Views From Outside the Apiary: Inflation and Interest Rates
VIEWS FROM OUTSIDE THE APIARY: IAN FLETCHER
Ian Fletcher explains how inflation is measured, what causes it, how it impacts us, and analyses the Reserve Bank’s response to rising inflation.
Has the Reserve bank got it wrong? As we all know, after several decades of low inflation, it’s back. Interest rates are rising, as the Reserve Bank (and pretty much every other central bank in the developed world, except Japan) has told us they are determined to tame inflation by raising interest rates. In New Zealand, the Reserve Bank has said this will mean causing a recession. They hope it’ll be shallow. So do I.
What’s inflation, and what’s so bad about it that it’s worth staging a slump to get it under control?
The International Monetary Fund (IMF – it’s a sort of UN for reserve banks) explains that “Inflation is the rate of increase in prices over a given period of time”. It’s usually measured as an economy-wide figure, expressed as an annual rate. So a 7% rate means that over a year, the price of a typical range of goods and services will be 7% higher after 12 months. Not every price will rise, or rise by the same amount.
That means inflation measurement is complex, with statisticians sampling a standardised ‘basket’ of goods and services over time – a basket that itself has to change as technology and consumer preferences change (out with fax machine; in with the smart phone). They also measure inflation in parts of the economy or particular goods or services. I don’t know of a standardised index for beekeeping costs, but we could construct one.
Inflation means that people on fixed incomes (benefits, pensions, most salaries at any point in time) are poorer: prices up, income not up. It also means banks want to charge more for loans (otherwise inflation erodes the real value of a loan, as the money buys less over time). Investments are harder to assess, as real returns are uncertain. Economic uncertainty and political pressure is bad for any economy. And may bankers remember the destructive effects of inflation when it really gets out of control (Germany in the early 1920s; Zimbabwe in 2008). Why take the risk?
Where does inflation come from?
Famously, the influential economist Milton Friedman said “inflation is always and everywhere a monetary phenomenon, in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.” So, the classical (and often correct) explanation is too much money chasing too few goods and services. Exactly the effect you’d expect from all the pandemic stimulus here and around the world. But inflation is a bit contagious too – the higher oil prices from the Ukraine war raise costs here, for example. Skill shortages have the same effect.
What’s the solution? Higher interest rates: this reduces demand for goods an
d services by making money more expensive, so people borrow less (it’s costly) and save more (they get better rates). This reduces economic activity, increases unemployment, and generally dampens things. Housing costs (through higher mortgage rates and rents) mean ordinary people are directly affected. That dampening is what our Reserve Bank expects to happen as interest rates rise. They see it as a necessary price to pay.
Is this right?
It’s important to say that interest rates in recent years were exceptionally low (part of the pandemic response, but also part of a longer-term trend). Some increase was inevitable, but should we explicitly plan to engineer a recession?
Inflation today probably mixes several causes. One is the pandemic stimulus and that needs to be unwound (in any case it has contributed to a property boom that has disadvantaged many, and it means there’s nothing in the locker for the next crisis). But some inflation is the effect of the Ukraine war on energy prices. Some inflation is the result of the pandemic disruption to world shipping and commodity markets (steadily improving). Raising interest rates here won’t affect any of that, except it’ll reduce people’s access to employment and income to manage the pressure.
The labour market
The most interesting area of pressure is the labour market – skill shortages. Here there’s population issues (boomers starting to retire, earn less and need more health care), changes in inward and outward migration (Kiwis off to Australia, as well as people moving here), and changes in technology and skills (nursing today is unrecognisably more skilled and responsible than even a few decades ago, and that is reflected in pay expectations, for example). If wages are rising because of those pressures, that ‘inflation’ isn’t a problem – it reflects changes in the relative value of work. That’s a good thing – it means prices come to reflect scarcity, skills, and demand, and signals to people where they might want to work.
There’s one other point too: the Reserve Bank here (like many others) has accepted performance targets based on low inflation, usually around 2%. This is an arbitrary number, and didn’t really bite for many years while inflation was low. Now that inflation is higher, there may also be central bank ego at play, as seen in ostentatious determination to crush inflation, whatever the causes, and consequences. If 2% is OK, what’s so bad about 3% or 4?
What does all this mean? Yes, inflation is troublesome. But maybe it’s not as black-and-white catastrophic as all that. The pandemic stimulus does need to be wound back, and interest rates go up a bit. But I’m not convinced it’s worth a recession. We all need to really understand what’s happening in the jobs market before that case can be made. Having owned up to one mistake – rates too low for too long – the Reserve Bank risks the opposite. Too wrongs won’t make it right.
Ian Fletcher is a former head of New Zealand’s security agency, the GCSB, chief executive of the UK Patents Office, free trade negotiator with the European Commission and biosecurity expert for the Queensland government. These days he is a commercial flower grower in the Wairarapa and consultant to the apiculture industry with NZ Beekeeping Inc.