The drivers of New Zealand inflation

Maybe this is not what you want to hear, but you need to hear it, writes Dennis Wesselbaum.

Inflation has now returned to New Zealand for about one year. The unlucky numbers are: 3.3, 4.9, 5.9, 6.9, which are the last four quarterly inflation rates. The return of inflation has triggered lively exchanges between the Government and the opposition and a lot of bad reporting in the news media.

A central point has been the discussion about what drives inflation: global factors or government spending? Maybe supermarkets? Putin? Statements by National and Act put fiscal policy in the hot seat, while Labour argues it is all about global factors, which are beyond their control. Watching TV news, you might think it is entirely driven by supermarkets.

The Adrian Orr-led Monetary Policy Committee of the Reserve Bank of New Zealand concluded the key drivers of inflation are: (i) strong global economic activity, (ii) supply disruptions, and (iii) the Ukraine War. This is surprisingly in line with what Finance Minister Grant Robertson argues: global factors.

When you look into the data you see that these arguments miss the key point.

Yes, supply chains are adding to inflationary pressures; however, these have been easing (but could easily increase depending on China’s Covid policy). For example, the Freightos Global Container Index (FBX) has decreased since its peak in September 2021 by about 20%. The Ukraine War has only temporarily increased commodity prices and, according to the Hamburg Institute of International Economics’ HWWI commodity price index, prices are trending down. Further, recall that inflation started to increase way before the Ukraine War started.

What then, is the main driver of inflation?

In early 2020, Covid started to spread and the Government decided to put NZ into a lockdown for almost two months, with more lockdowns to follow, especially for Auckland. At the same time, it seems many believed that Covid and the public health measures would cause a substantial fall in aggregate demand.

In response, the Government started to increase spending. The average annual growth rate of Government final consumption expenditures between 2020 and 2021 was 11.5%. In comparison, from 2010 to 2019, it was 4.6%. According to OECD data, government consumption increased from $4.6 billion in 2019 to $6.9b in 2020 and $9.2b in 2021.

This was mainly financed using the RBNZ’s balance sheet, which roughly tripled since 2019. Broad money (the amount of money in an economy) increased by about 21% since January 2020. The main driver was the Large-Scale Asset Purchase (LSAP) programme. LSAP bought New Zealand Government bonds on the secondary market, which, essentially, is fiscal financing by the central bank. It started in March 2020 and stands at about $53b.

What does research tell us about the effects of fiscal policy? Robust lessons are that fiscal policy has larger effects in a recession, that it has larger effects when interest rates are close to zero, and it creates inflation with a delay of about one year.

When did the Government start to spend? During the June 2020 quarter, when the OCR was 0.25% and GDP fell temporarily by about 10%. When did inflation start to increase? During the June 2021 quarter: about one year later.

The large, persistent fall in aggregate demand did not materialise. From a purely macroeconomic perspective, Covid and the public health measures caused a large, negative supply-side shock. Supply goes down and demand goes up. What happens? Prices go up.

Chris Luxon and David Seymour have it exactly right when they say that wasteful Government spending contributed to inflation. I think the Government overspent over the last couple of years (especially in 2021 and 2022) and, in particular, spent wastefully rather than in productivity-enhancing activities.

Further, the proposed “Grocery Commissioner” is nothing but a futile attempt by Labour to put blame on a scapegoat: the supermarkets. Inflation is not related to supermarkets.

Yes, the low competition in the supermarket sector in NZ will have an effect on the level of prices (relative, for example, to Australia) but it will not affect the change of prices (i.e. inflation). In fact, the policies discussed by the Government could actually lead to more cooperation between the current supermarket companies to engage what economists call “entry deterrence” (i.e. work together to prevent someone from entering the market).

Here is what you should be really worried about:

First, the unwillingness of the Wellington elite to accept that fiscal policy adds to inflation and, therefore, continued wasteful spending. Second, that inflation expectations become unanchored: household’s one-year, five-year inflation expectations are already at 7, 3% respectively.

Monetary policy is all about keeping expectations stable (at about 2%). To do so, the central bank needs to make good policy decisions, needs to be credible, and clearly communicate with the public. Unfortunately, in my opinion, the RBNZ has lost credibility and economic expertise under Governor Orr, which poses a major threat to the functioning of monetary policy and macroeconomic stability.

• Dr Dennis Wesselbaum is a senior lecturer in the Department of Economics at the University of Otago.