Inside the Reserve Bank's (even bigger) rate hikes
Bernard Hickey interviews RBNZ Chief Economist Paul Conway about why the RBNZ is cracking down even harder on inflation, and which types of our inflation are stickiest, and trickiest, to slow
TLDR: This week’s tougher-than-expected moves by Te Pūtea Matua (the Reserve Bank) to engineer a recession next year to get inflation back under control has surprised a generation that became inured to low and stable inflation and interest rates.
I spoke to Reserve Bank Chief Economist Paul Conway yesterday about why the bank is cracking down so hard, and whether it could have waited longer for inflation to subside naturally. He details why the supply shocks from Covid and the war in Ukraine cannot be ignored. The full interview is in the podcast above and there is a full transcript below.
Lynn and I are now travelling on holiday (mostly) in Australia for the next couple of weeks, which means we’re dialling back our weekly features on a Friday until Friday December 16. That will conclude our last full publishing week of the year. We’ll have a final Ask Me Anything for 2022 at midday on December 16 and a final ‘Hoon’ at 5pm on December 16. I’ll still produce daily Choruses Monday to Friday through to December 13, but will not do quite so much. This is our first proper holiday since we launched paid version of The Kākā and will get to see our Australian family and friends for the first time in three years.
A lightly-edited transcript of our conversation
Bernard: Welcome to The Kākā to Paul Conway, who is the Chief Economist at the Reserve Bank. It’s been a busy week?
Paul: It has been another busy week. To get the latest Monetary Policy Statement out the door — on top of our RAFIMP five-yearly review of monetary policy, which went out the door a week and a half ago — feeling pretty satisfied to get those two chunky bits of work out into the world.
Bernard: And it's been a big week because 75 basis points is the biggest hike since the Reserve Bank started using the official cash rate in 1999. And there's been a hike every decision so far this year. And for a generation of people watching interest rates, thinking about mortgages and thinking about the economy, they've never seen 7% inflation and four percentage points of increases in the official cash rate before.
So could you explain for people why there's been such a big change, why there was also a big increase in the forecast track for the official cash rate now, what's changed in three months that meant that the Reserve Bank has had to do all?
Paul: We've been tightening policy for a little over a year, and we've done 400 basis points or 4%. We've increased the official cash rate from a sort of emergency low of 0.25%, which was put in place in 2020 going into the pandemic. As you said, it's the most rapid escalation in the official cash rate since we've had the official cash rate.
That speaks to how quickly the economic environment has changed from one in which, going into that pandemic, it was all very serious, with a risk of a massive recession, if not a depression and double digit unemployment, impinging on people's wellbeing. And the call then was let's go hard, both in terms of fiscal policy and in terms of monetary policy.
Now 18 months, two years down the track all of that worked and instead of having double digit unemployment, we've got inflation up at seven 7.2%. So that's what we are pushing back against: how do we contain inflation?
So why is the engine red-lining now?
Bernard: For 20 years or so, the engine room of the global economy and our economy, had a certain speed limit and capacity and seem to be able to handle quite low interest rates without generating lots of inflation. What's changed in that engine in the last couple of years? Why are we past the red line and we're overheating?
Paul: I do think the pandemic accentuates trends that were already underway in the economy. Over that pre-pandemic period, economists used to talk about the great moderation where the business cycle was really minor. Inflation was low and stable. The challenge was actually to get inflation up to the 2% midpoint of the Reserve Bank's target band.
And that was tough, although a good problem to have in hindsight. The reason being we lived through positive supply shocks, technology shocks. We were getting better at producing stuff. We also had, globalisation came along and China became the workshop of the world and exported deflation with cheap, cheap products that were made very efficiently, very competitively. Demographics were also on our side. The working age population was increasing over that time.
And workers tend to produce more than we consume, because we save, ideally, which again is deflationary. And a lot of those things have turned around. So globalization — I don't sort of buy into the idea it’s going backwards, but it's definitely peaked and it's definitely changing.
The world is splintering into different factions or clubs of countries. So globalization, at least for the meantime, isn't being that sort of dependable deflationary force. China’s inward migration of people from the west of the country or the farms in the west to the cities in the east has sort of slowed down and demographic change has also slowed down.
We're back to worrying about aging populations around around the world, the OECD and here in New Zealand. They're all big slow moving forces, but the pandemic has hastened that switch. So obviously we are grappling with too high inflation at the moment and a labour market that's overheating beyond maximum sustainable employment.
We’ll sort all that out definitely, but I think we are entering into an economic period that is a bit more volatile, these kinds of supply shocks come along a bit more regularly. We will probably see that underlying inflation a bit higher than what it's been over the last decade or two.
So what are the permanent and temporary supply shocks?
Bernard: Let's talk about those demand and supply shocks. We can understand there's been some demand shocks in that a few more people had a bit more money during covid. There were cash payouts all around the world from governments and sometimes to companies. We had had very low interest rates for a long time, and in some places people used quantitative easing to push down interest rates further out, and New Zealand did that for the first time.
But on the supply side, I'm trying to understand what are the permanent supply shocks, and what are the ones that might be temporary? I can see with Covid that people had to stay home for a few weeks. Maybe there are a few people sick, but how much of the supply shock is permanent, and therefore we have to really adjust for it and think about it, and how much of it is temporary that maybe we could just let go through to the keeper?
Paul: When we were all in lockdown the first time, that was a huge supply shock because not all of us could just keep on working from home, but obviously temporary, because we can't do that for the rest of our lives. So that’s been and gone to a large extent, although sickness is higher now than it used to be. Who knows how that's going to play out, and I think that that is significant.
In the last MPS we were factoring 2% of the labor force being out at any one time with Covid and with winter illnesses, which will be easing up a bit now as we move into into summer. But again, that’s a supply shock, that's at least semi-permanent in that it's persisting into the future.
Then there’s the scarring effects
Then you could think about other supply shocks coming out of the pandemic, around what economists call scarring effects, like education. I was really feeling for the year 12, year 13 kids who had exams and even first year university, where it's meant to be all fun and you sort of come together and all that, and it kind of didn't.
I think there's a risk there and we are sort of seeing it with low rates of kids going to school, that sort of scarring effect that can persist for some time into the future. It cuts to the question that central banks were grappling with last year, around is the inflation that we were starting to see, is it going to be temporary, or is it going to be persistent?
If it's temporary, central banks tend to look through it, especially if it's something like an oil shock or something like that, there's nothing we can do about it. So there’s no sense in changing interest rates, throwing the economy around, to sort of deal with this shock that we can't do anything about, and it'll sort of look after itself in due course.
But if inflation more permanent, so getting into core inflation and inflation is feeding into wage expectations, and then wages are feeding back into, higher prices, that is exactly the kind of thing that a central bank will lean against.
I think the inflationary pressures we've been living through, they're obviously more permanent than people were thinking a year or so ago, but there's still a reasonable possibility that some of that inflationary pressures will fall away reasonably quickly.
Touch Wood. Fingers crossed.
How much could we have let go through to the keeper?
Bernard: So that was the Covid supply shock. And then no one knew what Vladimir Putin had up his sleeves. So that's an energy market supply shock that unleashed all sorts of forces around world energy system, with electricity and gas and LNG.
How much do you think of the Russian invasion of Ukraine is a temporary supply shock that we can let go through to the keeper. And how much is a permanent thing we have to really think about.
Paul: We've been exposed to a whole series of supply shocks. The pandemic was one and we responded quite appropriately with fiscal support and and really loose monetary policy to keep people attached to the labor market. So incomes actually didn't take a hit over that period, which is one reason why demand stayed quite strong through that period. The labour shortages kind of came a bit later, but with a really tight labor market, and supply chain disruptions.
And then just as we were getting our heads around all of that, along came the conflict in Ukraine, which send a shudder through global energy markets and global food markets as well. Between them, Russia and the Ukraine exported something like 13% of global calories prior to the pandemic.
So this has been massive and is causing all sorts of problems throughout the world, in developing countries in terms of food prices. Hunger is going up, and to some extent we're a bit isolated from it here in New Zealand, particularly the energy aspect.
Yes, we get it through oil prices, but we're obviously self-sufficient in terms of electricity. What you see when you look at inflation rates around the world, the countries that are closest to Eastern Europe are at the epicenter of high headline inflation that's being driven by high energy costs and high food costs.
The further away you get from that, the less those costs are impacting on headline inflation. So in New Zealand, for example, our headline inflation rate currently is among the lowest in the OECD, which is still far too high and we have to fix it, but in a relative sense, we are being spared the worst effects of that crisis.
How much is domestic and how much is from overseas?
Bernard: How much of the inflation is generated here? We've had people with Covid as well, and obviously with the restrictions on people coming in and out now through Covid, our ability to add extra labour into the labor supply has created a labour supply shock. And how much of the inflation is overseas demand and supply?
Paul: It's a little bit tricky to separate them. Tradables inflation, inflation that comes over the border, goes into inputs of businesses and then affects the prices of their products, which might be what we call non tradable or homegrown inflation.
But our best estimates at the moment are that half of the 7.2% inflation right now originated overseas and about half is homegrown. Those external inflation shocks or tradable inflation shocks, they came over our border and they hit a really tight labor market.
That kicked off that homegrown or domestic inflation that we are now pushing back against. So it's been a really interesting period in terms of inflation dynamics and as you say, many listeners, won't have seen this before.
You and I are lucky, Bernard, we've actually seen it before in the late eighties.1
Bernard: For those people who wonder ‘it's not my fault that we've got all this inflation. I didn’t do Covid and Putin did Ukraine – how come I'm now having to pay for it with higher mortgage rates?’
Can't we just wait for this to wash out of the system and no one get hurt? No one loses their jobs.
Paul: First of all, the labour market is so strong that there's a lot of jobs out there at the moment. There's a lot of vacancies out there at the moment, which is great.
That's a real bedrock of our economy at the moment. And if the labor market stays strong, like we're projecting, with with the contraction of economic growth coming up next year. It could be job rich contraction.
We're all part of this system. We're not islands. So yes, I do see the economy as a sort of collective, a community of people really, and what happens to it affects all of us, uh, one way or another.
Supply was shocked lower, so we have to lower demand
Inflation in a typical business cycle would be where demand would get out of the box for whatever reason, and we'd put on the brakes and it would slow down. But now it's more supply side. Inflation is more driven by what's happening on the supply side, but there's still excess demand in the economy.
So essentially we have to respond in the same way. We call it the output gap, the difference between aggregate demand and aggregate supply. And we have to close that one way or another.
If only there was a positive productivity shock
A positive productivity shock would be great. We could increase the supply capacity of our economy and that would be disinflationary. Say, greater competition in New Zealand markets, as we’re seeing with supermarkets and fuel retailers in the like.
That's all very positive as well and will keep inflation pressures contained, but none of that is likely to have an effect over the next 18 months, two years. Any productivity boost would be too slow, so it falls to the Reserve Bank to engineer a slow down in aggregate demand.
But what about a profit margin-price spiral?
Bernard: So overseas we've seen the likes of the US Federal Reserve Vice Chair Lael Brainerd point to higher profit margins there as potentially responsible for some of the inflation. What are we seeing here in terms of profit margin expansion? Is it actually part of the reason for the inflation?
Paul: Unfortunately, we don't have great data on profits. It’s a real blind spot in hows we measure our economy. So I can only answer in an in-principle sort of way.
It is true that we fret about the possibility of a wage-price spiral, that higher prices are going to feed into higher wages and so on and so forth. What happens on the profit side of the equation, if firms are able to increase their profit margins for no good reason, it’s a battle that's existed over millennia between the owners of capital and the owners of labour.
As economists, we summarize it as a thing called the labour income share. So what share of national income is being paid to the owners of labor, and what share is being paid to the owners of capital?
We’re all for higher wages. It's obviously a fundamental driver of wellbeing in our economy, but they have to be based on productivity improvements. So if productivity is going up, we're creating more for less, and there's more surplus for workers and for the owners of capital.
If wages are going up more quickly then productivity, which hasn't happened for a while, then the labor income share would be increasing. Whereas if wages are going up more slowly than productivity, then that labor income share would be decreasing. What we’ve seen internationally, at least lately, or at least pre-pandemic, is consistent with the situation you were talking about.
So the labor income share has been declining across a bunch of OECD economies as technology has made it easier to swap workers out. Trade unions don't have the bargaining power that they once had. So it’s been in favor of the owners of capital.
Now that pendulum is very much swinging back to being in favor of workers. The competition for workers in the labour market is bidding wages up. Um, so I think, um, you know, I'd be interested to know more about that Lael Brainerd stuff in the US, but economist intuition at the moment tells me that the labour market is so tight.
Then you have to think about what's competition like? Are these firms competing or can they simply put their prices up because they have got a monopoly or a oligopoly? And if they don't, then it's hard to envisage that profit share increasing in any meaningful way.
Are higher profit margins gumming up and overheating the engine?
Bernard: If you think about labour productivity as a very efficient engine that's producing more power with the same amount of pistons and gaskets. You could argue that an engine where the controllers of capital, the businesses that effectively increase their profit margins because there isn't as much competition in the sector, are in a way gumming up the engine. You could argue that’s one of the reasons why the engine is overheating because there's too much gum in there.
Paul: In our monetary policy statement that we put out yesterday, there's a chapter in there on wages, which kind of cuts to this productivity issue. If you look at what's called the labor cost index, which sort of measures the cost for a business of a lump of labor, like just the same amount of worker doing the same amount of work, if you look at wages for that, they haven't been keeping up with inflation.
So there's negative real LCI wage, which we sort of take a bit of comfort from, because it means that the chances of that wage price spiral getting going, we're not seeing too much evidence of, which is fantastic.
But then if you look at broader measures of what's happening with wages through the quarterly employment survey, and as well as accounting for that sort of lump of labor idea, they also factor in people moving between jobs, people working longer hours, getting promotions, going to other employers.
When you look at that broader measure of labor, it is keeping up with inflation. So real wages in that sense are not too bad given the sort of period that we've been through. And the difference between those two is that labour costs for firms are below inflation, so that's good keeping their prices down.
What’s so bad about inflation again?
Bernard: For those who weren't around in the eighties and nineties wondering why everyone's so het up about inflation, when perhaps their wages, as you say, in total, are rising as fast as prices and there’s 3.3% unemployment. Sounds good to me. What's so bad about inflation that we have to really pull the lever so hard.
Paul: There's many problems with inflation. It's a tax on your savings and a pay cut rolled into one, and we are just expending a lot of energy on understanding what's happening with pricing in businesses, and then feeding into wage negotiations.
I kind of think of it like a dog chasing its tail. There's economic energy going into just doing all of that stuff instead of focusing on what really matters. It's a really good question. Inflation's going up. Why is the Reserve Bank turning up and saying interest rates need to be going up as well? Inflicting more sort of pain on people who have debt. We don’t talk so much about savers who probably quite like interest rates going up a bit.
Stopping inflation expectations racing away
The reason we do that is if inflation gets out of control, if it gets embedded in the economy, if people expect inflation's going be 10% from here to infinity, they’re going to demand a 10% pay increase and that spiral gets away on us.
So the thing is now we just try and slow the economy. We get inflation back down into its box, because that's the best contribution that monetary policy can make to economic performance over the longer term, just is to bring balance into the supply side and the demand side of the economy.
And that's what the Monetary Policy Committee is very focused on doing. And I have no doubt that we will achieve that objective and get back to low and stable inflation.
Bernard: Paul Conway, the Chief Economist for the Reserve Bank, thank you.
Ka kite ano
Lucky indeed. I’m 55 so was in my teens in the late 1980s and remember the high inflation well, although I also have to say I remember the high unemployment of the early 1990s, caused partly by the Reserve Bank’s tough measures to fight inflation, even more well.