Keeping NZ inflation in perspective

Holy shit.  Since I’ve started getting the chance to read opinion pieces again I’ve noticed one extreme theme running through them – a sharp and angry fear of inflationary pressures.

This in itself doesn’t bother me, but it has been combined with people saying that ALL of the following will happen:

  1. The economy will implode
  2. The currency is/will be too strong
  3. Borrowing will be/is too high.
  4. We will have out of control inflation.

And that ultimately this is the RBNZ’s fault.

Like some sort of arbitrary rant, a large number of commentators have gripped onto any negative element element they can about the domestic economy, laid it down as a failure of monetary policy, and then used it as an excuse to attack the Reserve Bank.  To be honest, I find it all patently ridiculous.  Let me explain why, saying all these things will happen at once is inconsistent.

From what I can tell, this is the model that explains poor growth, high borrowing, high currency, and hyperinflation among its proponents:

  1. There is “hot” money.
  2. The money comes in, pushes up the currency, drives down the growth, gets borrowed – we also have some inflation washing around.

Now I don’t know about you, but that model just isn’t convincing – it just seems weird.

What do people mean by “hot money”.  They mean that people are want to lend to New Zealand on short-terms at a low rate of interest.  Seriously, that is what it means.

The money doesn’t just turn up and push up borrowing and the dollar – we actually NEED someone in New Zealand to decide to borrow it as well.  Like any market there is supply and demand.

People are willing to lend to New Zealander’s at a low rate of interest because they think we can repay, they don’t see it as too much of a risky bet.  That is their choice.  If we are borrowing the money (which at the moment we don’t really seem to be), we are doing so at a very favourable interest rate – so we either value consumption now more than consumption in the future enough to bear this interest rate, or we think we can make a greater return on top of it.

Either way, the access to affordable credit leads to greater investment and employment of resources – and ultimately stronger economic activity.  At the moment, we have weak growth because people are unwilling to spend/invest – people are unwilling to make decisions because of uncertainty about the economic outlook.  Once that begins to subside (as it does seem to be) the Bank will act by lifting interest rates.

Surely there can be concerns about hot money/overborrowing

Sure, why not.  There are models that say that – and we can run around with gut feelings that say the same.  However, any issue like this is one of “structural policy” – something where we may want to introduce say core funding ratios among lenders – not a matter of monetary policy, or a matter that require a current knee-jerk reaction from government.

On a personal level, I think that people attacking hot money aren’t looking at the issue in a global frame – why is there such cheap lending?  Are there policies overseas that are distorting prices?  In that context, what is our best response – none of this is answered with monetary policy, and all of this needs to be thought through in detail before policy is made (which I’m sure government authorities have been doing).

But explain the currency

The currency is high, even though we seem relatively unwilling to borrow.  Interesting.  So what do we have here:

  1. Elevated commodity prices,
  2. Relatively weaker trading conditions in developed economies
  3. Droughts (more of them) improving the outlook for future commodity prices
  4. The expectation that interest rates will need to be higher, as growth in the economy is picking up sooner than expected
  5. Reinsurance flows

But we need to rebalance the economy/cut borrowing/innovate

Look, we may have an argument for all sorts of things – but picking random points on the economic cycle to jump around and complain is arbitrary.

First, we need to ask why we need to rebalance (for example) then we need to discuss fundamental factors that are working for or against the rebalancing – the currency is a relative price that adjusts with these fundamental factors, not a factor in of itself.

So how are the 3 conclusions inconsistent?

Essentially, if borrowing remains weak, investment will be soft, and growth will be soft – soft growth will push down the currency.  If the Reserve Bank lifts rates it will be BECAUSE growth and borrowing are accelerating, and the fundamental rate of interest in the economy needs to be higher.  All this is consistent with inflation targeting, since underlying pressures on prices should come from the level of growth in the economy.

A central bank that is targeting inflation is not going to drive a huge destructive shock to the domestic economy – for that to happen we need external factors to blame.

But what about GDP/CPI – growth is picking up and inflation is out of control!

Seriously, have you guys been hearing the number of people saying that inflation is out of control following the June CPI number!  What a  complete joke.

And this is ignoring journalists – who keep complaining that wage growth has been to weak compared to inflation because they’ve already forgotten about the income tax cuts …

Everyone keeps say, “WOW, 1% in the June quarter  – and you can’t blame GST, we’ve in trouble”.  But hold up a second – let me list a bunch of one-off factors:

  1. Winter clothing appeared in CPI, now with GST
  2. Food prices spiked, partially due to the Queensland flood
  3. Car prices spiked, partially due to the Japanese earthquake
  4. Electricity prices rose as the ETS continued to roll on
  5. Wasn’t their some additional excise tax on tobacco.

Now the RBNZ knew about these things and only picked 0.7% – so the market was right to say “hey, they may have to lift rates sooner”.  But this is far from the “the RBNZ is violating their mandate” rubbish that I have heard repeated on the radio, on TV, and in the paper.

But the cost of living is out of control

We have seen the structure of the economy change over time, food has become relatively more expensive.  If as a society we think this is unfair we could increase the minimum level of income people receive through benefits/transfers – we shouldn’t f around with the price signals that exist.

As we’ve said before, the Reserve Bank doesn’t control the cost of living – their mandate is inflation.  This is different, and the reasons why they target this is not related to the “cost of living/well being” idea because that is not what they control (link, link).  So the fact the cost of living is rising has nothing to do with the Reserve Bank or interest rates, why don’t we spend more time discussing what is going on and whether current benefit levels are appropriate.

And by the way, if you’re a middle-class household and you are struggling now – just realise this has to do with things genuinely being more scarce.  Trust me, if the dollar falls as a lot of people are saying it should you are going to feel a hell of a lot worse.

Note:  A lot of people have said that the type of inflation I’ve described previously is too hard to understand – my response to that is, if you don’t understand it you CANNOT blab on about what the Bank should be doing or how it could target inflation better … because you don’t understand how it works.  That sounds terrible, but surely its important to know what something is before arguing about it?


A collapsing economy and a strong currency is not consistent with hyperinflation and elevated borrowing – there are trade-offs that exist between these outcomes, and only by trying to understand why things are the way they are can we say much about policy.

The Reserve Bank sets interest rates in a way that are consistent with managing inflation.  Inflationary pressures are positively related to growth, and so they will lift rates if the growth outcome and inflation outcome begin to pick up.

Recent economic and inflation data has not been inconsistent with this.

And as a side-note, when did running round panicking become so popular among business analysts – I am sure there used to be more reasoned debate.  Have I just got back to reading this stuff during a “weak moment”?

I guess I will see what “end of days” article appear after the Reserve Bank statement on Thursday.

8 replies
  1. Bill Bennett
    Bill Bennett says:

    Aren’t actual rates set by the market?

    Surely if there’s a shipload of hot money waiting to enter New Zealand (and be lent out at ridiculously low rates of interest) then a rates hike by the Reserve Bank will be ineffective because that hot, low-rate money will get dished out before local funds.

    (I’m by no mean an economist, just applying layman’s logic to the so-called problem).

  2. Eric Crampton
    Eric Crampton says:

    I’m usually pretty hawkish but just am not worked up about CPI right now. Greece and the US remain scary. I would give RBNZ a pass if they held fire.

  3. andrew coleman
    andrew coleman says:

    Dear Matt

    You seem quite agitated over this. Perhaps you should relax and listen to a fairy story.

    Once upon a time there was a land where beautiful songbirds lived. The people in the land loved their songbirds, and tried to ensure the population kept increasing. Their efforts were undermined, however, by a population of weasels that would stalk and prematurely kill the birds.

    The people put their heads together and decided to create a Department for Weasel Control, thinking that if they could minimize the death toll on the bird population the population would grow. The move was not uniformly popular, however, for efforts to kill weasels sometimes temporarily lowered the birth rate of the songbirds. Moreover, it was not clear exactly how the Department would work. In the end, it was decided that the Department would be left to its own devices, subject to being accountable for ensuring the general level of the weasel population was stable. A department head would be hired – popularly known as the chief weasel whacker – and left to get on with it.

    The move was controversial. Some people said that the weasel population didn’t really matter if the song bird population was growing. Others didn’t like the reduction in the songbird population that occurred when a full-scale weasel eradication programme was in full swing. Others were enthusiastic, but warned that someone with a paranoid hatred of weasels should be hired as chief weasel whacker to ensure the department did its job well.

    One day a new chief weasel whacker was hired, someone with a background in songbird appreciation. From the start he argued that it was both unfair and unnecessary to require him to make sure the weasel population was stable, all that was needed was a requirement that it didn’t grow too fast, maybe not faster than 3 percent in the medium term. The real objective was the increase in the population of songbirds, and the eradication of weasels was just a means to an end. In any case, the weasel population fluctuated naturally, and it was silly to hold him responsible for factors outside his control. Not all people were convinced, but he was good with songbirds.

    At first, things weren’t too bad. The songbird population initially increased quickly, after the weasel control programme was eased. Not everyone was happy, as the population of weasels wasn’t stable at all but increasing at nearly three percent a year, but the songbird population increased at a steady pace. Then a major shock occurred, when a weasel disease crossed to songbirds and killed a few. The Chief Weasel Whacker put on hold efforts to control weasels until the songbird birthrate started to increase. Weasel control was neglected for several years

    Soon debate broke out up and down the land. Should people be worried that the chief weasel whacker didn’t seem to go around whacking weasels? Or should they just monitor to songbird population? Did it matter that the weasel population had been growing at nearly 3 percent for several years? And what about the original intention of keeping the weasel population stable? It had increased by nearly 20 percent, and never shown any indication of falling. Matters came to head when one year the weasel growth rate couldn’t be counted on the fingers of one hand. The loony weasel haters emerged from the undergrowth making outrageous and funny claims about a world that would be overrun by the Great Weasel who would go around stealing human babies. Fans of the Chief Weasel Whacker denigrated the loons, but others could help but wonder if the original founders had it right after all. Perhaps if you let the weasels increase by a maximum of 3 percent a year, soon they would increase by 3 percent nearly every year. Maybe hiring someone with a paranoid hatred of weasels would have been clever. And maybe there might be a better way of controlling the weasel population than simply trying to whack them after they were born. Perhaps it would be useful to understand weasel physiology and psychology and see if their breeding patterns could be controlled……

    Unfortunately I don’t know how the story ends but apparently it might be time to hire a new Chief Weasel Whacker soon, so the story is sure to be interesting.

  4. Matt Nolan
    Matt Nolan says:

    @Bill Bennett

    Hot money, tehehehehe. That term always sounds a bit filthy.

    Anyway, the core funding ratio ensures that we need a certain maturity of debt and that it needs to be matched by local funding – so that isn’t really the case at the moment.

    Even in the previous case where this didn’t exist, by pushing up the dollar the “flow of hot money” would become more risky, and in itself increase interest rates.

    We know for a fact that the Reserve Bank can influence interest rates (as we’ve seen them do it repeatedly)

    To clarify. As long as people are willing to pay the “world interest rate” there is an infinite amount of money out there. As a result, your point is a great one. However, when rates are set we need to think about the margin – what is the rate of interest when a bank wants to increase lending. By using the OCR the Bank believes they have control over this – it may have to work in part by influencing the currency – but in terms of total monetary conditions the Bank can have an impact on them in the short term.

    Hope that does clarify, I’m worse than usual at writing these things in the morning 😀

    @andrew coleman

    A lovely fairy tale, thank you! I sent it around work and it went down very well 😀

    I see what you are saying but my solution might be a bit different.

    I think we should measure actual inflation and make it a punishable and transparent target – depending on how the actual measure sits we could have a “3-5 year point target” or a “narrow range”.

    Looking at this exercise in the US, a narrow range really looks like the way to go with it:

  5. Matt Nolan
    Matt Nolan says:

    @andrew coleman

    Also, I’m alway agitated. I’m half Irish Catholic and half English Anglican so I’m constantly in an uncomfortable state of truce with myself – given this it is hard not to rant incessantly about everything.

  6. Eric Crampton
    Eric Crampton says:

    @Andrew, @Matt: I’m just going to steal Andrew’s comment as a post over at Offsetting. With a minor bit of commentary and full links back. Too nice a story to be stuck over in a comments section.

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