What if?

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.

25 thoughts on “What if?

  1. Inflation – a process of growing the money supply is entirely at the feet of the government(s) who want to continue to appear that they are able to fund the wishes of their favourite voters. The history of this is unchanged since John Law told the king of France he could have everything and we know how that ended.
    Our McBank local franchise has been happy to buy the treasury paper and for a socialist government to continue to appear to create prosperity they will be shoehorned into buying more and more. A recession is baked in now as the “gains” in social equality voiced by Ardern and Robertson are complete mirages seen in the distance as we consume our savings ,the drivers of production. Thank you for the history entrails. It proves that governments learn little and usually too late. Less Keynes more Hayek would help our economy. The brain drain will pale against the capital flight and we can expect many more restrictions to come along with punitive taxes as the government who can give you all you want will have to take all you’ve got.

    Liked by 2 people

  2. A political issue for everyone is that all Parliamentary political parties stress the importance of work for the citizenry, usually in terms of wellbeing as being in work is good for people’s mental health, finances etc (subject to a disclaimer that work has to pay enough to avoid financial stress, and not be overly unpleasant to avoid mental health issues). Politics and media also target the unemployment rate as a KPI of the government of the day, and like golf, the aim is a number as low as possible.

    Politically speaking, walking that back is hard.


    • And in many ways it is good to have politicians seriously about keeping unemployment low, but they need also to respect the limits (themselves the result of some mix of micro policies, demography etc). Last week’s Labour publicity hyping the 3.2% was really quite unfortunate since they (notably MOF) know it isn’t sustainable and has to rise to some extent from here.


      • I don’t disagree economically, I’m saying that politicians can’t respect those limits, because the voters don’t respect them. There is no political gain to be had for large parties (ACT could pull it off) in telling voters that more of them need to be unemployed on an ongoing basis so price increases can be reigned in and stay down. The underutilisation rate is also at its lowest rate (more or less) in decades, and yet is still nearly 10%, so it’s not even a narrative that’s supported that well by the current figures. Imagine a politician trying to sell to the electorate that 10+% of them need to be perpetually short of work, and 4+% out of work – however true it is, it’s an awfully tough sell and rather open to political rhetoric from any opposition to it.

        Additionally, if politics and media properly acknowledged that the current economic system is designed around an acceptable range of unemployment to keep prices down, they would also have to give up blaming unemployed individuals for being unemployed. Even if some of the unemployed aren’t trying that hard, if the rest of NZ depends on people staying unemployed, it’s a form of abject cruelty to deliberately hound those people to find work when everyone else depends on them failing to find work.


      • I’d frame things a bit differently, but mostly I guess what I take from your argument is the need for the independent central bank to be doing well the job the govt has given it, and minimising the incidence of really badly-overheated domestic economies (to keep to a minimum the inevitable political pressure that results from unemployment rising again).


      • Looking at Stats NZ they report 93,000 on the unemployment register so @3.2% equals a working population of 2.9 Million, however with 188,000 on the job seekers allowance (surely they are unemployed?? ) So with 281,000 Kiwis not working that seems to me an unemployed rate of 9.6%, I hope I am wrong will someone confirm that with accurate facts?

        Liked by 1 person

      • Remember that different things are being measured. THe official unemployment number measures only those actively looking for work and ready and willing to start work next week if a job was offered. The benefit numbers will capture all sorts of people – some actively looking (so you can;t add the 2 numbers), some ill, some slack. If they aren’t looking for work, they are irrelevant to the inflation pressures arising in the labour market.


  3. Michael, the recession dynamics are already in place. Grant can say what he likes…

    If one year swaps realise their forward rate and mortgage spreads normalise, then one year mortgage rates are rising to around 6.5 percent. House prices are going to slump (20%y/y in real terms???) and first home buyers who purchased post 2020 are doomed. They’ve been the ones banks have been ‘helping’ – after all NZ is lead with empathy apparently – by being the ones accessing LVR>80% (with Mum and Dad fronting the deposit) and they are the ones either on interest only or have (83% of them) 30 year term mortgages (which incidentally extend beyond many of their working lives given that the average age of a new FHB in Aucjland is now 34). With DTIs >5x income, and debt servicing consuming half their income, with essentially no way banks can restructure their loans, they are utterly stuffed.

    A recession is almost guaranteed now, and is clear in a range of partial indicators, its clear in the ANZ consumer and business confidence indices and in the economics…

    Liked by 1 person

    • I probably wouldn’t put it quite as starkly as you Peter – altho I’m staggered there isn’t more political focus on the looming recession – but to the extent you are right, it simply reinforces my point, that a higher inflation target could easily look more attractive, at little/no economic cost.

      NB, 20% real fall in house prices is “only” about 13% nominal. The “attractions” of unexpected inflation shocks.

      Liked by 1 person

      • Having learned my lessons that the RBNZ really has no clue after a almost disastrous 2008 to 2010 when retail interest rates hit 10% plus and the economy plummeted to a deep recession, I have not added to my portfolio of properties since and instead have sold down to 11 properties with a $15million valuation from a peak of 13 properties and also been paying down debt to around $2 million. I am certainly much better positioned to handle interest rate increases with already significant rent increases. Also my wages had risen from $100k to $200k over that period. Don’t forget also the loss limitation and interest limitation effect kicks in with a loss of 25% tax deductibility this year. Next year 50% interest limitation will kick in from April 2023 which will put upward pressure on rents and as a result higher inflation..


  4. Think a government can spin/sell a recession as an unexpected ‘shock’ and hope they get a pass (maybe with a bit of fiscal easing). Selling higher prices as a policy point opens them up. Demographics also – gold card holders make up a large share of the voting base and they wouldn’t want said cards turning into brass.


  5. Michael – I think you are right

    First step would be to align closer to RBA target

    I’m waiting for the baulk moment in the second half of the year as the economic costs of taming inflation in terms of housing become too tough

    Liked by 1 person

  6. There are not many votes for a recession but nor are there many votes for entrenching a higher rate of inflation

    I am reminded of the old Irish gag “if I wanted to get to Skibbereen I wouldn’t start from here”

    I am depressed you have even floated this idea. If we are not going to properly defend the value of the fiat currency we might as well abolish the RBNZ (a useful fiscal saving?) and throw our NZD into the pot with bitcoin. Hrrrumph


    • THanks for those comments Peter

      As I’m sure you read, I’m not at all keen on the idea of a higher inflation target (I would happily revert to a 0-2% target, at least if the lower bound issues were properly addressed, which isn’t hard).

      If we were starting from a full employment (at NAIRU) plus core inflation at the target situation, I’d agree there would be no obvious bias in public preferences for a lower or higher inflation target. But since we are at the undesirable starting point, I’m not convinced public opinion would not be content enough with a higher target, if to do so eased some transitional econ pain. Recall that back around 1990, getting inflation down from 15% had been popular, but 0-2% was something of a high-wire act, including in both main parties’ caucuses, and relatively limited commitment from even those responsible for it (I was in a meeting with Caygill as MOF when he declared “well, everyone knows if we don’t hit the inflation target we’ll just change it”).

      On your final sentence, a higher target does not of itself prevent mon policy fulfilling some macro stabilisation role (the only case for discretionary mon pol anyway – metallic standards will give one reasonable long run price stability.

      The sobering issue for me is that when my economics-student son yesterday asked me how I would make the case against a politician who wanted to raise the target at present I found myself on weak ground. I would run arguments about the tax system interacting with high inflation to produce some distortions, I would run old arguments (I used to use 30 years ago) about not changing the kilogram or the metre every year so why target large changes in the value of money, I’d mention risks to future credibility (but am conscious of our own past target changes), and they didn’t sound all that persuasive, at least to anyone starting sceptical.

      If MoF came to you and said he was thinking of making a change along the lines my post toyed with, which arguments would you emphasise in response to attempt to persuade him against?


      • I think all of those arguments can be beefed up to be quite persuasive.

        As you probably recall, I have always had an almost ethical view that the role of the RBNZ is to maintain the value of the currency. It’s the “weights and measures” argument. Quite well summed up by “stability in the general level of prices”.

        As to distortions, unexpected inflation causes massive wealth transfers as well as real income effects. Savers and kiwisavers are taking a beating, borrowers are getting windfall gains (although they may not be feeling it!). There are some complicated dynamics around this, but it is all a big mess in terms of incidence right now. And little of it is “fair”.

        Meanwhile we are still sitting on very negative real after-tax interest rates. Still fuelling the fire…


      • I’ve always been fond on the ethical argument (complete with weights and measures quotes from the Old Testament) but even if it could be made to have wider public appeal, it was stronger when the target was centred on something – 1% growth in the CPI – plausibly close to zero “true” inflation. A 2% midpoint could be said to be as ad hoc as a 4% one.

        Agree that unexpected inflation is highly distortionary and generally unfair. But someone favouring change could mount a semi-plausible argument that we’ve already had that shock and “all” they are now arguing for is stable and predictable inflation centred somewhere close to where things are now (perhaps 4% core inflation).

        Indexing the tax system is always an option. I’ve always been a bit wary on the basis that doing so would undermine the case for price stability. But if one were not much inclined to believe in price stability anyway, indexation is quite appealing for exactly that reason – remove the govt-set distortion that they would concede does arise from positive expected inflation.


  7. Hello Michael.

    Interesting conjecture. No comment from a NZ & AU perspective. I would think that such an upward shift in explicit inflation settings from a G7 perspective (taking Japan out of the equation as it’s still a problem they would like to have) might be, at first blush, tempting for politicians, but still unlikely to eventuate. Central Banks can rightly argue that by acquiescing they’d lose their inflation fighting credentials ‘against the head’ when its most need; cynically, politicians would then have no one to blame should things really go wrong.

    Larry Summers had an interesting take recently when he was asked about the Fed’s average inflation targeting policy:

    “To be blunt, I think that policy was almost completely ill-conceived. Nobody really cares at any moment what inflation was five years ago. So saying that inflation’s going to average out over a long period of time is inviting fairly wide swings to the rate of inflation. I think the statement they made in association with that policy, that they would not respond to the threat of inflation under any circumstances but would wait only until they saw inflation, was a change from long-standing practice. And given that monetary policy operates with a substantial lag, it was a mistake. And I think the statement that even if they saw inflation, they wouldn’t tighten monetary policy unless they judged the economy to be at full employment was a confusion as well, because why would you have rising inflation if in some sense you didn’t have an overheating economy relative to its potential? I think those statements were a response to the economic environment that occurred before the pandemic. In the context of 12-percent-of-GDP stimulus programs, it doesn’t really have much to do with the current situation. So I think the Fed should make it clear that it has shifted to a framework appropriate to a moment where disinflation is the primary policy challenge.”


    On the issue of labour markets – Summers has also written another paper where he continues to expect a labour markets in the US to be tight. I’d heard the demographic argument before on labour market conditions ( and more in in relation to the structural moves in bond yields), but it was interesting to see he’d attributed its impact to current US labour markets with an actual (significant) number.




    • Thanks for those thoughts.

      On average inflation targeting, while I tend to agree with Summers longer-term I thought (and still think) that as a bit of guide to policy emerging from the worst of the pandemic econ disruption, it wasn’t a bad approach. May seem strange now, but only 18 months ago the track record of central banks was of consistently undershooting targets, and the active embrace of something a bit over target for a while seemed to send the right message (incl about the extreme macro uncertainty then).

      On your argument that central banks/govts that raised targets would lose crediblity, having buckled at the first test, I’d really like to believe so, but I think the argument is weaker than I would like. As I noted in the post, NZ raised our target twice, and people/markets just took it in their stride (partly reflecting that actual outcomes tended to be a bit more in line with the new target than the old). But the lower bound issue/argument has the feel of one authorities could use persuasively, to suggest with a bit of credibility that they had reassessed what inflation rate was needed to provide suitable countercyclical flexibility in a low real neutral rate world. Of course, I’d prefer they dealt with the lower bound issues directly and allow deeply negative nominal rates, but – rationally or not – there does seem to be an aversion to negative nom rates that doesn’t apply to negative real rates.

      I still fear that were a politician to ask me to write the best case I could make for (a) the status quo targets, and (b) raising the target to 3-5% that to many readers my (b) case would seem the strongest. And that even tho I would much prefer a), subject to sorting out the lower bound issues,

      Anyway, thanks again for the comments – eliciting alternative perspectives was half the motivation for the post.


  8. Agree with Peter Ledingham who has said most of what I think probably much better.
    Further these are high stakes we are playing for.
    If the NZD falls out of bed it will be too late for 90% of New Zealanders.
    Recession could end up depression particularly given the appalling productivity in this country!
    It is the RB duty to ensure price stability,and as a corollary a stable NZD.They will not be able to achieve any of these targets without a more hawkish approach with the OCR.
    They must use their vaunted “independence “to do their job.
    So far they have failed!
    This second thought may be a step too far ,but here it is.There is the possibility that todays politicians may view these economic challenges as an opportunity to redistribute the wealth in this country. That means your concept of adjusting targets to fit would be part of it.
    Won’t go further but this possibility remains!


    • The NZD is a speculative currency. There are 2 key things the government can do to maintain stability.

      1. Reopen borders fully for tourists and international students.This is a $16 billion industry that is a daily demand of the NZD at retail rates boosting the value of the NZD

      2. Remove Foreign Buyers Ban of NZ residential property. Although foreign buyers represent less than 4% of property buying activity a year, it does create a demand for the NZD. This is a $1.5 trillion house asset that can provide fundamental support for the NZD. A sought after asset available to sell to foreigners needs only a few keen buyers to create value for the NZD.


  9. You make some excellent points in this blog. Given where things sit, the Reserve Bank urgently needs to embark on a purposeful ‘disinflation’ along the lines of the late 1980s — early 90s. We are no longer in target maintenance territory and the costs of getting inflation back to the target range, will, alas, be material. You are right that this is likely to involve a recession but I suspect there is widespread denial of this within the bank and government ranks. The dual mandate has falsely created the perception that inflation can somehow be finessed lower without any real pressure on activity or the labour market. Some additional observations:

    – The disinflation in the late 80s was significantly assisted by a rising exchange rate, much to the chagrin of exporters. That isn’t happening this time for various reasons.

    – High global inflation (not present in the late 80s to anywhere near the same extent) will also make the job tougher.

    – Nor do we have a large scale deregulation/liberalisation/tariff reduction programme occurring, which provided useful assistance to the RBNZ when it was reducing inflation in the late 80s.

    In an ideal world, the MoF would set an interim inflation target for the Bank (eg get inflation down to 3-4 percent by end 2023) so that the MPC’s hand is forced into meaningful action. Without a yardstick, it will be all too easy for things to keep slipping.


    • Interesting idea re an interim target. At this stage it would prob have to be for at least Mar or June years 2023 (allowing for mon pol lags), and would prob have to be for some core inflation measure to be meaningful (oil could be sharply up, sharply down or not much changed and we would want the RB reacting strongly to any of those possibilities).


      • Yes you’re right, it would need to be an ex-oil core inflation measure of some sort. I doubt it will happen but it would be a useful way of holding the MPC to account and would help build a bit of credibility that the bank/mpc is serious about the task of getting inflation back down. At the moment, the bank seems to be free to take as much time as it likes!


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