Inflation has spiked to a 32-year high. So how did we get here — and what lies ahead?
This story was originally published on March 18, 2022. It has been updated to reflect current economic data.
First things first: definitions. Inflation describes the general increase in the prices of goods and services in the economy. Everything from food and fuel to health and housing. And the Consumer Price Index is how we measure inflation. Each quarter, Stats NZ minions take a field trip to sample the prices of a representative basket of goods and services. The (weighted) average price of today’s basket is compared to the basket of a different point in time. A positive change means a rise in prices – inflation. A negative change means a decline in prices – deflation.
New Zealand’s inflation story over the past 50 years is something of a trilogy. And it begins in the 1970s. The ’70s will be remembered for its high flare jeans, high-heeled boots and even higher prices. Inflation averaged 11.5% between 1970 and 1980, largely underpinned by skyrocketing oil prices. The oil embargoes sanctioned by Opec saw oil prices more than quadruple. And as an economy heavily reliant on imported oil, NZ’s consumer prices lifted in lock-step. Inflation spiked to a high of 18.4% in 1980.
In an attempt to control the upward spiral in prices, prime minister Robert Muldoon introduced a wage and price freeze in 1982. The policy certainly did the job and inflation dropped to below 5%. But the freeze was hugely unpopular. Profit margins were squeezed with sticky prices, and workers wanted to bring home more bacon. In 1984, the new Labour government was ushered in and the policy freeze was booted out. But inflation returned to the highs of the 1970s. As many had feared and warned, the policy had merely suppressed inflation, not banished it.
Across the street, the Reserve Bank of New Zealand was also working hard to curb inflation. And in the 1990s, all eyes were on our island country. The RBNZ had introduced a revolutionary approach to monetary policy known as “inflation targeting” – later adopted by central banks across the world. Initially, the target band was set between 0 and 2%. Soon after, inflation was successfully brought under control. And the RBNZ’s inflation-fighting credibility was established.
Over time, tweaks were made to the target definition. Eventually, a target band of 1-3% with a focus on the 2% midpoint was decided. And in 2018, an additional policy objective was added to the RBNZ’s mandate: to support maximum sustainable employment. But the 2018 amendment was merely a formality. Employment had always been considered when setting monetary policy. And that’s thanks to the work of pioneering New Zealand economist, Bill Phillips. The Phillips curve describes the inverse relationship between unemployment and wages. That is, when unemployment is low, wages tend to rise. And rising wages put upward pressure on costs, which firms pass on to consumers via higher prices, thereby creating inflation. Central bankers used the Phillips curve to predict inflation and set monetary policy accordingly. To curb inflation, central banks would raise interest rates. To generate inflation, central banks would lower interest rates.
The GFC and post-GFC
In the post-inflation-targeting era, prices were well behaved with inflation averaging around 2%. But Part II of NZ’s inflation saga was relatively brief, cut short by the Global Financial Crisis. Financial markets were in disarray and economies were under significant pressure. Inflation in NZ reached a high of 5.1% with chunky increases to the price of petrol, food and cigarettes. The unemployment rate rose sharply from 3.4% in 2007 to 6.2% by the end of 2010. The RBNZ slashed the cash rate in response. In the span of just nine months, the cash rate went from 8% to 2.5%. Inflation dropped to below 2%. But even as the economy recovered, and the unemployment rate fell to 4%, inflation remained mysteriously low. Part III saw the Phillips curve invert in NZ and textbooks thrown outside windows.
Post-GFC, inflation had consistently fallen short of target, averaging 1.5%. Several theories emerged in attempt to explain this economic conundrum. One theory points the finger at globalisation and the influx of cheap manufactured imports from emerging economies. Another at ageing populations and the global saving glut. Advancing technology also stands guilty: a TV today with “smart” technology sold at the same price as last year’s version is deflationary. These developments have put downward pressure on prices. But with interest rates pushed to record low levels, central banks had little room to lower rates further to generate inflation.
Return of the beast
With the turn of the decade came the Covid-19 pandemic. And a new chapter to our inflation story begins, but one which rings familiar. Because just like bell-bottoms and knee-high boots, the inflation of the 1970s has returned. At 7.3%, inflation is running at the fastest pace in 32 years. And there are a few reasons why.
Firstly, base effects are in play. The 2020 lockdown depressed demand, especially that for oil as economies were switched off. The NZ economy even experienced a period of deflation. But in 2021, the recovery firmly took shape and demand rebounded strongly. Annual percentage changes are therefore slightly exaggerated given that prices began at a low “base”. But we can’t hide behind the maths forever. Especially since inflation is forecast to remain elevated for some time.
High imported inflation explains the initial spike in headline inflation. The price of oil bounced, and Covid-related restrictions dislocated supply chains. Shipping costs spiked and there were considerable delays in sourcing goods from overseas. Altogether, it became more costly to move goods from the ports to the stores. But this cost pressure comes at a time when demand has been surprisingly strong. Job security was well supported by fiscal policy. Easy monetary policy made money cheap. And a closed border left many households with money in the travel jar. Spending on everything from pools to pets showed no lack of demand. But a supply shortage and resilient demand is one potent cocktail of rising prices.
Imported cost-push inflation should eventually fizzle out – though predicting exactly when is nothing short of a guessing game. What’s more concerning is the momentum in domestic inflation, because domestically generated inflation is harder to tame. Already we’ve seen non-tradable (domestic) inflation shoot to the highest on record. And that represents three-fifths of all items in the CPI basket. So it’s not just used cars and fruits and veg with pricier price tags. The NZ economy is experiencing a stellar recovery and is now running above its potential. Demand continues to outstrip supply and this imbalance is driving prices higher.
The labour market is no exception. A capacity-constrained economy has sent the unemployment rate to 3.2% – a new record low. The pool of available talent is quickly evaporating. Employers are having to pay up to attract and retain workers. Wages are forecast to rise, which means greater cost to firms and thus higher consumer prices. Setting off this wage-price spiral risks transitory price spikes becoming more persistent.
Another worry is rising inflation expectations as these have potential to be self-fulfilling. If firms and households expect prices to rise, which would erode expected profit margins and the purchasing power of a hard-earned buck, then prices and wages should adjust now. For the past decade, medium-term expectations have remained relatively well anchored at the target 2% midpoint. But the five-year ahead expectations have since risen to 2.42%. The recent creep higher certainly challenges the RBNZ’s inflation-fighting credibility.
Is inflation bad?
Reading thus far, it may seem that inflation is the big bad bogeyman who needs to stay hidden. But high inflation can be a good thing. Especially coming out of a recession. It signals a strong, growing economy. What we don’t want is the inflation bogeyman spending too much time outside the closet. High inflation for an extended period of time is what concerns us. Especially when wage growth isn’t keeping up with the rise in the cost of living. At 3%, wages are growing at a snail’s pace and households are seeing their real incomes eroded. And households on low or fixed incomes are disproportionately affected, as food and fuel typically make up a larger share of the household budget for lower-income households. And inflation hurts those who don’t have as much wriggle room.
Can we tame the beast again?
With the threat of persistent inflation, the RBNZ has begun paring back the monetary stimulus it injected early in the pandemic. Last October, the RBNZ lifted the cash rate for the first time in seven years. The cash rate has since been hiked in successive moves to 2.5%. And we see more hikes in the pipeline to bring the OCR to 3.5% by the end of the year. The RBNZ has a lot of work to do to rein in inflation and better balance the economy.
An increasing cash rate means interest rates in the economy have further to rise. Days of a 2% two-year fixed mortgage rate are deep in the rear-view mirror, and a rate nearing 6% is inevitable. Tightening monetary conditions should pull the handbrakes on economic activity – especially in the housing market – and relieve inflationary pressures. But only time will tell if we can tame the inflation beast once again.