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Inside Economics: Why Reserve Bank can probably ignore return of inflation

Inside Economics: Why Inflation is Back and Why the Reserve Bank Can Probably Ignore It

Inflation has made a surprising comeback in New Zealand, catching many economists and policymakers off guard after years of subdued price pressures. Recent data from Statistics New Zealand reveals that the Consumer Price Index (CPI) rose by 3.3% in the year to June, marking the highest annual increase since 2011. This surge has reignited debates about whether the Reserve Bank of New Zealand (RBNZ) needs to tighten monetary policy to rein in rising costs. However, a deeper dive into the drivers of this inflation suggests it's largely transitory, driven by external factors rather than domestic demand overheating. As such, the RBNZ can likely afford to look through this spike without immediate action, maintaining its current stance to support economic recovery.

To understand why inflation is back, it's essential to break down the components contributing to the recent uptick. A significant portion of the increase stems from global supply chain disruptions exacerbated by the ongoing COVID-19 pandemic. For instance, international freight costs have skyrocketed, with shipping container prices multiplying several times over the past year. This has directly impacted imported goods, which make up a substantial part of New Zealand's consumption basket. Items like electronics, vehicles, and building materials have seen sharp price hikes due to these logistical bottlenecks. Additionally, energy prices have played a pivotal role. Global oil prices have rebounded strongly as economies reopen, pushing up petrol and diesel costs locally. In New Zealand, tradable inflation—prices influenced by international markets—jumped to 4.5% annually, far outpacing non-tradable inflation at 2.4%.

Domestically, the housing market has been a hotbed of inflationary pressure. Construction costs have surged due to shortages of materials like timber and steel, compounded by labor constraints amid border closures that limit migrant workers. The government's infrastructure spending and a post-lockdown building boom have amplified demand, leading to higher prices for new homes and renovations. Food prices have also ticked up, influenced by weather events affecting agricultural output and rising input costs for farmers. Yet, these factors are not indicative of broad-based, persistent inflation. Core inflation measures, which strip out volatile items like food and energy, remain relatively tame at around 2.1%, well within the RBNZ's target band of 1-3%.

The RBNZ's mandate is to keep inflation near 2% over the medium term while supporting maximum sustainable employment. With the economy still recovering from the shocks of 2020, including lockdowns and border restrictions that hammered tourism and exports, the bank has been cautious about overreacting to short-term price blips. Governor Adrian Orr has emphasized the importance of distinguishing between temporary supply-side shocks and demand-driven inflation that could spiral if left unchecked. In recent statements, Orr noted that while headline inflation is elevated, forward-looking indicators suggest it will moderate as supply chains normalize and global commodity prices stabilize.

This perspective aligns with international trends. Central banks worldwide, including the Federal Reserve in the US and the European Central Bank, are adopting a similar "look through" approach to current inflationary pressures. For example, Fed Chair Jerome Powell has repeatedly described US inflation as "transitory," attributing it to pent-up demand and supply bottlenecks rather than entrenched wage-price spirals. In New Zealand's context, wage growth remains subdued, with annual increases hovering around 2-3%, not the kind of acceleration that would fuel sustained inflation. Unemployment, though falling, is still above pre-pandemic levels at about 4.7%, providing a buffer against overheating.

Critics argue that ignoring inflation now could lead to complacency, potentially requiring sharper rate hikes later if prices don't subside as expected. Some economists point to the 1970s stagflation era as a cautionary tale, where central banks were slow to respond to oil shocks, allowing inflation expectations to become unanchored. However, today's environment differs markedly. Modern central banks have tools like forward guidance and quantitative easing to manage expectations. Moreover, inflation expectations in New Zealand, as measured by surveys of households and businesses, remain anchored around 2%, showing no signs of de-anchoring.

Looking ahead, several factors could ease inflationary pressures. The global vaccination rollout is progressing, which should alleviate supply chain issues as factories and ports return to full capacity. In New Zealand, the planned reopening of borders in 2022 could boost labor supply in key sectors like construction and agriculture, helping to contain cost pressures. Commodity prices, while volatile, are showing signs of peaking; for instance, lumber prices have already fallen from their highs earlier this year. Domestically, the RBNZ's recent decision to taper its Large Scale Asset Purchase program signals a gradual normalization of policy without abrupt tightening.

That said, risks remain. Geopolitical tensions, such as those in the Middle East affecting oil supplies, or new COVID variants disrupting global trade, could prolong the inflationary episode. Climate change is another wildcard, with extreme weather events potentially driving up food and insurance costs. The RBNZ must stay vigilant, monitoring data releases like the upcoming quarterly CPI figures and labor market reports.

In the broader economic context, New Zealand's recovery is robust but uneven. GDP growth is projected at around 4% this year, driven by strong exports in dairy and meat, alongside fiscal stimulus from the government. Household spending has rebounded, supported by low interest rates and accumulated savings during lockdowns. However, sectors like international tourism and education remain depressed, underscoring the need for accommodative policy.

The RBNZ's next Monetary Policy Statement in August will be crucial. Markets are pricing in a potential Official Cash Rate (OCR) hike as early as next year, but the bank has indicated it will tolerate inflation above target temporarily to ensure a durable recovery. This "flexible average inflation targeting" framework allows for such deviations, prioritizing employment over rigid price stability in the short term.

For everyday New Zealanders, rising inflation means higher living costs, eroding purchasing power. Petrol prices above $2.50 per liter and grocery bills climbing are tangible pains. Yet, if the RBNZ's assessment holds, these pressures should ease without derailing the recovery. Wage earners might see some relief through negotiated pay rises, though unions are pushing for more to keep pace with costs.

In summary, while inflation's return is headline-grabbing, its roots in temporary global disruptions suggest it's not a harbinger of 1970s-style woes. The RBNZ can probably ignore it for now, focusing on nurturing growth. By maintaining a steady hand, the bank avoids the pitfalls of premature tightening, which could stifle the nascent recovery. As always, economic forecasting is fraught with uncertainty, but the current data points to a soft landing for prices in the coming quarters.

This analysis underscores a key lesson in economics: not all inflation is created equal. Distinguishing between transitory spikes and structural shifts is vital for effective policy. For New Zealand, navigating this balance will determine the strength of its post-pandemic economy. (Word count: 1,028)

Read the Full The New Zealand Herald Article at:
[ https://www.nzherald.co.nz/business/economy/inside-economics-why-inflation-is-back-and-why-the-reserve-bank-can-probably-ignore-it/SLUGLT72ZNDOHD7AXUXNBTH3DY/ ]