Research from Treasury economists has highlighted the effect of government spending and low interest rates on New Zealand’s persistently high rate of inflation.
The research comes as Stats NZ is about to publish the latest consumer price index (CPI) inflation figures on Thursday - with the inflation rate now 7.2 per cent.
In a recent note, Treasury economists sought to disentangle the supply and demand components of the inflation spike we’re experiencing. The economists looked at spending and inflation data and created models to look at which parts of that inflation were driven by demand and which parts were driven by supply.
The research was the work of Treasury economists, but did not represent the official view of the Treasury.
At stake is a very important political question: The key drivers of demand are government spending and the Reserve Bank’s monetary policy; the Opposition is trying to argue that the Government and the bank went too far in stimulating the pandemic-hit economy and unleashed unacceptable levels of inflation, while the Government wants to diminish its blame by pointing towards the fact that most economies are experiencing high inflation.
This research suggests the Opposition has a point.
The research found that “supply and demand drivers that the model can explain have contributed roughly equal amounts to annual inflation in the past year, although different models give different estimations”.
While supply and demand contributed roughly equal amounts to inflation, they did not always contribute equally at the same time.
When inflation first began to tick upward outside of the 1-3 per cent window targeted by the Reserve Bank in 2021, it was mostly driven by demand thanks to government spending, the Reserve Bank, and New Zealand’s then-hot housing market.
“The surge in inflation from 2021 was initially demand-driven by stimulatory monetary and fiscal policy, and rapidly increasing house prices which fuelled economic activity,” the report said.
Demand inflation stuck around, contributing around 2 percentage points of New Zealand’s 6 plus per cent inflation since then.
Unfortunately, demand inflation was joined by supply inflation, which itself contributed about 2 percentage points. This was due to several factors such as the war in Ukraine, labour shortages, and broken supply chains.
“[F]rom the second half of 2021, supply-side factors drove the continued accelerated in inflation. Contributions from supply and demand drivers have been relatively stable across 2022,” Treasury said.
The report calculated that supply and demand factors contributed to about a third of inflation each, with the remaining third down to unknown factors.
The National Party’s finance spokeswoman, Nicola Willis, said the report put to bed the “idea that inflation is a visitor from overseas and global forces”.
“Yes, global supply factors have had an impact on New Zealand, however there have been domestic issues at play,” she said.
Willis said Labour had got “too used to pushing the spending dial”.
Prime Minister Chris Hipkins had recently challenged politicians promising to trim inflation by cutting spending to detail what they would actually cut, noting that making material impacts on the inflation rate would require fairly large cuts.
Willis said she would not put numbers on what National would do, but she said future National budgets would not “have the level of increased spending Labour has grown accustomed to”.
“I’m not going to give you a specific number today, but what I think we will be doing in our first Budget is a combination of repurposing some spending and we will be reallocating some infrastructure spending,” Willis said. She added there would still be some areas where spending levels would increase. The party has promised to increase health and education spending.
Willis noted that a key driver of inflation was building materials, and said National would shortly have policy in this area.
“We still have highly vertically integrated supply chains. There are still for us real questions around whether builders are getting fair price on their materials,” she said,
“We are looking at what is required to make sure we have fair pricing,” she said.
The Government’s contribution to inflation may already be easing. December GDP figures showed central government consumption fell 2.8 per cent in the December quarter and 1 per cent in the September quarter.
The fiscal impulse, which measures the effect of government spending on demand, also shows the spending becoming a net drag. The current forecast is for government spending as a share of the economy to reduce to about 30 per cent - the long-run average.
The Treasury report noted that New Zealand was experiencing less supply-side inflation than other countries such as the United States and Australia.
In the US, supply-side inflation accounted for 60 per cent of the total annual inflation.
“The similar experience of New Zealand likely reflects the global nature of some of the supply-side shocks that have occurred across the pandemic.
“However, the lower impact of supply-side shocks may reflect that New Zealand has been more insulated from some energy inflation from the war in Ukraine than other countries. The larger contribution from demand factors may also reflect the relatively large policy response in the early stages of the pandemic,” the report said.
Infometrics chief executive and economist Brad Olsen said the paper “reinforces what we’ve been saying: There is pressure on both sides but importantly the sustained level of the demand component”.
“In hindsight everyone knows we did too much, but as well as that I think what comes through a lot more is when it was clear we were doing too much, we didn’t pull back quickly,” Olsen said.
He said the Government had clearly signalled it would be cutting back on spending and reprioritising existing spending to fund new things rather than adding to the level of spending.