Government stokes the flames of inflation while RBNZ reaches for the hose

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By Don Brash

Liam Dann (Herald on Sunday, 29 May 2022) seems very keen to absolve the Government of any responsibility for the pain which a great many people are going to endure as the Reserve Bank grapples with getting inflation back under control.

In the opening line of his editorial, under the heading “Why slashing govt spending right now would be a bad idea”, he argues that “it’s important New Zealand gets through this tough economic cycle without panicking and reaching for brutal, unnecessary and ineffective policies of fiscal austerity”.

Of course, we all hope that inflation will be reduced from its present level “without brutal, unnecessary and ineffective policies”, but as he recognises further on in his column “we have to deal with excess demand in the local economy”. The Reserve Bank has, by law, the primary responsibility for achieving that in order to return the inflation rate to the target which Government has established.

The single weapon the Bank has to achieve that goal is monetary policy, which in the New Zealand context means making it more or less expensive to borrow by varying the Official Cash Rate (OCR). When the OCR goes up, borrowing becomes more expensive and saving, by spending less, becomes more attractive. Those who have borrowed, perhaps to buy a home, find themselves paying more to service their mortgage and their other spending has to be reduced to compensate. Total spending in the community is reduced, which is precisely the objective which the Reserve Bank is seeking.

But let’s not pretend that that process is painless: it certainly isn’t. Some people find they can no longer service their mortgage, and are forced to sell their home, currently in a market where house prices are falling. As total demand in the community falls, jobs are lost, wages and salary increases are less than expected, some companies fail.

The Government on the other hand is trying to retain popularity with voters by spending up big, and that is working in direct opposition to what the Reserve Bank is trying to do.

The Governor was reluctant last week to point the finger too directly at the Minister of Finance but it is only a few months ago, in an interview with the International Monetary Fund, that he made the obvious point that “monetary policy needs mates” – which means that both monetary policy (controlled by the Bank) and fiscal policy (controlled by the Government) affect total demand in the economy, and if overall demand needs to be reduced, as currently, then the more the Government stimulates the harder the Reserve Bank has to work by pushing up interest rates.

Mr Dann sets up a straw man by comparing the present situation to the early nineties. At that time, we suffered the employment consequences not only of tight monetary and fiscal policies but of the collapse of a property market bubble, of the corporatization of many over-staffed government businesses, of the abolition of import controls and of export subsidies. Moreover, we were coming out of a prolonged period of high inflation, with expectations of future inflation deeply entrenched.

But nobody should be under any illusion: the Government’s ongoing stimulatory fiscal policy is contributing to the need for the Reserve Bank to increase interest rates, something which the Treasury warned the Minister just weeks before the Budget when the Minister decided he wanted to dole out some cash sweeteners to help low income New Zealanders with the cost of living.

It’s like a car being driven with one foot on the brake and the other on the accelerator – the more the Government stimulates the economy with fiscal policy, the harder the Reserve Bank will need to apply the brakes of higher interest rates.

See also Don Brash talking to Jack Tame on Q & A about the political challenge of inflation

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