Post COVID-19 has seen the rapid rise in prices globally which in turn has led central banks implementing a tight monetary policy (higher interest rates) to counter this rise in inflation. The impact on consumers of higher interests depends in their current financial situation. In most economies a mortgage is the largest liability that consumers have and the property market is a large part of the economy. Mortgages can be fixed or floating and research from the IMF show that fixed-rate mortgages have become more common globally – see image. Fixed-rate mortgages vary – close to zero in South Africa to more than 95 percent in Mexico or the United States.
Those on floating rates = payments rise with higher interest rates so monetary policy is more effective
Those on fixed rates = payments stay the same for the duration of the fixed term so monetary policy is less effective
The effects are greater where mortgages are larger compared to home values and in countries where household debt to GDP is high. Therefore consumers are more exposed to changes in interest rates. Nevertheless there will be a time when fixed mortgages reset and you could see a big drop in consumption and a more effective monetary policy. The timing of the reset is crucial as the new rate will most likely be linked to the central bank rate at the time, with the latter being indicative of inflationary conditions. See monetary policy transmission mechanism below.
Countries mortgage markets vary – where there is a declining share of fixed mortgage rates, greater debt and limited housing supply monetary policy is more effective as higher interest rates cut into consumers disposable income e.g. Canada and Japan. Monetary policy seems to have weakened in its impact in countries such as Hungary, Ireland, Portugal and the US where the reverse applies in some areas.
John Mauldin’s book “End Game: The End of the Debt Supercycle and How it Changes Everything” and his weekly publication ‘Thoughts from the Frontline’ address the topic of debt and in particular when debt-fuelled asset price explosions seem to be to good to be true, they probably are. Debt is useful if you can pay back the borrowed money and from it are able to generate value in an economy. This ultimately raises living standards and economic growth. However throughout history debt has been misused by both the private sector and government. This area has also been studied by Ken Rogoff and Carmen Reinhart in their book “This time is different” – see previous blog posts. Historically there has been the temptation of governments and companies to keep borrowing even during a bubble. But highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid assets, seldom survive forever, particularly if leverage continued to grow unchecked. Failure to recognise the unpredictable nature of confidence especially when you are rolling over short-term debt can lead to a collapse of confidence and fewer lenders
How the debt cycle works. Central banks manipulate interest rates and credit conditions to encourage more spending. If this spending is not controlled it may lead to inflation (most central banks target 2%) forcing the bank to tighten monetary policy – higher interest rates. This may lead to some debt being liquidated but some debt remains and is carried over to the next economic cycle. In the forthcoming cycle the same happens again and you get more unliquidated debt which is added to that of the previous cycle and so on. As the debt load increases a country’s ability to stimulate growth falls and more debt is required to produce the same amount of growth – see image below.
In 2022, global public debt – comprising general government domestic and external debt – reached a record USD 92 trillion. Developing countries owe almost 30% of the total, of which roughly 70% is attributable to China, India and Brazil. China’s current problems can be traced back to its massive post-2008 investment stimulus, a significant portion of which fueled the real-estate construction boom. After years of building housing and offices at breakneck speed, the bloated property sector – which accounts for 23% of the country’s GDP (26% counting imports) – is now yielding diminishing returns. This comes as little surprise, as China’s housing stock and infrastructure rival that of many advanced economies while its per capita income remains comparatively low.
Sources: ‘Thoughts from the Frontline’ John Maulden This Time Is Different: Eight Centuries of Financial Folly. Ken Rogoff & Carmen Reinhart
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Japan’s central bank (BOJ) has ended what could be considered one of the most aggressive expansionary monetary policy programmes. The BOJ raised its short-term policy rate from -0.1% to between 0-0.1% on deposits held with the bank. This brings to an end negative rates, charging banks for money held at the BOJ, which have been in operation since 2016 – see image from Trading Economics.
The BOJ see the wage increases of 5.28% hopefully inducing more consumer spending and ultimately higher prices ending a long period of deflationary pressure. See mind map on Monetary Policy.
However even though interest rates are into positive territory monetary policy still remains very loose (expansionary) and borrowing and mortgage costs are not likely to rise by a large amount. The very loose monetary policy has been a key factor the decline of the Yen v US dollar which had helped exporters but made imports more expensive therefore putting pressure on households. This is a very good example of macro policy that could be included in A Level essays. Below is a news item from ABC Australia explaining the rise.
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The Monetary Policy Committee of the Reserve Bank of New Zealand (RBNZ) operates monetary policy in New Zealand through adjusting the official cash rate (OCR). The OCR was introduced in March 1999, and is reviewed 7 – 8 times a year. The recent amendment to the Reserve Bank’s legislation sets up a Monetary Policy Committee that is responsible for a new dual mandate of keeping consumer price inflation low and stable, and supporting maximum sustainable employment. The agreement continues the requirement for the Reserve Bank to keep future annual CPI inflation between 1 and 3% over the medium-term, with a focus on keeping future inflation near the 2% mid-point. Through adjusting the OCR, the Reserve Bank is able to substantially influence short-term interest rates in New Zealand, such as the 90-day bank bill rate. It also has an influence upon long-term interest rates and the exchange rate. In theory this is what the impact should be:
Higher interest rates = contractionary effect which leads to lower inflation and less employment growth Lower interest rates = expansionary effect which can lead to higher inflation but more employment growth.
However the Reserve Bank of New Zealand acknowledge that it is a very complex mechanism as interest rates impact the aggregate demand through various channels – C+I+G+(X-M) – and over varying time periods.
On a normal day consumers, producers, government etc undertake financial transactions involving the commercial banking system. At the end of each day they need to ensure that their accounts balance but some registered banks may find that they are short of funds following the net aggregate result of these transactions, while others may find that they have substantial deposits. Commercial banks that have positive balances can leave this money with the Reserve Bank overnight. They receive the OCR on deposits up to a threshold level, and then receive the OCR less 1% for the remainder. Commercial banks that have a negative balance can borrow overnight from the Reserve Bank at an overnight rate of the OCR plus 0.5%. Therefore if you use the current OCR rate of 5.5% you get this situation. Remember that 50 basis point = 0.50% and 100 basis points = 1.00%
Banks have the option (and incentive) of borrowing from each other, and using the Reserve Bank as a last resort. In doing so, both parties gain as the lending and borrowing rate tends to mirror the OCR (given the level of competition in the banking market).
The RBNZ seems very attentive to both the upside and downside risks and is content to leave the OCR at 5.5% for now. This is especially the case given that longer term interest rates have risen to the extent that the market is doing some of its work for it. The RBNZ’s reaction function to persistent core inflation and upside demand/migration/housing market factors has been to wait and see if the 5.5% OCR will prove sufficient to sustainably reduce inflation pressures – see graph below:
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The Bank of Japan (Japan’s central bank) and the Japanese government seem to be moving in opposite directions with regard to monetary and fiscal policy. On the one hand you have the Bank of Japan exiting its long-running experiment with ultra-loose monetary policy (low interest rates) with a depreciating currency (yen) rising bond yields and persistent inflation. Therefore the economy is preparing for positive interest rates which is normal for monetary policy. On the other hand you have the government implementing an expansionary fiscal policy.
Japan has a headline inflation rate above 2% for many months but there could be a delay in tightening as a lot of the pressure on prices is imported with local wages still not rising to match the inflation target over the long term. Also whilst inflation can be tackled with higher interest rates Japan has little chance to cut rates if prices undershoot. Consequently it makes sense to have a tighter monetary policy with the chance of higher inflation.
Adapted from CIE A Level Revision Book – Susan Grant
What is perplexing is the government’s expansionary fiscal policy which is estimated to be 3% of GDP. It consists of large tax cuts and rebates for households which appears to be more political than economic as an unpopular government is trying to please an unhappy electorate. Over the last 30 years Japan has required huge fiscal stimulus to achieve positive economic growth and avoid the risk of deflation. A positive inflation rate means that the business cycle could be managed by using interest rates and therefore less pressure on the government budget deficit to keep the economy going – injecting money in the circular flow of the economy.
Adapted from CIE A Level Revision Book – Susan Grant
Although it remains important for the central bank to avoid tightening monetary policy too early it seems irrational that the government should implement an expansionary fiscal policy. This makes the Bank of Japan’s job even harder and also uses up fiscal ammunition in the event of a global downturn.
Source: Japan’s fiscal and monetary policies are moving in opposite directions – FT November 10th 2023
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In looking at the causes of inflation, textbooks will cover demand-pull and cost-push but not go into much detail about inflationary expectations. If the consumer believes that prices of goods are going to increase this will have an impact on future price levels and the wage demands – a self-fulfilling prophecy.
Higher wages = Higher labour costs = Higher prices
Jerome Powell, US Fed Chairman, has made four 0.75 percentage point hikes in a row is an aggressive monetary policy to reduce inflation. Yesterday’s increase of 0.5% takes the bank’s benchmark lending rate to 4.25% – 4.5%, a range that is the highest since January 2008. He also alluded to inflationary expectations:
“We can’t allow a wage-price spiral to happen,” he said. “And we can’t allow inflation expectations to become unanchored. It’s just something that we can’t allow to happen.”
So how do you measure inflationary expectations? Policymakers use surveys at different times to monitor households’ and firms’ beliefs about prices. Furthermore, in order to try and shape consumer expectations central banks are very transparent as to their forecast of inflation and future interest rate changes.
How well do we understand households’ expectations? An article in the IMF Finance & Development (September 2022) looked at a deeper understanding of how consumers think about inflation. There seems to be a disagreement between consumers and policy makers with the former relying on the price change in a few products like coffee and petrol as an overall indicator of a country’s inflation rate. Past experiences —such as living through events such as the 1970’s oil crisis, the stagflation years of the late 1970’s, the Global Financial Crisis 2008, stock market crash of 1987 (Black Monday) etc, can influence peoples understanding of inflation for years to come. For instance if you lived through the stagflation years you are you more likely to be less optimistic about controlling inflation?
Andre et al (2022) recent research set out to see if economic policy (fiscal and monetary) and economic events result in the same expectations by laypeople and experts. They focused on unemployment and inflation and distributed surveys to 6,500 households and 1,500 experts. The survey asked respondents to consider four hypothetical shocks to the US economy:
a sharp increase in crude oil prices
a rise in income taxes,
a federal government spending increase,
a rise in the Federal Reserve’s target interest rate.
All respondents were given the current figures for inflation and unemployment and were asked to give their forecast of their movement over the following year after being given news about one of the four shocks. Interestingly laypeople believed that an increase in interest rates and income taxes would increase inflation which is contrary to what economics textbook models show – see Chart 1. The difference of opinion seems to stem from the interpretations of demand versus supply models see Chart 2. The experts used theoretical models and economic toolkits whilst the laypeople were more likely to rely on personal experiences, political views and a different interpretation – i.e. they look at supply-side issues:
higher interest rates = higher costs for firms = increase in prices to maintain profit margins = inflation↑
Experts take the view that it is a demand-side issue:
higher interest rates – higher cost of borrowing for consumers = less borrowing = inflation↓
Central Banks look to make communication more accessible
Central banks are now trying to, not only make communication accessible, but also much easier to understand. For example the European Central Bank (ECB) has built a presence around social media platforms using simpler language to explain the impact of interest rates on inflation.
Economic models depend on ‘rational expectations’ according to which households base their individual decisions—on how much to save, consume, and work—on expectations about the uncertain future state of the economy.
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Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.
Further goals of a monetary policy are usually to contribute to economic growth and stability, to lower unemployment, and to maintain predictable exchange rates with other currencies. Monetary policy is referred to as either being expansionary or contractionary, where an expansionary policy increases the total supply of money in the economy more rapidly than usual, and contractionary policy expands the money supply more slowly than usual or even shrinks it. Expansionary policy is traditionally used to try to combat unemployment in a recession by lowering interest rates in the hope that easy credit will entice businesses into expanding. Contractionary policy is intended to slow inflation in order to avoid the resulting distortions and deterioration of asset values. See a mindmap of Monetary Policy below.
Have interest rates gone far enough? A graphic from the FT below shows that cuts in interest rates are set to outnumber increases among the world’s 30 largest central banks. It could be that the global monetary tightening cycle has ended and economies were now approaching a point where lower growth and inflation is evident. With this is mind interest rates have done the job but cutting them straight away is always risky if inflation creeps back up again. Monetary authorities have got to be sure to avoid embarrassment so there maybe a ‘steady as she goes’ attitude and no change in rates.
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Useful video from the IMF that addresses the impact of higher interest rates on developing economies. The increase in the US Fed Funds rate increases the likelihood of financial crises among vulnerable developing countries. The main concerns are:
Public debt burdens in developing countries have been exacerbated in recent years by back-to-back global crises.
A lot of the debt accrued by low-income countries is coming due over the next couple of years.
Rising interest rates mean these countries will find it increasingly difficult to meet their repayments.
Raising U.S. interest rates has the effect of making American government and corporate bonds look more attractive to investors. The result is money flows out of developing countries as they are seen as too risky. This makes the exchange rate weaker and imports more expensive.
With interest rates still rising and global growth slowing, more collaborative efforts from international bodies and developed economies would be needed.
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An interesting graphic from the ANZ “Charts that matter” publication in which they look at the increase in interest rates by central banks and compare the current rate with that of 2002. Norway, Australia and New Zealand stand out for not having gotten nearly that far.
In both Norway and Australia, household debt relative to disposable income is meaningfully higher than it topped out last business cycle, increasing the potency of monetary policy:
Norway: 254% now vs. a peak of 209% in 2009 Australia: 197% now vs. a peak of 179% in 2007 New Zealand: 160% now vs. a peak of 168% in late-2008.
New Zealand OCR
December 2007 – 8.25%
today 5.5%
New Zealand – interest rate forecast
Inflationary pressure continues to be supported by a tight labour market, with employment above its maximum sustainable level. The unemployment rate remained very low at 3.4 percent in the March 2023 quarter. Although most indicators show that labour market pressures have eased since last year, they remain strong.
Overall, high interest rates are still needed to further slow demand. This will help to reduce upward pressure on prices, leading to lower headline inflation.
Sources: ANZ and RBNZ
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Last week Fitch, one of the three major private credit-rating agencies, downgraded the US economy credit rating from AAA to AA. The main reasons for this:
There is a major issue with US government spending and debt. Currently the US is now borrowing to pay its debt on interest on money it’s already borrowed (Ponzi scheme).
Politically neither the Democrats nor the Republicans seem to have much interest in the country’s long-term fiscal trajectory. They walked away from debt-ceiling negotiations without doing much of anything
Despite strong growth, the US government is running as large a deficit as it was during the worst of the Great Recession. And the debt now stands at $32 trillion.
The US borrowing costs are up 35% a year as central banks hike interest rates to tackle inflation. The average interest rate on US government debt has risen from 1.6% as of 2021 to 2.1% today.
Fitch is saying that the US government is not able to raise taxes or contain spending in a way that makes people confident that they can pay off its debt in the long-run.
What impact will this have? The debt would increase the country’s borrowing costs, thus reducing investment relative to consumption. Larry Summers, the former Treasury secretary, stated that there maybe insufficient investment for venture capital, inadequately trained armed forces and maintain leadership in AI and biomedicine. There is also the risk of stagflation and of investors dumping American assets. The major concern is the government’s inability to do anything effective whilst the Republicans keep taking the debt ceiling hostage while running up huge deficits themselves. Below is a report from Al Jazeera which discusses the downgrade.
Who are the credit rating agencies? There are three main rating agencies in the global economy – Standard & Poor’s, Moody’s and Fitch and they control more than 94% of outstanding credit ratings. They are basically an oligopoly influencing financial portfolio investments, the pricing of debt and the cost of capital. Their authority is also enhanced by the SEC (Security and Exchange Commission) who see them as the official CRA. See below for ratings.
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Double-digit inflation and aggressive tightening by central banks has been the order of the day in the global economy, however consumer spending still remains robust especially in the more elastic (luxury) goods and services market. Events like Beyoncé concert in Stockholm increased the inflation rate in Sweden – see here for previous post. As well as concerts, tourist activity has also been back to pre-COVID levels, so why has consumer demand held up when monetary conditions are very tight i.e. high interest rates.
The labour market remains very strong with low unemployment and strong wage growth.
The COVID times saw stimulus payments to consumers who were unable to spend their money therefore accumulated savings. This money is now finding its way into the circular flow.
A decade of low interest rates has led to greater liquidity and consumer spending.
Mortgage payments are the biggest debt that households but the rapid increase in interest rates has had less of a profound effect especially in the euro area. The ECB has risen interest rates by 4% (-0.5% – 3.5%) since late last year but the average rate for a mortgage is 2.19%.
Mortgage holders are now favouring a fixed term for their loan so they are only impacted when they have to refinance existing loans.
Households and firms are still optimistic about the future and continue to spend and borrow.
The boom in property prices since the GFC has meant a lot of younger people have been pushed out of the market and rent accommodation – see graph. The dominance of young people in the rental market is driven by both circumstances (such as an inability to afford a down-payment to buy a home, or to qualify for a mortgage) as well as choice (due, for instance, to the greater flexibility of renting relative to owning). The higher average age of homeowners has led to more that are mortgage free.
However as is the case with monetary policy there is the pipeline effect a time lag for the impact of higher rates to reduce spending and therefore can be inappropriate. Sometimes instead of offsetting the effects of the business cycle this policy might reinforce the business cycle rather than acting counter-cyclically. Until then the consumer is still keen to spend whether it be travel, concerts or the latest fashions.
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Productivity refers to the rate of output per unit of input. For an economy to increase output it can either increase its factors of production or combine them in a way that is more efficient – greater productivity. The latter is the key to boosting per-capita incomes and overall living standards.
Compared to the OECD New Zealand has been a poor performer with labour productivity averaging around 1% per annum since the early 1990’s but the small size of the economy and its isolation remain significant barriers. More inputs of factors of production have been required to generate the same amount of output which suggest that we are working harder but not smarter. As in many other OECD economies, labour productivity growth in New Zealand declined after the global financial crisis, to about a half of the pre-crisis rate – see graphic from OECD.
New Zealand’s productivity has struggled to keep apace with other OECD countries and is around 20% below the average. Its real GDP per hours worked is 40% below the US and 30% below Australia. The OECD have indicated that there are reasons for this poor productivity record namely a lack of international connection, a mismatch of skills in the labour force and low rate of capital investment / R&D.
Productivity is a way of reducing inflation by increasing output per unit of input. But if New Zealand is unable to improve its productivity performance inflation will only slowly subside. This means a contractionary monetary policy (higher interest rates) from the RBNZ will remain in place for longer.
Source: OECD Economic Surveys New Zealand – January 2022
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Figures out yesterday show that unemployment in New Zealand remained at 3.4% which makes for a very tight labour market. One wonders if this figure is beyond the maximum sustainable levels with the RBNZ worried about the pressure on private sector wages feeding into inflation. The RBNZ would like labour market pressures to ease – i.e. they want unemployment – as this should bring down inflation. However on 18th May the government deliver the Budget and no doubt there will be some fiscal stimulus that the RBNZ will need to be aware of – Expansionary Fiscal Policy vs Contractionary Monetary Policy. It seems the Government want to put money into the circular flow especially as it is election year but the RBNZ want to keep inflation between 1-3%. Ultimately it is Politics vs Economics.
Full employment doesn’t mean all workers benefit Full employment has normally been the concept that has been used to describe a situation where there is no cyclical or deficient-demand unemployment, but unemployment does exist as allowances must be made for frictional unemployment and seasonal factors – also referred to as the natural rate of unemployment or Non-Accelerating Inflation Rate of Unemployment (NAIRU). Full employment does suggest that the employee has a lot of bargaining power as the supply of labour is scarce relative to the demand. In theory a tight labour market should lead to higher wages and improved conditions of work as the employer has less labour to chose from. We have seen in the labour market incentives for employees in recommending potential candidates for vacancies in the company. Other incentives for potential employees include shorter working weeks, hiring bonuses and special leave days.
Michael Cameron’s article in The Conversation suggest that this doesn’t apply to all workers. A lot depends on the bargaining power of the worker and the elasticity of supply of labour. If the supply is very inelastic for a particular job (higher skilled) it is harder and most likely more expensive for the employer to find an alternative worker. This is evident when unemployment is low as the worker can easily look around at other job opportunities. On the contrary if the supply of labour is more elastic (lower skilled jobs) the worker has less bargaining power and the employer will have more potential workers to chose from. The graph below shows the elasticity of supply of labour – high skilled has a steeper curve (inelastic) whilst low skilled as a flatter curve (elastic)
Central Banks have often used the term ‘the neutral rate’ which refers to a rate of interest that neither stimulates the economy nor restrains economic growth. This rate is often defined as the rate which is consistent with full employment, trend growth, and stable prices – an economy where neither expansionary nor contractionary measures need to be implemented. The neutral interest rate is the rate of interest where desired savings equal desired investment, and can be thought of as the level of the OCR that is neither contractionary nor expansionary for the economy.
OCR > Neutral Rate = Contractionary and slowing down the economy
OCR < Neutral Rate = Expansionary and speeding up the economy
This neutral rate dictates when the RBNZ end their tightening or loosening cycle. If the neutral rate is seen to be 3% it is the expectation that the RNBZ will increase the OCR to 3%. The graph below shows the difference between the estimated neutral rate and the OCR. Note that:
2008 – positive gap as RBNZ trying to bring inflation under control – contractionary level 2019 – the gap narrows and monetary policy becomes less stimulatory as the neutral of the OCR is likely lower.
What determines the neutral rate of interest in an economy?
Supply of loanable funds (people who save money) and Demand to borrow money – neutral rate generates a level of savings and borrowing that delivers the economy to maximum sustainable employment and inflation – 2% in NZ but with Policy Target Agreement of 1-3%. Potential growth rate of an economy – if people expect more growth = higher incomes = higher borrowing = upward pressure on neutral rates. Economists tend to look at the production function and how much we can produce in the long-run therefore impacting aggregate supply. With higher potential growth rates investment spending is expected to increase and with it interest rates. Population growth – strong population growth = larger labour force = larger national output which supports the neutral rate of interest. Age and life expectancy – higher life expectancy increases the amount that people save during their working years. If consumers buy now rather than later = potentially either lower saving rates and/or higher borrowing = neutral rate of interest rises. Superannuation / retirement age – burden of funding retirees fall on a smaller working age population. This could require higher taxes which leads to less spending putting downward pressure on interest rates. Debt – with low mortgage rates, debt servicing have been at record lows. People have therefore borrowed a lot money and now have high level of indebtedness levels. Therefore higher mortgage rates mean that consumers disposable income will be reduced. Government debt – COVID-19 has led to increased government spending and bigger budget deficits. New Zealand economy is probably as sensitive to higher interest rates and an increase in rates by the RBNZ will be very influential, limiting how far interest rates have to rise. And with households and the Government already loaded up on debt, future borrowing capacity is now reduced, which will put downwards pressure on interest rates too. Overseas investment – as New Zealand comes a more attractive place to invest it increase the supply of loanable funds to New Zealanders. The investment will also strengthen the dollar which make exports less competitive but imports cheaper. Global capital flows mean that we can’t get too far out of sync with other advanced economies – as long as global neutral rates continue their relentless move south, so too will New Zealand’s.
Outlook In New Zealand, as in most economies, estimates of the real neutral interest rate have been trending downwards over several decades. In recent years, the RBNZ indicator suite suggests that the real neutral interest rate has stabilised at low levels. The RBNZ current average estimate for the real neutral OCR is around 0 percent. However, the wide range between the maximum and minimum values of RBNZ estimates demonstrates that there is significant uncertainty about the level of neutral interest rates, particularly since the beginning of the COVID-19 pandemic. RBNZ Monetary Policy Statement – November 2022. P. 30
Source: NZ Insight: Neutral interest rates – 20th August 2021 – ANZ Bank
The Argentinian central bank has continued its tightening cycle with 300 (3%) basis point increase in interest rates to 78%. Even with such high interest rates inflation has accelerated as basic food items such as grains and meat have increased mainly due to the drought that is affecting the country – CPI 103%. But such high rates are necessary to avoid a big outflow of the currency (Peso) as Argentinians look to the safety of the US dollar and therefore exchange their Pesos for US dollars. This would lead to a collapse of the Peso and a loss of confidence in the Argentinian economy.
The major worry about the inflation is that it has been so prevalent over the last five years that there is strong inflationary expectations. This causes consumers to buy now, rather than later when goods and services are more expensive – AD shifts to the right causing further increases in prices. It is essential for central banks to maintain a stated target for inflation – RBNZ 1-3% – as this leads to greater confidence in the economy and especially in the banking sector. New Zealand was one of the first countries to adopt inflation targeting in1990.
Trust. Ultimately the trust in the central bank meeting their inflation target is important to businesses and households as they plan for future expenses etc. Expectations are anchored around these targets and essential for consumer and producer confidence and ultimately growth. It is imperative that central banks need to be able to build up trust and institutional creditability.
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On my way to work last week there was a very good interview on National Radio (NZ) with Robert MacCulloch an economics professor at the University of Auckland. This ended up to be my lesson plan with my A Level class for the last day of term. MacCulloch argued that the interest rate hike of 50 basis points was too great an increase and could lead to a hard landing and deeper recession that could be avoided. His main arguments were:
Inflation has stabilised as quarterly inflation had dropped from 2.2% to 1.4% therefore no need for a 50 basis point rise.
In other countries (USA) inflation is dropping and those central banks are holding off on interest rate increases.
Stated that the RBNZ wants a hard landing and therefore a recession which can be damaging with higher unemployment.
More gradualist approach should have been adopted.
RBNZ stated that the post-covid inflation was a temporary blip and that stagflation was back in the early 1980’s – we live in a different world today.
Would it be better to go hard early with higher increases and then be able to loosen monetary policy? This may mean recession where you hit mortgage holders and those that become unemployed.
A lot of other central banks adopting a wait and see approach – couldn’t the RBNZ do the same?
Okun’s Law – A slowdown in GDP growth typically coincides with rising unemployment. A hard landing will result in this.
In NZ GDP shrank 2% compared to the UK 11%. NZ grew in 2021 so was there a need to have close to 0% interest rates and print $50bn?
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Martin Wolf in the FT wrote an interesting piece in the FT yesterday talking about loose monetary policy and not to wholly blame the central banks for the economic environment today. Below are some of the main points that he makes:
Deregulation of financial markets, free trade and China joining the WTO in 2001 lowered the global inflation rate.
Huge savings were prevalent in the global economy – especially in China and Germany
Balance global demand and supply = big investment in housing driven by financial liberalisation.
COVID – money growth exploded with expansionary monetary and fiscal policy.
Fiscal deficit of G7 countries jumped by 4.6%.
Monetary – quantitative easing and stimulatory level of interest rates
With supply chain issues, China’s lockdown and the Ukraine War, the dramatic increase in demand could not be met by a corresponding increase in supply. See graph
Inflation = higher interest rates = shock to banking system
Loose monetary not the blame for what has gone wrong in the global economy
Mistake to think that there is a simple solution to the failing of the banking systems
Things would not be wonderful if central banks had stood idly by. We cannot abolish democratic politics. Economic policy must be adapted to our world, not to the 19th century. Martin Wolf
Source: IMF
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Below is a useful flow chart for anyone studying monetary policy. Both the NCEA Level 3 and CIE A2 courses cover this topic.
Negative – lower interest rates might depress spending by some retirees who rely on interest income. But these counterproductive channels are small compared to the Positive – lower interest rates = a lower propensity to save and a higher propensity to spend.
The side effects of monetary policy. Falling interest rates = accelerating house prices = social problems and political anxiety. If RBNZ kept interest rates at around 8% as in the 2000s to prevent the house price = New Zealand in deflationary spiral.
The economic and social consequences of deflation would be far worse than the (undeniable) problems with rising house prices. The low inflation / falling interest rate dynamic of the past two decades has been a global phenomenon, ultimately caused by a global change in the balance between savings and investment. The Reserve Bank of New Zealand could not have prevented this global trend from affecting New Zealand interest rates without causing severe damage to the economy. In New Zealand, the most important transmission channels are asset prices and the exchange rate. Falling interest rates tend to push asset prices up, which stimulates consumer spending. Falling interest rates also tend to reduce the exchange rate, which generates inflation via the prices of internationally-traded goods and services.
Source: Westpac Bank
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Supply chain disruptions and large fiscal deficits have been part of the cause of the inflationary problems that have been prevalent in the global economy. Increased aggregate demand from government spending accompanied by supply constraints have seen prices soar. The IMF blog looked at how we should go back on history and look at how globalisation in the past has offered an antidote to inflationary spirals.
In the 1970’s technology improved global supply chains with the introduction of the shipping container which reduced transport costs of goods. Policymakers like the former US Fed Chairman Alan Greenspan see the relationship between globalisation and innovation a transition to low inflation. This idea has been embraced by current Fed Chairman Jerome Powell who talks of not only technology but demographic factors that bring about sustained disinflation. Trade liberalisation had a part of play here with the role of the General Agreement on Tariffs and Trade (GATT) – now know as the World Trade Organisation (WTO) – providing the rules for much of world trade and presided over periods that saw some of the highest growth rates in international commerce – see graph.
Modern inflation targeting by central banks (1-3% in New Zealand) also brought inflation under control as countries established a process that would allow them to attract capital flows or to globalise further. New technologies will produce better growth and increase the potential capacity of the economy (Production Possibility Curve shifts to the right) but requires a lot of cross-border co-operation. Some countries pursue costly ‘friendshoring’ strategies of steering trade to friendly nations and regimes while attempting to hobble rivals. In particular big economies look to protect strategic vital and strategic resources thereby preventing global economic growth. All of this may seem an easy solution to tame inflation but the reality is there are many variables that influence the inflation figure within countries.
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Below is a link to an interview with RBNZ Governor Adrian Orr on National Radio’s Morning Report last week. For those new to economics he explains the concept of supply and demand in layman’s terms with regard to inflation. Notice that he doesn’t mention the word ‘recession’ although talks of a couple of quarters of negative activity. As was predicted the RBNZ increased the OCR by 50 basis points to 4.75%.
Remember in 2012 the focus for inflation was given to 2% which is the mid-point in the 1-3% band. Later in 2018 an additional policy objective was added to maintain a maximum sustained employment. Worth a listen. Also below is a mindmap on monetary policy which might be useful.
ECONFIX 