Are we actually in recession and is a wage-price spiral on the cards?

For the majority of textbooks a recession is defined as two consecutive quarters of negative GDP. Whilst a lot of economies might technically go through this objective measure in the next year it is a rather strange economic environment that we live. I don’t recall a recession that coincides with record level unemployment, high consumer spending and a huge number of job openings which in turn has led to wage increases. Recession is usually associated with the opposite – high unemployment, low to nil wage growth and little spending. Therefore the economy isn’t in the usual boom-bust cycle but more of an intentional slowdown. Central banks need to get inflation under control by reducing aggregate demand through higher interest rates. Consumer prices, especially in food and energy, rising faster than wages but with wages rising there is a risk of a wage-price spiral. In order to get the inflation down most central banks only have the tools of interest rates and bank liquidity with both currently in the tightening phase.

New Zealand Employment Data – 3rd August 2022

Today’s figures labour data statistics in New Zealand were interesting to say the least. Although unemployment went up 0.1% to 3.3% against expectations it was wage growth of 7% that really stood out and reflected a really tight labour market almost matching the CPI of 7.3%. This is a major concern for the RBNZ the labour market appears to be the major driver of inflation and the threat of a wage-price spiral is very real. A self-perpetuating inflation cycle could cause domestic inflation in New Zealand to remain high, even if global pressure start to ease. In previous periods of inflation the RBNZ got help in the form of redundancies that forced numbers of consumers to cut their spending. This is unlikely in such labour market conditions and what can be sure is that the OCR will be on the rise again and is likely to increase to 4% by the end of the year.

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.

BoJ still buying bonds as other central banks reverse asset purchases.

Within the OECD are annual inflation has been rising at an average of 9.6% – its ranges from 2.5% in Japan to 73.5% in Turkey. The US and the UK has inflation of 9.1%, Australia 6.3% and NZ 7.3%. Most of the bigger economies target a 2% inflation rate and in response to these higher rates the US Fed increased its interest rates by 75 basis points to 1.5-1.75% with a potential 50 or 75 basis point rise in July. The Reserve Bank of Australia also lifted its interest rate by 50 basis points to 1.35% in July.
In order to tackle this inflationary pressure it is normal for central banks to sell bonds / assets back into the market which is turn reduces the money supply and raises interest rates. This should depress aggregate demand as there is now less money in the circular flow and the cost of borrowing goes up. However, the Bank of Japan (BoJ) is out of kilter with accelerating interest rates as it has committed to its policy of yield curve control intended to keep yields on 10-year bonds below 0.25% by buying as much public debt as is required – see graph below:

FT – Investors crank up bets on BoJ surrendering yield curve controls

How to Bond Yields work?
Say market interest rates are 10% and the government issue a bond and agree to pay 10% on a $1000 bond = annual return of $100.
100/1000 = 10%
If the central bank increase interest rates to 12% the previous bond is bad value for money as it pays $100 as compared to $120 with the a new bond. The value of the new bond is effectively reduced to $833 as in order to give it annual payment of $100 a year the price would have to be $833 to it a market based return.
100/833 = 12%

Yield curve control
Yield curve control (YCC) involves the BOJ targeting a longer-term interest rate by buying as many bonds as necessary to hit that rate target. It has been buying Japanese Government Bonds (JGB) at a monthly rate of ¥20trn which is double its previous peak of bond buying in 2016. Although there is no theoretical limit on its buying ability it has impacted the currency which has fallen to a 24 year low against the US dollar. This will push up the price of imports and inflation although the BOJ is confident that the price rises in its economy are transitory. If inflation does start to consistently hit levels above the BOJ’s target of 2% will they reverse their bond purchasing policy and shift to a higher yield cap?

Shorting JGB’s
A lot of investment banks are looking to short JGB’s. In this situation the trader suspects that bond prices will fall, and wishes to take advantage of that bearish sentiment—for instance, if interest rates are expected to rise. This will likely happen if the Japanese relax their YCC with interest rates rising and bond prices falling – see image below for a simple explanation of shorting.

Source: Online Trading Academy

Sources:

  • The Economist: – BoJ v the markets. June 25th 2022.
  • Financial Times: Investors crank up bets on BoJ surrendering yield curve controls. June 23rd 2022

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Inflation and the Base Year Effect

A price index is a means of comparing a set of prices as they change over time. Index numbers allow for a comparison of prices with those in an arbitrary chosen reference (base year), a year that current values can be compared against. This base year is usually given a numerical value of 100 or 1000. The index number allows for percentage changes to be calculated between various time periods.

If we look at the last few years some of the current inflation increases has been exaggerated by what are known as base-year effects. What has happened is that annual inflation has been measured against a time during the COVID-19 pandemic when economies were locked down and prices slumped. Therefore the inflation figures around the world have been increasing quite rapidly but soon they will be measured against the current higher prices which should mean a lower inflation figure. Regions such as Europe that rely on imported energy may see a greater fall in inflation than others if the price of fuels like oil and gas were to quickly cool. But that doesn’t seem likely in the current climate especially with the war in the Ukraine and come October the northern hemisphere heads back into winter with greater energy use. The graph above is a little out-of-date in that inflation in the UK is now 9.1% and the Bank of England expect it to exceed 11% in October. The USA has an inflation rate of 8.6% and it is expected to reach 9%.

Central Bank rate increases in 2022
Below are the central bank rate hikes this year and the big question is have they got their timing and rate increases right.

  • With the threat of inflation should banks have increased their rates earlier?
  • If they tighten too quickly will that tip their economy into recession and a hard landing?
  • What is the right rate increase for the current inflation figure?
  • How long (pipeline effect) will it take for interest changes to impact the inflation figure?
  • These are the challenging questions that central bankers face in today’s environment.

For more on Inflation and Base Rates view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

IB/A2 Economics – Macroeconomic policies essay

With the mid-year exams next week here are a couple of mindmaps I produced using OmniGraffle (Apple software). I found it a useful starting point for students to discuss the effectiveness of each policy and the conflicts within macro objectives. This is a very common essay question in CIE Paper 4. My question would be:

What policies has the government in your country implemented since Covid-19 and how successful have they been in meeting macro economic objectives? (25)

Interest rates and controlling inflation

Excellent video from The Economist. It goes through the impact of raising interest rates in an economy – mortgages, spending patterns, inflationary expectations. Also looks at when interest rates in the US went to 19.5% during the 1980’s. There is a fine line between increasing interest rates too quickly and tipping the economy into a recession or being too slow with the tightening process and letting inflation spiral upwards. The video discusses all these points – great revision for the Inflation topic at NCEA, IB and CIE.

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Turkish inflation hits 73.5% but not surprising.

Most economists are in agreement that when there is an increase in inflation the central bank increases the base interest rates in order to reduce spending and encouraging saving. This takes money out of the circular flow and should lead to less borrowing and therefore less pressure on prices.

The Turkish lira dropped by 17% this year with three cuts in interest rates since September. This comes as inflation has climbed to 73.5%. So why would you drop interest rates when you have rapidly increasing inflation? President Erdogan sacked the governor of the head of central bank Naci Agbal who had been hiking interest rates to dampen down inflation – he was the third governor to lose his job in the last two years. Erdogan believes that raising interest rates would raise inflation rather than reduce it and he proceeded to cut rates further which saw an even steeper decline in the lira. An argument for this policy could be that the cheaper exports can drive economic growth.

Source: FT4th June 2022

The collapse of the lira make exports competitive and imports more expensive and in September Turkey posted a current account surplus thanks in large to a recovery in tourist numbers. Turkey relies heavily on imports of raw materials and energy and with the exchange rate falling these have become a lot more expensive. Although Turkish exports should be cheaper, the heavy import component of finished exports makes those goods more expensive so this outweighs the benefits of having a cheaper lira – e.g. in assembling kitchen appliances the price of imports of the component parts make the overall price of the appliance more expensive. This just fuels more inflation. Supermarkets are limiting customers to one item as they know people will stockpile produce with the ever increasing inflation rate.

So with inflation now at 73.5% and and interest rates at 14% this makes real interest rates = – 59.5%. The central bank kept its benchmark interest rate at 14% at its May meeting, extending a pause that followed 5% of cuts last year. This has led to the local population to turn to other currencies – US$ Euro – in order to protect the value of their money. Below is a very good video clip from Deutsche Welle (German World Service) outlining the crisis that Turkey face and how a policy of cutting interest rates has backfired.

The impact of a tighter monetary policy.

Below is a CNBC video on the impact of higher interest rates which is now the case in many developed economies. As post-covid demand surges and supply chain problems exacerbate, inflation has started to impact many economies with higher prices and a cost of living crisis. In order to control this inflationary pressure central banks around the world have been forced to adapt a more contractionary monetary policy which means higher interest rates. The Reserve Bank of New Zealand even gets a mention. Good for revision of the flow on effects in an economy from higher interest rates.

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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AS & A2 Economics Revision – Monetary Policy Mind Map

Going over monetary policy with my A2 class and have modified a mind map done by Susan Grant from a CIE Economics Revision Guide. Useful for those who are sitting the June AS and A2 Economics papers.

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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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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

Teaching Monetary Policy – Every Breath You Take – Every Change of Rate (Fed Funds Rate)

Here is a really funny video by the students of Columbia Business School (CBS) – you may have seen it before but I find it very useful when you start teaching monetary policy and interest rates.

Back in 2006 Alan Greenspan vacated the role of chairman of the US Federal Reserve and the two main candidates for the job were Ben Bernanke and Glenn Hubbard. Glen Hubbard was (and still is) the Dean at Columbia Business School and was no doubt disappointed about losing out to Ben Bernanke. His students obviously felt a certain amount of sympathy for him and used the song “Every Breath You Take” by The Police to voice their opinion as to who should have got the job. They have altered the lyrics and the lead singer plays Glenn Hubbard.

Some significant economic words in it are: – interest rates, stagflate, inflate, bps, jobs, growth etc.

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.

New Zealand’s interest up 25 basis points but is it still stimulatory?

Today, not surprisingly, the RBNZ increased the official cash rate (OCR) by 25 basis points – 0.25% – to 1%. There was a suggestion in the RBNZ Monetary Statement that the increase could be 50 basis points but noted a preparedness to move in bigger steps than 25bp if required”. The RBNZ forecast endpoint for the OCR has been increased to 3.35%. and expect annual CPI inflation to peak at 6.6% in the March 2022 year and to fall back to the 1-3% inflation midpoint by mid 2024. The reduction in inflation should come from the easing of supply chain disruptions, lower commodity prices and tradable inflation. But the question that needs to be asked is, will this tightening be sufficient to dampen the following:

  • domestic pressure from the housing market,
  • wage pressure with 5.9% inflation and unemployment at a very low 3.2%,
  • prices of locally produced products (non-tradable inflation)

The Neutral Interest Rate

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

The RBNZ’s  estimate of the neutral OCR is between 0.9% and 3.1% – see below.  Like many other countries, the neutral cash rate in NZ is estimated to have been declining over many years.

OCR - Neutral Rate

Since the GFC neutral rates around the world have been falling which reflects the following:

  1.  Lower expectations about growth in the economy = reduces the return to investment
  2.  Relative to pre-GFC, a wider spread between the central bank rate and the interest rates faced by households and businesses (i.e. mortgages and business lending rates).
  3. An increase in global desired savings. For instance, demographic trends offshore have led to an increase in saving among the cohort of the population going through prime earning years (as they save for retirement). Likewise, increased income inequality is thought to increase desired savings, as top income earners typically have a lower marginal propensity to consume – MPC.
  4. Higher debt ratios in some countries (including NZ) make the economy more sensitive to interest rate increases than before.

Central Banks don’t have the independence to set the neutral rate as it is very much influenced by global forces. However they do have independence as to where they set their policy rate relative to the neutral rate.

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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.

For more on Monetary Policy view the key notes (accompanied by fully coloured diagrams/models) on elearneconomics that will assist students to understand concepts and terms for external examinations, assignments or topic tests.

New Zealand’s ‘Output Gap’

A good example of the output gap from the RBNZ Monetary Policy Statement last week – see graph above. There are strong capacity pressures which are the result of the unleashing of domestic demand and supply chain disruptions. Although the latter has increased it is presently unable to keep up with the the overall aggregate demand of the economy and subsequently this has driven inflation up to 4.9% above the 1 to 3% remit target band.

With unemployment at 3.4% and *underutilisation of 9.2%, annual employment growth of 4.3% (September 2021) cannot be maintained with this pressure on the labour market. There has been strong demand for more workers in some sectors, but it has been difficult for businesses to recruit extra staff. This has seen wages rise as firms compete for workers. However it is important to remember that on 29th October there were still 1,282,152 jobs being supported by a wage subsidy. A total of NZ$3,719.7 million had been paid via the COVID-19 Wage Subsidy August 2021. With the continued demand for labour, wage pressure and salary costs are expected to increase. Consequently a rising unemployment rate could be evident.

*underutilisation  – measures spare capacity in New Zealand’s labour market. People do not have a job, but are available to work and are actively seeking employment

Notes on the output gap

If there is no long-term trade-off, low inflation does not permanently choke growth. Moreover, by keeping inflation low and stable, a central bank, in effect, stabilises output and jobs. In the graph below the straight line represents the growth in output that the economy can sustain over the long run; the wavy line represents actual output. When the economy is producing below potential (ie, unemployment is above the NAIRU), at point A, inflation will fall until the “output gap” is eliminated. When output is above potential, at point B, inflation will rise for as long as demand is above capacity. If inflation is falling (point A), then a central bank will cut interest rates, helping to boost growth in output and jobs; when inflation is rising (point B), it will raise interest rates, dampening down growth. Thus if monetary policy focuses on keeping inflation low and stable, it will automatically help to stabilise employment and growth.

Gapology

What determines the Neutral Rate of Interest?

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
With the COVID-19 lockdown, increasing levels of debt amongst households and business and record low interest rates there is an expectation the RBNZ will increase the OCR. But with the OCR at such a low level already the RBNZ is running out ammunition if it wishes to stimulate the economy through conventional monetary policy.

Source: NZ Insight: Neutral interest rates – 20th August 2021 – ANZ Bank

Inflation in Latin America


Latin American countries are now struggling to control inflation and have succumbed to raising interest rates despite having slow growth economies. Inflation in this part of the world has a bad track record with Argentina, Bolivia and more recently Venezuela experiencing hyperinflation. Furthermore, these countries have been hit hard by the pandemic and their economy’s need to develop more economic growth to create jobs and higher incomes. Rising interest rates is the last thing they require especially after government stimulus programmes are winding down and the revenue from commodity prices is starting slow.

Latin America is struggling with the combined health and economic impact of COVID-19 than any other region. Inflation rates are currently – Brazil – 9.7% Venezuela – 5,500% Mexico – 6.1% Chile – 4.8% Peru – 4.95% Columbia – 4.4%

Source: FT – The spectre of high inflation returns to haunt Latin America. 11th September 2021

Are we heading into Stagflation?

There is concern that the current mix of expansionary monetary (near 0% interest rates) and fiscal (lower taxes and increasing government spending with COVID-19) policies will excessively stimulate aggregate demand and lead to inflationary overheating. Add to this negative supply shocks and you have an increase in production costs. This combination could lead to a 1970’s stagflation – rising inflation and unemployment – see graph below. Since the days of stagflation in the US and UK in the 1970’s inflation has been the number one target for central bankers. The main cause of inflation during this period was the price of oil –

  • 1973 – 400%↑ – supply-side– Yom Kippur War oil embargo
  • 1979 – 200%↑ – supply-side – Iran Iraq War
Source: The Economist

US President Jimmy Carter’s attempts to follow Keynes’s formula and spend his way out of trouble were going nowhere and the newly appointed Paul Volcker (US Fed Governor in the 1970’s) saw inflation as the worst of all economic evils. Below is an extract of an interview from the PBS series “Commanding Heights”

“It came to be considered part of Keynesian doctrine that a little bit of inflation is a good thing. And of course what happens then, you get a little bit of inflation, then you need a little more, because it peps up the economy. People get used to it, and it loses its effectiveness. Like an antibiotic, you need a new one; you need a new one. Well, I certainly thought that inflation was a dragon that was eating at our innards, so the need was to slay that dragon.”

The policy of the time was Keynesian – inject more money into the system in order to get the economy moving again. This was also the case in the UK in the early 1970’s but Jim Callaghan’s (Labour PM in the UK ousted by Thatcher in 1979) speech in 1976 had reluctantly recognised that this policy had run its course and a monetarist doctrine was about to become prevalent. Below is an extract from the speech.

“We used to think that you could spend your way out of a recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists, and in so far as it ever did exist, it only worked on each occasion since the war by injecting a bigger dose of inflation into the economy, followed by a higher level of unemployment. That is the history of the last twenty years”

With this paranoia about inflation central bankers began to implement a monetary policy targeting inflation in the medium term. In NZ the Reserve Bank Act 1989 established “price stability” as the main objective of the RBNZ. “Price stability” is defined in the PTA (Policy Target Agreement) as keeping inflation between 1 to 3% (originally 0-2%) – measured by the percentage change in CPI. Around the world central banks were adopting a more independent approach to policy implementation and with targeting inflation a new prevailing attitude seemed to be like an osmosis and suggesting that low prices = macro-economic stability as well. Also, raising interest rates is an unpopular political move and governments could now blame the central bank for this contractionary measure.

So are we now concerned that we will be entering another period of stagflation? Like the 1970’s we do have a supply-side issue (although not oil based) and expansionary demand side. The following are concerns:

Growth – Supply bottlenecks have led to growth slowdown in the US, China, Europe and the other major economies. Furthermore the Delta variant is increasing production costs as well as impacting the labour supply and ultimately reducing output growth. There is also the problem of moral hazard in that generous unemployment benefits are reducing the incentive to find work.

Demand Side – Excessive fiscal stimulus for an economy that already appears to be recovering faster than expected and it is assumed that the US Federal Reserve and other central banks will start to unwind their unconventional monetary policies. Combined with some fiscal drag next year (when deficits may be lower), this supposedly will reduce the risks of overheating and keep inflation at bay.

Supply Side – Again Delta is impacting many global supply chains, ports and logistical systems. Shortages of semi-conductors impacts the car industry as well as electronic goods thus increasing in inflation. Will the global supply side be positively influenced by better use of technological innovation in artificial intelligence and the return to normality on global supply distribution networks. Also will demand pressure eventuate especially when the threat of unemployment is ever present.

Although there are negative price shocks which could deter potential growth, expansionary fiscal and monetary policy could still increase the inflation rate. The resulting wage-price spiral could lead to astagflationary environment worse than the 1970s – when the debt-to-GDP ratios were lower than they are now. That is why the risk of a stagflationary debt crisis will continue to loom over the medium term.

Source: The Stagflation Threat Is Real – Nouriel Roubini – Project Syndicate 30th August 2021