The global ‘Great Inflation’ of the 1970s and 80s was the last time New Zealand experienced a cost-of-living crisis. Kate Newton reports on what it took to curb inflation then – and why not all economists believe the same solutions can help us now.

This story was first published on Stuff.

“What the f… is inflation?” asks one TikTok user in a recent video. He’s a millennial: bearded, bandana’d, and using a pair of chopsticks to eat Doritos from the bag.

“We keep hearing about it, but what actually is it?”

It’s definitely not as fun as a viral song about corn but, in the last few months, inflation has crept its way into social media ephemera all the same. One common trope compares a trolley of groceries from the 1990s with what the same money will buy you today, while the explanations range from convoluted analogies to a single Harry Styles lyric (“I pay for it more than I did back then”).

The rash of TikToks and Insta reels reveals something important about the soaring inflation rates in many developed economies: those aged 40 or younger either weren’t alive, or were too young, to remember the last time this happened.

The 1970s and 80s, both in New Zealand and around the world, were characterised by near-relentless high global inflation, brought on by oil shocks starting in 1971 – a period referred to as the ‘Great Inflation’.

The effects for New Zealanders were not just felt in the cost of driving a car. The far-reaching, long-lasting consequences “took people by surprise”, Auckland University economics professor Robert MacCulloch says.

“We all discovered that oil was used in so many products – plastics and so on; a lot of factories around the world sourced their power from burning oil… So it just led to a more generalised increase in inflation.”

If you think the current annual inflation rate of 7.3% is eye-watering, try 18% – which is where New Zealand inflation peaked several times during those two decades. Average annual inflation over the period was 11.6%.

Oil prices stabilised after 1981 but by then a pattern of high inflation was entrenched. The initial government response here was a price and wage freeze, which did artificially drive down inflation in the early 1980s. But the freeze ended when Robert Muldoon’s National government was booted out – and inflation took off again.

Eventually, the government passed the Reserve Bank Act in 1989, which made ‘inflation targeting’ – the idea of keeping inflation within a narrow band to keep price rises as stable as possible – the primary purpose of the Reserve Bank. The idea was that rampant and volatile inflation would no longer be a feature of New Zealand’s economy.

The results were swift and long-lasting. The inflation rate had dropped to less than 3% by 1991 and more or less stayed within the target band (1% to 3%) – until now.

If we have inflation targeting, though, why have prices been shooting back up in the last 18 months, and what would it take to bring them back under control?

Sense Partners economist Shamubeel Eaqub says the fall in inflation last time occurred in a different context and against a backdrop of wide-scale economic reform. “The Reserve Bank played a huge part, but there were also many other drivers,” he says.

That included the breaking, or weakening, of unions; and a more flexible labour market. Deregulation of the economy, which allowed for much cheaper products to be imported, helped start bringing down the inflation rate in the 1980s. A deepening recession after the 1987 stock market crash accelerated the drop.

Economists Stuff spoke to agree on the major factors now driving inflation up again, but not on the extent to which each has contributed – or the solutions.

The two main ingredients are actions taken by the Reserve Bank in response to the Covid-19 pandemic; and a global supply shock stemming from Russia’s war in Ukraine combined with an ongoing surge in demand for both goods and people, even as borders around the world remained tightly controlled.

Executive director of economic think-tank Motu and former Reserve Bank chief economist John McDermott says domestic and international inflation contribute roughly 50-50 to the overall inflation rate, based on modelling he and colleagues have done.

While the Reserve Bank can’t stop the war in Ukraine, it does have tools to control domestic inflation, he says. But inflation targeting only works if the bank makes the right choices.

McDermott and other economists point to three things the Reserve Bank did over the course of the pandemic – rightly or wrongly – that have stoked the flames.

The first was slashing the official cash rate (OCR) to 0.25% in March 2020, as the world started closing its borders, in anticipation of a massive downturn in spending. It wasn’t the only one – central banks around the world did the same thing.

McDermott says cutting the OCR was the right thing to do at the time. But when spending held up better than expected, the Reserve Bank and its global counterparts should have started increasing rates again, he says. “The steps they took in 2020 were appropriate. But it looks like no one had an appropriate exit strategy.”

Instead, it took until October 2021 for the Reserve Bank to start raising the OCR, and only incrementally to begin with. “They should have reversed [the OCR cuts] much faster than they actually did,” McDermott says. “It’s not an excuse to say, we made the mistake but so did everyone else.”

The second thing the bank did was buy up large numbers of government bonds – which both pushed commercial interest rates down and gave the Government a huge wad of extra funding to spend on its Covid response. “Given how bad things looked, it was probably an appropriate thing to do,” McDermott says.

But the third step the bank took – which those who spoke to Stuff are overwhelmingly critical of – was to embark on a ‘funding for lending’ programme, which allowed commercial banks to borrow from the Reserve Bank at the official cash rate.

Funding for lending did not begin until December 2020, “long past when it was ever needed”, McDermott says. “That was a mistake.”

Shamubeel Eaqub also calls funding for lending a “big mistake”, because the vast majority of that lending was on mortgages, fuelling a massive, unanticipated growth in house prices from mid-2020 onwards. “No houses were ever going to die as a result of Covid. We knew that the problem would’ve been around business failures because businesses couldn’t trade.”

That cheap lending to banks should instead have come with caveats around its use, to funnel it into funding businesses and investment, he says. “If you had diagnosed that the biggest risk was to business then you would have targeted lending to business lending and, at a stretch, to consumer finance, because people who were on the margins would’ve benefited from access to easier credit conditions.”

McDermott says the Reserve Bank should have used its tools much more aggressively. Even before it started hiking interest rates, again, it should have scrapped funding for lending (or increased the rate it was lending at) and divested some of the government bonds on its books, he says. It should still do both, as soon as possible, he says. “If they take action on those other two things, that gives them more flexibility [on interest rates].” Otherwise, “they need to go much higher than people think, if you’re just using interest rates”.

Some of the lessons learned from the 1970s and 80s may be fading, he says. “We knew it was uncomfortable and we set up a whole framework of targeting inflation so it would never be repeated. It’s kind of frustrating that we’ve let it happen again as we move through time.”

But not everyone believes the blame for the cost of living crisis should be sheeted home to the Reserve Bank, or that the only way out is to hike up interest rates.

Eaqub believes there’s “a very lazy kind of economics going around”. He points to the fact that inflation is increasing in lockstep in developed economies as evidence that the crisis is largely driven by global factors beyond the Reserve Bank’s control. “Nothing the Reserve Bank does can reduce food or fuel prices, then [during the Great Inflation] or now.”

There are differences in each country’s inflationary pressures: European economies are much more vulnerable to the war because they rely heavily on Russian gas for heating and power. In New Zealand, housing costs – both rent and construction – are a huge contributor, Eaqub says. “Once you take those two things out, there isn’t a huge amount of additional inflation in New Zealand compared to other countries.”

If you accept, as Eaqub does, that inflation is largely due to external influences, the case for hiking up interest rates even further becomes shaky, he says. “The Reserve Bank is not well-placed to deal with inflationary periods that are not about domestic drivers. We’re just not equipped.

“Are we impacted by it? Yes. Can we control the price of fuel and food prices globally? No. So what do you want to do about it?”

Unlike John McDermott and Robert MacCulloch, who see further interest rate hikes as inevitable, Eaqub would do “nothing” with the OCR. “It’s an inappropriate tool for the current crisis. It doesn’t achieve anything. It hurts people even more.”

And he’s not convinced that inflation will spiral. “I’m much more uncertain about the inflation path than those people who are saying, inflation is really high, we must do everything in our power to bring it down. I don’t see the evidence that inflation is totally out of control.”

He points to a recent fall in oil prices, along with food prices that have come off from big highs last year. Global freight rates have also fallen in recent months.

How long might the current situation last, then?

“How long is a piece of string? We’ve had so many predictions about the war [in Ukraine] and none of them have been right ... The thing that people forget is that when things happen in this global commodity market it doesn’t hit us straight away, and it doesn’t benefit us straight away either.”

Economies are measured in months and quarters, not minutes and seconds, he says. “These things take time and I think there is this impatience that if it’s gone up, it must reverse straight away.”

McDermott says most forecasts point to at least another 18 months of pain. “There’s no quick fix. That’s why they need to get on with it.” Getting on with it includes, in his view, continuing with OCR hikes to curb domestically driven inflation. “The cure is painful but the problem with not fixing it is that this cost of living crisis keeps going until you take the medicine.”

That cure means everyone “will feel a lot poorer” for a while, McDermott says. A higher OCR means more expensive mortgages, which in turn means more expensive rent for those who don’t own homes as well as higher outgoings for those who do, he says. Higher housing costs means less money available for food – and more expensive groceries that eat into that smaller budget. “Then there’s the fact that higher inflation does not affect everyone equally in the economy. Anyone on superannuation, anyone on a benefit, is in real trouble.”

Robert MacCulloch says an end to global price shocks will obviously help, but there is nothing the Reserve Bank can do about that. “They’ve got their fingers crossed, hoping that those external shocks will go away,” he says. “Maybe they will, maybe they won’t.”

He and Shamubeel Eaqub both mention what Eaqub calls “strange dynamics” at play that make it hard to predict the eventual outcome.

“One thing that seems to be worldwide, that none of us understand fully, is a change in culture and behavioural practices,” MacCulloch says. “The pandemic has gone on for years and I take seriously those headlines that people don’t want to go into the office as much. Employers are finding it hard to reorganise how people work.”

That reorganisation is part of the reason why the economy is responding to the usual levers “very differently”, Eaqub says.

“There’s just a lot of uncertainty in my mind about how flexible the economy is now and how different the economy is now after the last two years.

“So I don’t think we should be relying on the standard models and assumptions based on the 1980s and now to say, this is how we’re going to predict the outcome of the current inflation patterns that we’re seeing.”

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