The inflation virus

Headaches, sneezes, fevers . . . high inflation? If you want to understand the underlying cause of inflation, look no further than Covid-19, says Ting Huang, senior economist at the New Zealand Institute of Economic Research (NZIER).

Globally, inflation is being driven by the “unprecedented stimulus” that policymakers authorised to shore up their economies during the pandemic. This is combined with supply constraints and labour shortages that were exacerbated by border restrictions, and supply chain disruptions caused by lockdowns, Huang says.

Oh, and a rise in the price of oil, which is just starting to ease.

In New Zealand, we are seeing the impact of these global drivers, says Huang, also pointing to supply chain disruption and the tight labour market as a big part of our inflation situation.

What is different, as shown by annual consumer price index (CPI) data, is where our inflation is occurring, says Huang. “Food prices and costs of construction have been the largest contributors – especially food prices, where we are seeing a really rapid rise.”

Even though we are recovering from the pandemic, bad weather and high commodity prices are keeping the pressure on these areas, she says.

“The recent extreme weather events create upside risk and inflation pressures, especially to rents and food prices in the short term. Over a longer term, the rebuild from Cyclone Gabrielle will likely give construction demand a boost –contributing to capacity pressures in the construction industry, which may heighten the risk of inflation staying high for longer.”

Are corporate profits to blame?

In Europe, excessive profits have been highlighted as a driver of inflation, challenging the economic orthodoxy that inflation is caused by an imbalance between supply and demand. European Central Bank Board member Philip R. Lane acknowledged this in March, although he predicted this profit pressure inflation would ease.

“To the extent that supply capacity should improve over time and demand patterns normalise, the extraordinary conditions underpinning profitability in 2022 should not persist, with a decline in profit margins translating into lower inflationary pressures,” Lane said.

US research shows inflation – at least in 2021 – was also riding on profit hikes. A study by economists from the Federal Reserve Bank of Kansas City found inflation from corporate profits was the main cause of US inflation in the early stages of recovery, a time when costs were actually falling. Again, they expect this profit-driven inflation pressure to drop off over time.

Both the US and European data suggests this is a short-term pressure. But the recognition that corporate profits are part of the problem at this time challenges the typical central bank response to inflation – raising interest rates.

New Zealand’s annual inflation rate hit a 22-year high in 2022 of 7.3 per cent.

The Reserve Bank of New Zealand (RBNZ) is charged with keeping inflation in a 1-3 per cent band. When inflation exceeds this band – as it has for a long time – the RBNZ lifts the official cash rate (OCR), which causes banks to put up their interest rates.

These OCR hikes are intended to dampen demand in the economy, which in turn should help close the gap between demand and supply and reduce inflation pressures.

However, this doesn’t appear to be a major factor in New Zealand’s inflation environment, says Huang.

“Interestingly, from NZIER’s March Quarterly survey of Business Opinion, we have found out profitability continued to deteriorate, especially for building sector firms and retailers. Most of that is because of the intense cost pressures they continue to face, as well as the weakening demand the economy is beginning to show.”

Variety of opinions

More challenging is the small size of New Zealand, which makes it easier for our big players to dominate and reduces competition. “A limited competitive environment will certainly add some barriers to the efficacy of OCR rises,” she says.

Another challenge is that monetary policy works on the demand side, but this round of inflation has largely been caused by supply side constraints. “So you are trying to bring down inflation that is predominantly stemmed from supply factors,” she says.

The NZIER hosts an independent Monetary Policy Shadow Board which recommends what the RBNZ should do regarding the OCR. At the April Monetary Policy Review, the RBNZ lifted the OCR by 50 basis points to 5.25 per cent, which was a larger hike than the 25 basis-point increase the Shadow Board suggested. The OCR decision at the RBNZ’s May meeting was in line with the Shadow Board’s majority view that an OCR hike of 25 basis points to 5.5 per cent was warranted given domestic inflation pressures remained high.

While there were divided views on where the OCR should be in 12 months, they point to increased concerns about a weaker economic outlook and potential upside risks to inflation. The RBNZ, in its May Monetary Policy Statement, indicated a pausing in OCR increases, given they were starting to moderate demand and inflation in the economy, and the full effects were still yet to pass through. That said, the impact of interest rate increases will continue to be felt in the broader economy over the coming year.

For businesses, that means borrowing will remain more expensive than before the pandemic and that consumer demand is likely to decline.

The good news, although perhaps not for homeowners, is that around half of New Zealand mortgages are due to be repriced over the next 12 months, at today’s higher rates. Higher mortgage costs will help restrain household consumption, says Huang. “This will help to bring inflation down more quickly over the coming years.”

Still, she does not expect inflation to return to the RBNZ’s 1-3 per cent target range in 2023, suggesting interest rates will remain high even as inflation begins to fall. “Probably, inflation in New Zealand has already peaked,” she says.

Financial resilience and climate change

One of the IoD’s Top Five Issues for Directors in 2023 was “financial resilience”. It was selected because of the contemporary confluence of inflationary pressures, high interest rates and economic uncertainty.

Huang says directors should factor climate change (another Top Five Issue) into financial resilience planning. “The floods and Cyclone Gabrielle are a good example of the importance of financial resilience,” she says.

“Given New Zealand’s exposure to climate change, extreme weather events will likely happen more often in the future. So it is very important for the government and businesses to keep a financial buffer, sufficient cash at hand, in order to prepare for and respond to those type of events.”

Businesses should also be prepared to invest in strategies and technologies that can help them adapt to climate change, says Huang. “This is a call for increased urgency around these issues.”