Read Cost of Living Part 1: In the market-forces era, is there any alternative to belt-tightening? here.
People still occasionally wander into the reception area of New Zealand’s Reserve Bank – a 14-storey steel, glass and concrete building at the bottom of The Terrace in Wellington – and ask them how much gold they have in the vaults. There is a secure vault somewhere beneath the city’s parliamentary precinct but it contains only a few hundred million in cash. Our dollar came off the gold standard at the outbreak of World War I and since then it’s been a fiat currency – it has no inherent value. The money is created by the Reserve Bank (RBNZ): there’s currently about $8.3 billion in paper and coins circulating and another $400 billion in electronic form. The currency has value because the government declares it “legal tender”.
The RBNZ is also charged with maintaining the stability of the currency. Most of us experience inflation as a cruel and rapid rise in prices, but from an economist’s point of view, inflation is a drop in the purchasing power of money over time. The currency itself is worth less. Inflation is not just taking more of what you earn, it’s also steadily and stealthily destroying the value of what you already have. Every day of high inflation means your wages, savings and retirement fund are all worth a little less.
The primary mechanism for controlling inflation is the Official Cash Rate. If the New Zealand economy is like a vast machine, the OCR is a dial that speeds it up and slows it down. (If you prefer, think of the economy as one of those pyramids of champagne glasses; the OCR is the speed at which the wine pours into the top glass.) It’s a simple mechanism: commercial banks can borrow the money the RBNZ creates, and the cash rate is the interest rate they pay on that loan (or the amount the RBNZ will pay trading banks that deposit assets with it). That determines the amount of money the banks charge for their loans – including the $350 billion in property mortgages. It also sets the rates banks pay on savings deposits.
Everything flows from there. If interest rates are high, people will borrow less and save more. The economy slows, unemployment rises and inflation goes down, simply because there’s less money flowing through the economy. If rates are low then money is cheap. People spend, borrow, the economy speeds up. Unemployment goes down. Inflation increases.
That’s the theory. In the 1970s and 80s, the model broke down. New Zealand suffered a series of economic shocks and entered a period of low growth, high unemployment and high inflation. Robert Muldoon – prime minister and finance minister simultaneously – ignored the advice of Treasury and the Reserve Bank and exercised extensive control over the finance sector and the wider economy, setting foreign exchange rates and bank interest rates while implementing wage and price freezes to try to reduce inflation.
His goal, many economists suspected, was to enhance his short-term prospects of re-election – but this came at the cost of long-term damage to the economy.
Muldoon’s successor as finance minister was Roger Douglas, who instructed his officials to “Muldoon-proof” the Reserve Bank. Their solution was the Reserve Bank Act 1989, which was subsequently imitated by most developed economies. This established the bank as an independent agency, with the governor appointed by the finance minister to serve a five-year term. The governor’s mandate is to keep inflation within a narrow band, currently from 1-3%. The primary mechanism is the OCR.
The illusion of control
There were two key principles behind this model of central bank independence. The first is that combating inflation is about managing expectations. If consumers expect prices to keep rising they’ll spend their money instead of saving it. Workers will call for wage increases to meet the rising cost of living. Their employers will raise their own prices to meet the high consumer demand and cover higher staff costs. So the expectation of high inflation becomes a self-fulfilling prophecy.
The second principle is that inflation is primarily a monetary problem. In theory, politicians could stabilise prices by cutting spending and raising taxes – but they are seldom inclined to do so. Increasing interest rates is also very painful: mortgage rates go up; businesses fail; unemployment rises. Markets don’t expect politicians to keep rates high for long. But an independent central banker will, because it’s his or her job to keep inflation low, not to win elections. When Don Brash became Reserve Bank governor in 1988, inflation was 15.7% and mortgage rates were in the high teens. The early 1990s saw a sharp recession and a surge in unemployment, but by the time Brash retired from the bank in 2002 he’d presided over a prolonged period of low inflation, low unemployment and high growth. For most of the next two decades, inflation seemed to be a solved problem.
When New Zealand went into lockdown in the early stages of the Covid pandemic in 2020, most businesses around the country shut their doors. Economic activity nosedived. Economists around the world predicted that the pandemic would be deflationary: prices would go down. There could be a deep and prolonged recession. In March 2020, the RBNZ lowered the cash rate to 0.25%, dangerously close to the “zero lower bound” in which the bank can no longer stimulate the economy by lowering rates.
During the global financial crisis of 2008, a number of central banks around the world – the US Federal Reserve, the European Bank, the Bank of England – adopted a policy called quantitative easing. They printed money (electronically, of course) and used it to buy government and corporate debt. Critics predicted this would lead to runaway inflation. Some people panicked and bought gold; the gold price surged but the high inflation never came. So when Covid hit, many central banks – including New Zealand’s – turned to quantitative easing.
The RBNZ created $71 billion and used it to buy government and corporate debt. But instead of lowering prices around the world, the pandemic disrupted supply chains, which led to increased shipping costs and higher prices. Then in early 2021, Russia invaded Ukraine, leading to a spike in oil prices. Oil is the key energy input across most of the economy, so costs surged again, amplifying the effects of the money printing and supply chain disruptions. That triggered rounds of wage-price inflation: the spiral in which workers bargain for higher raises to meet increased costs, and businesses pass on the higher wage costs by raising prices. Which then repeats itself.
The RBNZ has raised the OCR 12 times in the past two years: from 0.25% in 2021 to 5.5% in May 2023 – higher than it’s been for 14 years. Its last announcement in August left the rate unchanged but indicated rates would remain high until the middle of next year. Its next announcement is due shortly, and on the back of high immigration and stronger than predicted economic growth, many economists are predicting another increase.