Was high inflation avoidable

Warnings were made about the likelihood of rising inflation, then along came Covid-19 measures followed by a war in Europe. By Dennis Wesselbaum.

High inflation rates have returned after years of low and stable inflation in many countries according to recent IMF data. The annual inflation rate for 2022 in Germany is 8.5%, 8.1% in the United States, 9.1% in the United Kingdom, 27.2% in Ghana, and 9.4% in Brazil.

In New Zealand, we have experienced high inflation rates since mid-2021 peaking at 7.3% in the June 2022 quarter. A reminder: the target for the Reserve Bank (RBNZ) is to keep inflation within the 1–3% range.

NZ has not experienced such rates since the 1980s and early 1990s, when inflation peaked close to 20%.

Inflation harms the economy by eroding real income and, consequently, decreases purchasing power. Inflation also creates inefficiency costs due to nominal rigidities (i.e. price- or wage-stickiness), increases effective tax rates, and has redistributive effects.

A worry with high inflation rates is that they become self-fulfilling: if you expect prices to increase, you buy sooner, which drives up prices. Further, once inflation expectations affect wage setting, even temporary inflation can have long-term adverse effects due to the wage-price spiral.

Could these high inflation rates have been prevented? Naturally any answer to this question suffers from “hindsight bias”. This bias essentially makes past events appear to be more predictable than they really were.

To limit this bias and address the critique that I am an expert only after the fact, I would like to stress I have written many op-eds since early 2021 – before the high inflation rates appeared – about economic policy mistakes and warned about high inflation. For example, in May 2021, I concluded “we are likely heading to a low growth-high inflation environment, so-called ‘stagflation’, over the near future.”

Fiscal policy is key

The key reason we have high inflation rates is fiscal policy and the still missing coordination between monetary and fiscal policies.

The average annual growth rate of government consumption expenditures between 2020 and 2021 was 11.5% (average 2010 to 2019 was 4.6%). This was financed by the RBNZ’s large-scale asset purchase programme, which bought government bonds of $53 billion. This increased the amount of money in the economy by more than 20%.

This spending was especially powerful for two reasons. First, because fiscal policy has stronger effects in recessions and, second, fiscal policy has larger effects when interest rates are close to zero. Both factors were given in 2020.

Further, a theory in macroeconomics (called the Fiscal Theory of the Price Level) states that monetary and fiscal policies are bound by a common budget constraint and coordination is needed. Any difference between the real value of government debt and the present value of surpluses generates changes in the price level (i.e. inflation) that leads the economy back to equilibrium.

The key mistake was to ignore the importance of this mechanism. Monetary policy was too accommodative for too long, given the large debt-financed fiscal spending programmes that were issued without a strategy on how this debt would be repaid.

Some of the fiscal spending was an appropriate response to the pandemic, but much should have been pared back later. For example, the “cost-of-living payment” put additional oil (demand) into the (inflation) fire. But should you blame the RBNZ for fiscal policy mistakes? Of course not. Neither should we blame the RBNZ for cutting and keeping interest rates low for much of 2020. We should also be grateful that the RBNZ made sure banks had liquidity and the public had access to cash once public health measures were in place.

Most of the blame should be attributed to fiscal policy, not monetary policy. However, the RBNZ did make mistakes and continues to make them. There are two types of mistakes that interact with each other.

First, structural mistakes since Governor Adrian Orr took office, and policy mistakes since the end of 2020 that were “unforced errors”.

Structural mistakes included the demise of the research team, which led to an inexcusable brain-drain. It installed a culture in which research was not appreciated by senior leadership, and there were some appointments of individuals to senior leadership positions, the board, and the monetary policy committee who did not have a credible history of research, expertise, or practice in monetary policy (often not even macroeconomics). This was contrary to international standards and focused on topics not related to core monetary policy making. By the way, the monetary policy committee, as far as I remember, has always made a unanimous decision, whereas that hardly ever happens in, for example, the United States.

Second, monetary policy makers should, at least by early 2021, have realised the danger of high inflation rates combined with more insights into how Covid-19 affects the economy, and therefore should have increased the OCR at that time.

Even if the RBNZ had not made these mistakes, I doubt they could have avoided high inflation. At best, they could have limited the increase and maybe the duration of inflation. My guess is that, at best, they might have kept inflation somewhere about 5–5.5%.

At this point, the RBNZ can only hope that the economy will not experience a severe recession. However, hope is never a good strategy. As the saying goes: “Hindsight explains the injury that foresight would have prevented.”

Upward price pressures

Compare this to the May 2021 Monetary Policy Statement: “A range of domestic and international factors are expected to lift headline inflation above 2% for a period. Members noted these factors are expected to be temporary […].” It gets even better. “The Committee (monetary policy committee) discussed the risk that these one-off upward price pressures may promote a rise in more general inflation and inflation expectations. However, the Committee agreed that these risks to medium-term inflation were mitigated by ongoing global spare capacity and well-anchored inflation expectations.”

In the statement you can see a graph (Figure 2.16) that forecasts inflation. Guess what the maximum inflation rate was they predicted. It was way below 3% and, by now, should be closer to 1.5%!

Reserve Bank of New Zealand governor Adrian Orr gave a speech in March 2021 about “Some policy lessons from a year of Covid-19”. One section of his speech was titled “Being prepared beats guessing”. You cannot make this up.

We experience high inflation rates and then discuss the mistakes the RBNZ made that contributed to them. In short, and oversimplified, Covid-19 was a large labour supply shock rather than a demand shock.

Supply chain issues add to inflationary pressures. However, these have been easing for more than a year now. The Freightos Global Container Index has decreased since its peak in September 2021 by about 77%. The Russia-Ukraine war plays some role (mainly for energy, petrol, and food prices), but remember that inflation started to increase well before it. Further, the HWWI (Hamburgische WeltWirtschafts Institut) commodity price index has decreased by 20% since its peak. While these factors matter, they are not the key drivers.

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