BBC Podcast – How do we stop high inflation?

This is a very good podcast on inflation and for anyone new to the subject it explains a lot concepts in very simple language. Concepts like fiscal policy, monetary policy, recession, stagflation etc. Click link below:

BBC – The Real Story – How do we stop high inflation?

The question that the economists try and answer is will the global economy go through a recession in order to get inflation down. Both central banks and governments cushioned the economic shock of the pandemic with low interest rates and spending respectively but this action has been blamed for increased inflation.

Larry Summers suggested that the US Fed had mistakenly seen the inflationary problem as transitory but there is a bit more stubbornness about price increases today. As he put it – some central banks need to go through their ‘full course of antibiotics’ (interest rate hikes) to control inflation as failure to do so means that inflation will return promptly and another course of antibiotics will need to be administered. The longer you leave it the more damaging the downturn/recession will be. He also states that every time the US economy has had an inflation rate greater than 4% and an unemployment rate below 4% the US economy has gone into a recession within two years. Those figures align with US inflation 8.5% and unemployment 3.6%.

Some great discussion and would be useful for a macro policy essay at CIE AS or A2 level. Good for revision of policies and their usefulness today.

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Global Economic Outlook

Below is a look at economic conditions in leading global economies. Unemployment is surprising low and with the rise in the cost of living (see inflation figures) this should put pressure on wages. The unemployment rate within the OECD area fell to 5.2% in February, the first time it has fallen below the pre-pandemic unemployment rate (which was recorded in February 2020). The unemployment rate within the OCED had peaked at 8.8% in April 2020.

Inflation, Unemployment and Interest Rates
Annual inflation within the OECD area rose to 8.8% in March 2022, its highest annual increase since 1988. Energy prices have risen by over a third during the past year, while food prices have risen by ten percent within the OECD area. Most central banks have already commenced a tightening programme with the on-going threat of inflation. The Australian Reserve Bank commenced tightening their cash rate in early May, increasing the cash rate by 25 basis points to 0.35%. It is expected that the RBNZ will increase the OCR by 50 basis points next week.

Outlook
If you look at conditions in the major economies you find the following:

  • China – limited growth potential with severe lockdowns
  • USA – higher interest rates could lead to a bust scenario
  • Euro Zone – cost of living crisis
  • Emerging markets – food crisis / famines.

With the indicators looking at recessionary conditions the best news for the global economy would be a withdrawal from Ukraine by Russian troops and an end to a zero-Covid strategy in China. These actions should reduce food and energy prices and therefore save government spending on raising benefits and subsidising food and energy. Economists are fairly optimistic that we will avoid a recession in 2022 as they still have the tools to stimulate if things get worse. However with no end in sight for the Ukraine conflict and interest rates on the rise a recession is on the cards.

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Strong US$ bad news for global recovery

The recent tightening of monetary policy by US Fed Chair Jerome Powell to combat inflation has seen higher borrowing costs and financial-market volatility. The US$ has risen 7% against a series of major currencies since January this year – a two year high. It has always been a safe haven currency and with a rising Fed Rate and market rates even more capital could flow into the US increasing the demand for US dollars and therefore appreciating its value. See mindmap below for the theory behind a stronger currency.

Adapted from: CIE A Level Economics Revision by Susan Grant

A high value of a currency makes exports more expensive but does lead to cheaper imports especially of the inelastic nature. But to foreign economies it does drive up import prices further fueling inflation. For developing countries this is a concern as they are being forced to either allow their currencies to weaken or raise interest rates to try and stem the fall in value. Also developing economies are concerned with the risk of a ‘currency mismatch’ which happens when governments have borrowed in US dollars and lent it out in their local currency. However it is not just developing countries that have had currency issues. This last week saw the euro hit a new five-year low with the US Fed’s aggressive tightening of monetary policy. The real problem for some economies is that they are further down the business cycle than the US so in a weaker position.

“While domestic ‘overheating’ is mostly a US phenomenon, weaker exchange rates add to imported price pressures, keeping inflation significantly above central banks’ 2% targets. Monetary tightening might alleviate this problem, but at the cost of further domestic economic pain.” Dario Perkins – chief European economist at TS Lombard in London

Source: Bloomberg – Dollar’s Strength Pushes World Economy Deeper Into Slowdown. 15th May 2022

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Food and fuel prices impact on Sub Saharan Countries

Just finished completing policies for developing countries with my A2 class and invariably with all my economics classes you cannot get away with not talking about the war in Ukraine and the inflationary problems that the global economy is experiencing. The increase in food and and fuel prices hits the developing world the most and could not have come at a worse time as economies around the world are starting to open up after the COVID pandemic. For the developing world, especially in Sub-Saharan Africa (SSA) there is a significant erosion in living standards and macroeconomic imbalances – see graph below. The IMF has identified 3 main areas that the war is impacting countries:

  • In SSA food accounts for 40% of consumer spending with 85% of wheat supplies being imported. Add to that higher prices for fuel and fertiliser.
  • Higher oil prices mean adds $19bn to the regions imports which worsen the current account balance. However the eight petroleum exporting countries do benefit.
  • SSA countries are not well placed to cope with the need for increased government spending which means using more tax revenue. Increasing oil prices have a direct fiscal cost through fuel subsidies and rising interest rates globally make it more expensive to borrow money to keep the economy ‘above water’ let alone for actual development.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

More inflationary problems with Shanghai port chaos

Shanghai is one of the world’s busiest ports and is usually a well-choreographed operation. Containers ships drop off component parts, empty containers and pick-up exports etc. However with the port in total lockdown the number of ships waiting offshore to be loaded and offloaded of goods is quite staggering – see image from Scott Gottlieb (Twitter).

This is the accumulation of 3 weeks when the port is not operational – workers are in lockdown. The effect of this will be to clog up other ports as ships arrive at the same time and are completely out of sync with what is normal.

The graph below shows that twice as many ships are waiting near Shanghai ports as opposed to last year, which was already above average.

Although consumer and business spending has remained strong, the delays will add to inflationary pressure as goods arriving late from China will mean a short supply in the shops. Add to this the Ukraine war and rising energy and food prices and we have a major inflationary problem on our hands. It’s time to ‘batten down the hatches’.

Source: Thoughts from the Frontline – 23rd April 2022

Inflation – should central banks hold off on tightening?

In New Zealand the recently published CPI figures published yesterday saw the yearly inflation rate climb to 6.9%. The main points to note are:

  • Tradeables inflation (imported) – makes up 40% of CPI – 8.5%
  • Non-tradeables (domestic) – makes up 60% of CPI – 6.0%
  • Housing and household utilities increased 8.6 %,
  • Transport increased 14 %,
  • Food prices increased 6.7 %,
  • Petrol prices 32.3%

The continued rise in domestic inflation means that the RBNZ will probably look at another 50 basis points rise later in the year.

Source: IMF

Ukraine War adds another supply shock – are higher interest rates the way to go?
With a second supply shock and inflation globally on the rise (see graphs) central banks have raised interest rates. However the Russian invasion of Ukraine and the subsequent increase in food and energy prices has asked questions of how central banks should approach monetary policy in what is unusual circumstances. Martin Sandbu in the FT suggest that they should rethink how they look at the operation of an economy. He made 3 main points:

  • Are central banks committed to aggressively increasing increasing rates every time there is a supply shock? This has a huge impact on households and businesses.
  • Do central banks know how their monetary policy works? Higher interest rates reduce aggregate demand and therefore easing the pressure on the supply side. However this is difficult to vindicate in that nominal spending has only just returned to pre-pandemic levels and still fell short in the EU and the UK.
  • These supply-shocks are ‘out of left field’. COVID caused greater spending on durable goods and non-durable goods by 25% and 10% respectively. Services remained depressed.

With the energy shortages arising from the Ukraine War there will be a movement away from production and consumption that use coal, oil and gas. Russian coal is already banned and it is likely that oil and gas will follow. Sandbu asks how monetary policy should approach a supply shock of this nature. If lower interest rates makes it easier to relocate resources then that is the best option for central banks. A tightening of monetary policy would make investments in new capacity both more expensive and less attractive as demand growth slows.

Today there are abnormal circumstances – COVID, Climate Crisis, Ukraine War, supply chain problems. These will mean huge structural shifts which can improve an economy’s productivity and lower inflationary expectations. If there are still higher interest rates productive potential would be reduced which would mean added pressure on inflation. Heading into a time of global supply chain problems monetary policy seems to be less effective.

Source: Central bankers should think twice before pressing the brake even harder – Martin Sandbu – FT 20th April 2022

Inflation today – what is the best response?

The Inflation globally has been on the increase and above the target band in most developed economies. This applies to both Headline and Core inflation.

Headline Inflation – all goods and services
Core Inflation – all goods and services excluding food and energy.

Economic theory suggests that inflation could accelerate and return to levels seen in the 1970’s. A lot will depend how policymakers react to the challenge of bringing inflation down to their specific target level – RBNZ 1-3% but CPI in NZ is 5.9%. See chart for inflation breakdown in OECD countries.

Source: IMF

Key reasons for inflationary pressure.

Supply chain bottlenecks: Lockdowns and shipping problems (container shortages) but latterly the demand side has accelerated – economic recovery and demand for durable goods as well as panic buying.

Demand for more goods than services: Much of the inflation has been in durable goods whilst service inflation has only seen a small increase. This is dependent on which country – for instance demand for used cars in the US has soared.

Fiscal and Monetary stimulus: Approximately US$16.9trn of government spending has been injected into the global economy. This is accompanied by expansionary monetary policy (low interest rates) is conducive to more spending and higher inflation. Savings that accumulated during the lockdowns were now being spent. There was a debate between leading economists whether the inflation would be transitory or persistent. It seems that the data now supports those of the persistent camp. Whether it persists depends on central banks.

Labour supply: Labour participation rates have dropped – for instance for every job opening in the US there is only 0.77 unemployed people per job. See previous post – US Economy – potential for wage-price spiral. This is due to continue meaning that there is a job seekers market where there is likely to be pressure on wages.

Russian invasion of Ukraine: Russia and Ukraine are big exporters of food and major commodities so higher prices have been inevitable with major disruptions to the supply either through sanctions or conflict areas. They supply 30% of global wheat exports so prices have been increasing.

Source: IMF

What should central banks do?

Mainstream policy by central bankers should ignore supply-side shocks like higher commodity prices as this is only temporary. When central banks have intervened and raised interest rates they have ended up worsening economic conditions – ECB raising rates post GFC in 2008 and 2011. Already inflation globally is increasing but there is little central banks can do with higher global energy prices. A focus on home grown inflation (core) might be a better indicator to watch as well as the labour market – fast wage growth might mean higher interest rates. Economist John Cochrane argues that bringing down inflation through higher interest rate is a blunt tool, especially when prices have risen predominately through a loose fiscal policy. He states that inflation might get worse if people doubt the government’s ability to repay its debt without a discount from inflation.

Ultimately the outlook for inflation depends on how determined central banks are to rein in inflation and the confidence of the bond market to governments willingness to pay their debts. Below is a good video from the IMF on the inflationary problem.

Sources: IMF – Will Inflation Remain High? The Economist – ‘War and Price’ – March 5th 2022

Quantitative Easing – put your printer by the window and press Enter.

Doing quantitative easing (QE) with my A2 class last period today and showed a humourous video with the late John Clarke about ‘What is Quantatitive Easing?’ – Point your printer out the window and make sure the wind is blowing in the right direction. Below is an explanation but Clarke and Dawe have an interesting take on it.

Quantitative easing (QE) is a type of monetary policy used by central banks to stimulate the economy when standard monetary policy has become ineffective. Governments and central banks like there to be “just enough” growth in an economy – not too much that could lead to inflation getting out of control, but not too little that there is stagnation. Their aim is the so-called “Goldilocks economy” – not too hot, but not too cold. One of the main tools they have to control growth is raising or lowering interest rates. Lower interest rates encourage people or companies to spend money, rather than save.

But when interest rates are almost at zero, central banks need to adopt different tactics – such as pumping money directly into the economy. This process is known as quantitative easing or QE.

Quantity Theory of Money – you can’t have your cake and eat it

I blogged on this topic last year but I thought it appropriate to look at it again especially I have just completed it with my NCEA Level 2 class and about to start the topic next week with my CIE A2 class. – it refers to Unit 4 of the CIE A2 Economics course and the Inflation topic at NCEA Level 2. Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250
Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change
in the money supply causes an equal percentage change in the price level.

The speed at with which money goes around the circular flow is a significant indicator as to the economic activity of an economy. Money’s “velocity” is calculated by dividing a country’s quarterly GDP by its money stock that quarter – the bigger GDP is relative to the money supply, the higher the velocity.

Recessions – dampen the velocity by increasing the attractive of a store of value. People tend to save rather than spend. E.G. The Great Depression and the GFC. See graph for US velocity of money.

Covid-19 – with the closure of a lot of businesses and people worried about job security personal savings increased to 33.6% of disposable income. Also consumers didn’t have the money to spend.

The stimulus measures and the glut of dollars could cause problems once the consumer confidence starts to become prevalent. Inflation will inevitably rise again – which is not a bad thing considering the threat of deflation that we are currently experiencing. But the major concern is if the increase in spending spirals out of control with high inflation. It seems that central banks want the velocity of money to increase to kick-start the economy but they will need to consider how to control it if it gets above the ‘speed limit’. “You can’t have your cake and eat it”.

The concern now is that inflation is at very high levels around the world caused by both supply and demand issues. Velocity of circulation is increasing but also major supply chain problems and still expansionary monetary conditions – low interest rates – are contributing to higher prioces.

The table shows the global problem of inflation. The OECD area climbed to 7.2 percent in January 2022 – the highest level in the area since February 1991. In the US inflation has risen to 7.5% – main cause being petrol up 40% and cars/truck up 40.5%. In New Zealand the CPI is 5.9% above the 1-3% target range. The outlier is Japan who has had deflationary concerns for a number of years.

Source: Why money is changing hands much less frequently – The Economist 21-11-20

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Could war in Ukraine lead to economic crisis?

From Al Jazeera – Counting the Cost. Main discussion points:

  • Ukraine and Russia are expected to experience a severe recession this year. But the sanctions imposed on Russia and the increasing energy price can inflict inflation on other countries.
  • IMF to cut its growth forecast on the Global Economy.
  • Russia to turn to the Chinese Yuan to survive and are counties dumping the US$ as the global reserve currency?

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Surge in food prices hits developing countries

With the war in Ukraine there have been serious concerns about global food supply especially when you look at the graph below. Main points to consider:

  • Russia and Ukraine are both major grain and sunflower oil exporters
  • Spring planting near impossible for farmers in battle zones
  • Sanctions on Russia agricultural goods
Source: Thoughts from the Front Line – Another Strange Recession By John Mauldin | March 12, 2022

How will it impact developing countries.
The staple diet of many developing countries relies on imports of wheat and sunflower oil – for instance Egypt imports 85% of its wheat and 73% of its sunflower oil from the Ukraine and Russia. Countries in these circumstances have no choice but to not put sanctions on food imports. The Food and Agricultural Organisation of the UN Food Price Index – meat, dairy, cereals, oils, and sugar – rose 24.1% in February compared to a year ago. This price shock will impact developing countries as food takes up a greater percentage of a person’s income in the developing world. In the developed world food costs 17% of consumer spending in contrast to those in poorer countries where it takes up 40% of income.

IMF Blog

Many developing countries subsidise food prices to maintain law and order and avoid its population from starving but with higher food prices how are they going to afford subsidies? There is also the problem of repaying debt as feeding the population will the priority rather than servicing foreign debt. Furthermore there is an opportunity cost – money won’t be spent on eduction, healthcare, infrastructure etc which it was originally intended for.

In getting out a recession consumers and producers make adjustments sufficient to reinstate growth. I can’t see that happening soon. The entire world order is experiencing a shock adjustment — economically, geopolitically, and otherwise. John Mauldin

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Stagflation – 1970’s v Today

The Financial Times had a good piece about the current state of the global economy and the likeness of the stagflation of the 1970’s. Using that article and other sources I have attempted to differentiate between what was happening then and the current situation with the war in the Ukraine. With oil still having an impact in an economy today this could be the catalyst needed for more greener technologies but this is not going to help in the short-term. Therefore, for global oil prices to stabilise there needs to be an increase in the output of OPEC countries and the likes of Venezuela which could add 400,000 bpd to oil output – the US has been in talks with President Maduro. However, there is a dilemma here in that you may reduce oil prices by getting Venezuela to increase production but you are also assisting an authoritarian regime that is closely linked with Russia.

Source: War brings echoes of the 1970s oil shock. FT 12th March 2022

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High commodity prices but also high input costs for NZ agricultural sector

New Zealand commodity prices have been on the rise over the last year. Global dairy prices have increase by 14% this year with beef and lamb prices setting record highs. Some economists have said that it is the perfect storm of supply and demand factors.

Supply
As it does every year, the weather has influenced the price of dairy prices especially. A wet start to the dairy season accompanied by a very hot summer has reduced the supply of milk and therefore increasing its price. Also Covid has impacted the supply chains especially that of sea freight (see below) which in turn have impacted feed, fertilisers which has reduced supply. Although the NZ inflation rate has hit a 30 year high at 5.9% this is nothing compared to the costs down on the farm. This year farming cost have increased by:

  • Fertilisers 200% (breakdown in the graph below)
  • Chemicals 50%
  • Sea Freight 500%
  • Diesel 40%
  • Electricity 21%
  • Winter grazing 36.9
  • Cultivation, Harvesting & Animal Feed Cost 18.9%

Fertiliser price inflation

Source: Westpac Economic Overview – February 2022

Demand
The Chinese recovery has mainly been responsible for the rebound in demand as well as other countries coming out of Covid restrictions. Another factor helping the primary sector is the weaker NZ$. It is now trading around the US$0.66 from over US$0.70 in late 2021. Remember that a weaker dollar makes it cheaper for consumers overseas to buy our currency and therefore more price competitive goods

Carbon Prices influence farmer’s investments
In the past year the recent doubling of carbon prices to around $85/unit has encouraged some farmers to focus their attention on tree plantations to the detriment of sheep and beef supply. What is noticeable about investment is that with the high returns on commodity prices farmers are repaying debt rather than re-investing back into their business – although still very high agricultural debt fell from $64bn in July 2019 to $62bn today.

Source: Westpac Economic Overview – February 2022

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Global Stagflation and the threat to democracy.

In my economics classes this week one cannot get away from what is happening in Ukraine and the impact of that geopolitics will have on the global economy. Already I wrote a blog post on Russian interest rates and the collapse of the rouble but what are the challenges ahead for the global economy?

Before the invasion central banks worldwide were tightening monetary policy (interest rates) to reduce the increasing inflation pressure in their economy’s. The price of oil has increased to over US$105 adding to the inflationary problem as policy makers still have to deal with the slow recovery from the COVID pandemic. However the US Federal Reserve (US Central Bank) and the European Central Bank (ECB) have indicated that they intend to continue with their tightening policy of 25 basis points (0.25%) increase in interest rates this month but may have to be less aggressive in their future tightening. Their major concern now is that the war in Ukraine has increased the chances of a period of stagflation – stagnation and inflation at the same time. Therefore it is important that central banks are more sensitive to tightening their monetary policy as adding the Ukrainian crisis (with higher oil and food prices) to the present supply chain issues would increase the chances of stagflation and a significant downturn in the global economy.

Stagflation
In economic textbooks there are two main cause of inflation – Demand Pull and Cost Push (see graph below).

Source: Eleareconomics

The inflation that New Zealand is mainly experiencing is of a cost push nature especially when you look at the recent CPI figure of 5.9%. The major driver of this inflation is:

  • 30.5% rise in the cost of petrol
  • 15.7% rise in the associated cost in buying a new dwelling.
  • 4.1% increase in the food group

What you notice from the graph is that when the AS curve shifts left not only does inflation increase but also output and employment decrease. The last major stagflationary period was during the oil crisis years of 1973 (oil price up 400%) and 1979 (up 200%) – see video below from the Philadelphia Fed.

But when will these cost pressures ease in New Zealand? With a 5.9% inflation rate employees will put significant pressure on employers for wage increases and this is when there is already a very tight labour market (3.2% unemployment).

Final thought
2022 is going to be a very difficult year for the economy with both demand and supply issues:
Demand: higher inflation will mean a tightening of interest rates which will reduce spending and increase the debt burden.
Supply: higher energy costs, supply chain problems, increase in material costs and availability of parts for industry.

Add to this the war in Ukraine and we are in for a rocky ride. However the possible suffering is necessary if it nullifies the threat on global democracy.

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Russia puts up interest rates to 20% as rouble tumbles 40%

In an effort to stop the rapid decline of the rouble to protect Russians’ savings the central bank have increased interest rates from 9.5% to 20%. Furthermore, citizens have been withdrawing money from ATM machines with the loss of confidence in the economy. In order to try and stem the 40% decline in its currency the Russian central bank has been buying roubles with its foreign currency reserves. In the foreign exchange market this, in theory, should have the following effect:

  • increases the demand for the rouble – Demand curve to the right – price up of rouble
  • increases the supply of foreign currency – Supply curve to the right – price down foreign currency.

Another worry for Russia is the downgrade of Russian debt to junk status by Standard & Poor’s the credit rating agency. Below is a mind map that shows the factors that are impacted by a falling exchange rate.

Adapted from: CIE A Level Economics Revision by Susan Grant

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Ukraine conflict sees oil prices go above $100

An excellent video from the Wall Street Journal which explains how higher oil prices impact the inflation rate. By pushing up the price of transport this in turn affects the price of goods / services as producers pass on this extra cost to consumers. Although US focused it does go through simple supply and demand theory to explain how the price may fall or rise.

Today Brent Crude Oil prices rose above $105 a barrel (see graph below) for the first time since 2014 after Russia’s attack on Ukraine amplified concerns about supply disruptions. United States is working with other countries including OPEC on a combined release of additional oil from global strategic crude reserves – in theory the supply curve moves to the right to try and reduce prices. Russia is the third-largest oil producer and second-largest oil exporter and low oil stocks and limited spare capacity, will see additional pressure on prices. Furthermore increased demand with a lot of economies coming out their COVID restrictions will put further pressure on prices.

The RBNZ made a forecast that oil prices should head back to around the $80 per barrel mark but that seems to be rather optimistic with the current political climate. What is sure is that higher global oil prices will continue to put pressure on New Zealand’s CPI.

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Inflation. Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

OCR – LSAP – FLP = New Zealand’s Monetary Policy Toolkit

Below is a useful flow diagram from the ANZ bank which adds Large Scale Asset Purchases (LSAP) and Funding for Lending Programme (FLP) to the Official Cash Rate (OCR – Base Rate)

LSAP – this is the buying of up $100 billion of government bonds – quantitative easing
FLP – this gives banks cheap lending based on the Official Cash Rate – could be about $28 billion based on take up
OCR – wholesale interest rate currently at 0.75%. Commercial banks borrow at 0.5% above OCR and can save at the Reserve Bank of New Zealand (RBNZ) at 1% below OCR.

With FLP and more LSAP this will mean lower lending rates and deposit rates. This should provide more stimulus in the economy and allay fears of future funding constraints making banks more confident about lending. Add to this a third stimulus – an OCR of 0.75%. Although there is currently a tightening policy the rate is probably still stimulatory. The flow chart shows the impact that these three stimulus policies have on a variety of variables including – exchange rates – inflation -unemployment – consumer spending – investment – GDP. Very useful for a class discussion on the monetary policy mechanism.

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New Zealand’s inflation rate will put pressure on wages

With 5.9% inflation and 3.2% unemployment there is the prospect of significant wage pressure with employees seeing a reduction in the real value of their wages and the increased scarcity of labour. The major driver of inflation is the 30.5% rise in the cost of petrol and a 15.7% rise in the associated cost in buying a new dwelling. The average wage is shown by the Labour Cost Index (LCI) and although this has been mainly hovering above the inflation rate (CPI) since 2011, the last year has seen a significant increase in prices which has not been matched by a subsequent increase in the average wage. Workers therefore are suffering from a reduction in real wages (nominal wages – inflation rate).

With this reduction in purchasing power from inflation and such low levels of unemployment employees have more bargaining power to command higher wages from their employers. This could result in workers moving between jobs where there is higher wages to keep up with inflation.

The situation is problematic for employers because they could experience a productivity loss from workers moving between jobs, as new workers take some time to adapt to their new roles. This would lead to employers incurring higher training costs.

Where company’s or sectors have union power this could have a damaging impact on a business as workers demand higher wages and threaten to strike if wage negotiations don’t come to fruition in their favour. Furthermore, with increasing the cost of living workers savings are losing value to inflation and reducing their ability to save. What is certain is growing tensions between employers and employees as they both try to lessen their losses introduced by inflation.

Source: BERL – Feb 2022

New Zealand inflation hits 5.9%. Potential for wage price spiral?

Consumer prices in New Zealand rose 5.9% annually in the December quarter.
Core inflation measures rose to 5.4% annually. Core inflation excludes certain items that are known for their volatility — namely, food and energy. With this figures it seems that ‘transitory’ inflation is not as relevant and inflation does have some momentum. There is a lot inflation coming in from abroad with Tradable inflation at 6.9%.

Domestic inflation was also strong with non-tradable inflation at 5.3%. Some of the main movers in the CPI:

  • Construction costs up by 15.7%annually – major supply chain issues here
  • Petrol prices up by 30.5% annually – reflects rises in oil prices globally and a weak NZ dollar making imports more expensive.
  • Food – annual change in food prices was 4.1% although the quarterly change was -0.1%
  • 40% of CPI is made up of imports and with inflationary pressure prevalent in the global economy this has led to higher import prices.

Higher inflation in a tight labour market – wage price spiral.
With a tight labour market comes pressure on wages and if they increase and are not accompanied by an increase in output/worker, companies have two choices. Either they absorb the higher costs or they put their prices up. Then with higher prices there is pressure on wages again as employees try to maintain their purchasing power which in turn could lead to a wage-price spiral.

Theory behind the wage-price spiral

As from previous posts, the Phillips Curve analysed data for money wages against the rate of unemployment over the period 1862-1958. Money wages and prices were seen to be strongly correlated, mainly because the former are the most significant costs of production. Hence the resulting curve purported to provide a “trade-off’ between inflation and unemployment – i.e. the government could ‘select’ its desired position on the curve. During the 1970’s higher rates of inflation than previously were associated with any given level of unemployment. It was generally considered that the whole curve had shifted right – i.e. to achieve full employment a higher rate of inflation than previously had to be accepted.

Milton Friedman’s expectations-augmented Phillips Curve denies the existence of any long-run trade off between inflation and unemployment. In short, attempts to reduce unemployment below its natural rate by fiscal reflation will succeed only at the cost of generating a wage-price spiral, as wages are quickly cancelled out by increases in prices.

Each time the government reflates the economy, a period of accelerating inflation will follow a temporary fall in unemployment as workers anticipate a future rise in inflation in their pay demands, and unemployment returns to its natural rate.

The process can be seen in the diagram below – a movement from A to B to C to D to E

Friedman thus concludes that the long-run Phillips Curve (LRPC) is vertical (at the natural rate of unemployment), and the following propositions emerge:

1. At the natural rate of unemployment, the rate of inflation will be constant (but not necessarily zero).

2. The rate of unemployment can only be maintained below its natural rate at the cost of accelerating inflation. (Reflation is doomed to failure).

3. Reduction in the rate of inflation requires deflation in the economy – i.e. unemployment must rise (in the short term at least) above its natural rate.

Some economists go still further, and argue that the natural rate has increased over time and that the LRPC slopes upwards to the right. If inflation is persistently higher in one country that elsewhere, the resulting loss of competitiveness reduces sales and destroys capacity. Hence inflation is seen to be a cause of higher inflation.

Rational expectations theorists deny Friedman’s view that reflation reduces unemployment even in the short-run. Since economic agents on average correctly predicted that the outcome of reflation will be higher inflation, higher money wages have no effect upon employment and the result of relations simply a movement up the LRPC to a higher level of inflation.

Source: ANZ Research December 2021 Quarter CPI Review