Christopher Niesche: 70s spectre threatens comeback

Following on from flared trousers, platform shoes and disco, another 70s phenomenon may be due for a comeback - stagflation.

Contrary to what the name suggests, stagflation is not a blow-up deer.

Rather, it is low growth accompanied by high price inflation (though some would say stagflation entails an actual economic contraction rather than just slow growth).

Stagflation last hit in the 1970s, when soaring oil prices pushed prices up strongly, but caused economies around the world to contract as businesses had to accommodate the increased costs and consumers spent less.

In the United States, inflation hit double digits, the economy went into recession and unemployment rose.

In New Zealand, the experience was similar: The economy contracted by as much as 7 per cent one year and inflation climbed over 17 per cent, although unemployment remained low.

Such was the preoccupation with the state of the economy that Wellington punk band the Knobz wrote a song called Don't Give Me Culture, which bemoaned Rob Muldoon's inability do to anything about stagflation. "You don't give a stuff about inflation Rob," they sang in what was perhaps the only pop song to wade into macroeconomics. (Although, the Beatles' classic Taxman dealt with fiscal policy.)

This time around, stagflation is different. Bank of New Zealand head of market economics Stephen Toplis calls it "New World stagflation"; that is, inflation above the Reserve Bank's 1 to 3 per cent target band and below-trend growth.

This is what New Zealand now faces. High oil prices have combined with an economy running at full capacity after several years of strong growth to push annual inflation up to 4 per cent. But the lack of room to grow means that the economy will expand just 1 to 2 per cent over the next year or two, if that much.

While nothing like the magnitude of the stagflation of the 1970s, it raises the same sort of difficulty. Reserve Bank Governor Alan Bollard has to decide what's more important, containing inflation or encouraging growth.

Usually, high inflation is also accompanied by - and caused by - strong economic growth. For a central bank governor, it's then a simple (well, relatively simple) matter of raising interest rates, which then drag down growth and this, in turn, drags down inflation. Then when inflation is low enough, interest rates can come down and growth will pick up again.

But with growth slowing and inflation rising, Bollard faces a conundrum. If he decides he wants higher growth, he'll have to suffer higher inflation. If he wants to bring inflation down, he'll have to sacrifice growth and employment gains.

Bollard has let growth go on for as long as he can. His focus - like that of many of his colleagues around the world - is squarely on inflation. He will keep interest rates at their present high level for as long as it takes to bring inflation under control. He'll do this even if it takes a couple of years, even if growth slows more, and even if unemployment rises somewhat.

That's because the danger of inflation far outweighs the cost a relatively short period of economic pain, although that may be of little comfort to anyone without a job or trying to run a business.

Economies thrive when investors can be sure the value of their investments won't be eroded by rising prices.

High inflation also discourages savings: Why not spend your money now if it's going to buy you less in a few weeks' or months' time?

Also, those who do want to save tend to put their money into investments like gold and real estate, which hold their value, rather than into productive assets that might help the economy grow.

There's not much Bollard can do except wait it out; hope that oil prices will eventually come down and the economy will slow enough to free up some spare capacity and take the pressure off prices. In the meantime, he has to ensure that inflation doesn't rise much further.

ANZ National Bank chief economist Cameron Bagrie says research has shown that once inflation rises above 4 per cent, it starts to detract from long-term growth.

"Having a low inflation environment has been a key part of New Zealand's economic framework," he says. "It's a key reason why we've been able to perform so well on average over the past 15 years."

Unlike flares and platform shoes, a little bit of stagflation may not be such a bad thing.

* Christopher Niesche is business editor of the Herald. Richard Inder is on leave.