When inflation becomes established and pervasive – not just direct price effects of this or that supply shock or tax increase (or combination of them) – it generally doesn’t come down all by itself.
Expressed in terms of conventional monetary policy, it usually takes a period in which policy interest rates are raised to, and maintained at, a level above the (not directly observable) then-neutral rate. Of course, sometimes an adverse external demand shock – eg an external recession – comes along, which can do a big part of the job. But that isn’t usually much more pleasant. Either way, domestic demand growth typically needs to be held below growth in the economy’s productive capacity for long enough to lower inflation. And, among other things, that will typically mean a rise in the unemployment rate, to (for a time) levels beyond (not directly observable) then-neutral (sustainable, non-inflationary) rate.
In principle, it can all happen very smoothly and gradually (the vaunted “soft landings”, often talked of, rarely observed). Such “soft landings” are almost always forecast (not just by central bankers), at least until the alternative is unavoidably obvious. Of course, “soft landings” are generally preferable, but (except as a matter of luck) they assume a degree of understanding of what is going on, how economies are unfolding, that isn’t often present. If forecasters (central bank and otherwise) really had a good handle on how economies were behaving at present, we probably wouldn’t have landed in quite the current inflation mess in the first place.
Since the New Zealand economy and financial system were substantially liberalised after 1984, we’ve had two episodes in which pervasive (“core”) inflation has been lowered. Both fit the story. As it happens, in both cases, we had a period of quite-tight domestic monetary policy and an international economic downturn. Actually, in 1990/91 we had a fair amount of discretionary fiscal tightening as well.
Inflation had still been very badly entrenched in the late 80s. Core inflation was probably around 5-6 per cent, and hadn’t been lower for a long time. It took 90 day bill rates at 13-14 per cent for a couple of years. We didn’t have a concept of “neutral rates” then, but no one would have seriously doubted things were tighter than neutral: that was the point. The unemployment rate peaked at about 11 per cent (there were other structural changes going on at the same time) to get inflation down into the target 0-2 per cent range. It was a nasty recession, quite similar to one in Australia and no doubt with contributions from the US recession at much the same time.
Fifteen years later, core inflation had been rising for several years. On best estimates, it peaked at about 3.5 per cent, some way from the midpoint (2 per cent) of the revised target range. The OCR had been raised to 8.25 per cent to counter this inflation (at the time, from memory, the Bank thought of the neutral rate as being somewhere not much above 6 per cent). Core inflation, of course, came down, through some combination of the tight domestic monetary policy and a nasty global recession. The New Zealand unemployment rate, unsustainably low at the pre-recession trough (about 3.5 per cent), rose to about 6.5 per cent. Core inflation fell back to the target midpoint (and then overshot when monetary policy was kept too tight for years too long – but that is another story).
At present, of course, core inflation is probably a bit over 4 per cent (looking across the range of core measures). That is a long way below headline inflation (as was the case in 2007/08). The unemployment rate is 3.2 per cent, and even the Reserve Bank has been moved to observe that the labour market is unsustainably tight.
Core inflation can be brought down again, but it isn’t going to happen by magic. Most likely it will take a period of sustained weakness in demand growth, a period of a negative output gap, and – as part of that – a period when the unemployment is above the medium-term sustainable level. The Reserve Bank thought the neutral OCR was about 2 per cent pre-Covid: if so, then the subsequent lift in inflation expectations would suggest at least 3 per cent now. Getting above that is a long way from the current 1.5 per cent.
The situation isn’t much different in a bunch of other advanced economies, even if each have their own idiosyncrasies.
Most likely – here and abroad – getting core inflation back down again will take recessions.
Voters may not be altogether keen on recessions. That is understandable at the best of times, but right now it is only two years since the last dramatic dislocation and temporary loss of output and employment.
And so I’ve been wondering recently if, before too long, some government and/or central bank (probably the two together) might not just decide it is all too hard. Why put people through another recession? Perhaps especially if the government concerned is already not looking too good in the polls.
But, you say, wouldn’t that just be seen as feckless. “giving up” in the face of a “cost of living crisis”? How could serious people possibly defend such a stance?
Actually, quite easily.
Long-term readers of this blog will recall that for many years I banged on about the effective lower bound risks, and how difficult monetary policy would prove in the next recession. With hindsight, I (and the many others internationally who were raising such concerns) should have rephrased that “the next demand-led recession”. Covid proved to have been different, in ways little appreciated in March 2020. But the issue has not gone away. And not a single central bank has yet done anything much to ease the effective floor on nominal policy rates (at probably around -0.75 per cent, beyond which the incentives to convert to physical cash – neutering monetary policy – become increasingly strong). Nasty demand-driven recessions will come again.
Since the 08/09 global recession, several prominent macroeconomists abroad (including Ken Rogoff and Olivier Blanchard) had been suggesting raising inflation target, perhaps to something centred around 4 per cent) to grapple with exactly that lower-bound risk. I was not convinced then – including because these same central banks were failing to deliver even on their existing inflation targets (too low inflation was the story of the decade), and it was difficult to see how stated intentions of delivering even higher inflation were going to be given much credence.
To be clear, I still do not support such a policy change now. Economies function a bit less effectively at higher inflation rates (even stable ones), and the lower bound issues can be – and should be, as a matter of some priority – be addressed directly.
But the context has changed, a lot. Now, it wouldn’t be idle talk from ivory towers in the abstract about lifting inflation. Inflation is already high, and the question may soon be about willingness to pay the price to get it back down again. Few people are very fond of recessions. So why isn’t it quite possible – even likely – that some set of authorities somewhere, backed perhaps by some eminent economists focused on those lower-bound issues, as well as more-immediate political imperatives would suggest (initiate) a change. A 3-5 per cent inflation target range perhaps?
There would be pushback from some quarters of course. Do it once and won’t everyone believe you’ll do it again any time the pressure comes on? It is the sort of argument that sounded good 30 years ago, but actually New Zealand twice raised its inflation target – when the political pressure came on – and although I’m still not a big fan of those changes, it is hard for any honest observer to conclude that they were terribly damaging. Bond holders won’t necessarily like it, but many of the indebted would. Those on the margins of the labour market – the sorts of people most likely to lose their jobs, or find it harder to get one – might be responsive too. Realistically, in the face of such a change most forecasters would revise their numbers and project a little more output in the short-term (no long-term tradeoffs, but the costs of getting inflation back down are real).
There are quite a few places that aren’t likely to lead the way on any such change. The ECB, for example, sets its own specific inflation target, faces no election, and has a price stability focus embedded by treaty.
But there are other places where it could happen, and in particular any place where (as should happen) the elected government sets the inflation target.
New Zealand might be one of them. After all, the government is slipping in the polls, the likelihood of a recession between now and the election is steadily rising, and whatever merits the current Cabinet have, none of them seem like hard money people (to many of their voters that is probably a good thing). The current policy target Remit still has 21 months to run, but the Governor’s term expires in March, a new Board takes office in July, and so on. The Governor has already told us the Bank has analytical and research work underway – consistent with the provisions of the amended RB Act – for the next Remit review. Mightn’t it seem brave and pioneering, prioritising employment (immediate and in that next demand-led recession), to carve a new path and revise up the target (all perhaps flanked by distinguished experts).
To be clear, I do not (and would not) support such a change. Moreover, there is nothing in the public record to suggest that our government or central bank are looking at such a change. My point in writing the post is that, when one thinks about incentives, it isn’t obvious why some government or other mightn’t adopt exactly such an approach before too long. And it isn’t obvious why it wouldn’t be the New Zealand government. Just think of it, the ultimate product differentiation from Roger Douglas (the main consideration that seems to have driven Grant Robertson in the overhaul of the RB Act in recent years).
Of course, even if core inflation was to be stabilised at around 4 per cent, it seems almost certain that the unemployment rate will rise from here: that is the implication of the Reserve Bank’s observation that the labour market is unsustainably overheated. But there is quite a difference between settling at 4.0 to 4.5 per cent, and a couple of years at (say) 5.5 per cent. Shrewd political advisers will recognise this. They will also recognise that if most other advanced countries are heading for recessions we won’t fully escape the effects, but they might think that easing up on our target now might better position us for the (near-certainly) tough times on the horizon. Were I Ardern or Robertson – and I am very thankful I am neither – I might be tempted.
Perhaps the analysis here is all wrong. If so, I’d be really interested in reactions or alternative perspectives.