although this morning ANZ suggested it could rise to 4.5 percent. And, while much of our economic commentary comes from banks, it’s important to remember that they are not exactly dispassionate actors here and that rising interest rates bolster their profit margins.
Using the OCR to control inflation is called “inflation targeting” and is now standard practice for most central banks around the world. Aotearoa is a particularly important place in central bank folklore, not just because of Phillips, but also because we pioneered the inflation targeting approach in the Reserve Bank Act 1989.
In 2018 the Reserve Bank’s remit was altered, to balance price stability with “maximum sustainable employment”. In practice, what this has meant is that the Bank now enables unemployment to drop down lower before it yanks the interest rate chain, but now it yanks even harder to choke off wage growth. We may already seeing this start to happen, with unemployment rising slightly in the latest labour market data, although it’s unclear whether we can attribute this to rates hikes or just ongoing labour market churn.
Is inflation targeting still relevant?
Recent research from the US Federal Reserve (the US central bank) suggests the limits of this approach. In the provocatively titled paper “Who Killed the Phillips Curve? A Murder Mystery”, the authors suggest that changes in the bargaining power of organised labour have led to a breakdown in the relationship between unemployment and inflation.
In typically verbose economic language, they argue that organised workers are able to bargain bigger wage increases which businesses then pass on to their customers in the form of rising prices. Economists often refer to this situation as “wage price spiral”, where wages and prices feedback into one another, causing an upwards spiral.
In the short term, we could look at wiping Ministry of Social Development debt, expanding insulation initiatives in low-decile communities, and expanding access to public services – all of these would help to alleviate the cost-of-living crisis for our most vulnerable people
New Zealand should be a textbook example of the death of the Phillips Curve. From the beginning of the inflation targeting regime (which, incidentally, was bedded in at the same time as the Employment Contracts Act 1991) union density has declined from over 50 percent to under 20 percent of the workforce today.
A 2019 Reserve Bank report has also highlighted the “flattening” of the Phillips Curve, but doesn’t look at changes in bargaining power as a justification. The kind of stunted wage growth we’re seeing today, while crucial for workers trying to make ends meet, can’t alone be responsible for the inflation we’re seeing.
Central bankers tell themselves that inflation-targeting has been responsible for low and stable inflation over the past 30 years, but the explosion of international trade over that same period that has integrated cheap labour and resources into our economy, as well as the deregulation of labour markets, have been crucial – if untold – parts of the narrative.
The international sources of today’s inflation are also relevant. A quarter of price increases in the past year are in the transport sector, largely the result of petrol price spikes after Russia’s invasion of Ukraine. The same is true for rising food costs (17 percent of the increase), with Russia and Ukraine accounting for a significant proportion of global wheat, corn, sunflower oil and soy production. Add to that China’s continued pursuit of zero covid and a squeeze on global shipping and it’s no surprise we’re facing increased costs in many of our global supply chains.
Another third (35 percent) came from increased housing costs, both from rising rents and the increased cost of building a house, as spiking house prices has encouraged more building activity. The latest quarterly data shows that while petrol prices have eased slightly, housing is playing a bigger role in inflation, ironically driven in part by the increased cost of borrowing.
We’ve also seen some businesses unscrupulously take advantage of limited information in these markets. In July, when the barrel price of petrol fell, the pump price stayed stubbornly high as petrol retailers pocketed superprofits, declining precipitously after receiving a cease and desist letter from the Minister of Energy.
The Reserve Bank generally stays quiet on matters of profit, but my reading of Treasury’s corporate tax suggested an unprecedented 39 percent spike in corporate profits in the year to March 2022. Research from the US, the EU and Australia has highlighted the role of corporate profits in driving inflation, and this line of inquiry certainly warrants further research in the NZ context.
It’s difficult to see how hiking interest rates in Aotearoa would have any impact on Russian war-making, fragmented global supply chains or big firms’ fattening profit margins. In essence, we’re punishing low-income workers – those most vulnerable to rising prices – for things they have no responsibility over.
We intone beneficiaries to “get a job”, and then when inflation strikes, regardless of its causes, we throw them back out on their own, driving their living standards backwards.
Similarly, workers can’t get a pay rise when unemployment is high because there’s too much competition in the labour market, and we can’t get a pay rise when unemployment is low because it might cause inflation. This simply can’t be the way we structure an economy that works for working people.
A more equitable approach would seek to shift the costs of dealing with inflation onto the least vulnerable – higher-income earners and businesses that have made windfall profits during the pandemic.
Interest rate hikes should be consigned to the rarest of circumstances, and the Reserve Bank should work more actively alongside the Treasury and Inland Revenue to balance its monetary objectives with fiscal policy. This means raising tax on higher-income earners to constrain aggregate demand, and raising the corporate tax rate either as a windfall tax in response to recent largesse, or on an ongoing basis.
Treasury no doubt would have some pretty stringent criteria on how to spend any additional revenue so as not to create further inflationary pressures. In the short term, we could look at wiping Ministry of Social Development debt, expanding insulation initiatives in low-decile communities, and expanding access to public services – all of these would help to alleviate the cost-of-living crisis for our most vulnerable people. That should be the guiding principle of how our Reserve Bank operates, rather than boosting joblessness and freezing out wage growth.