Contractionary monetary policy will not be a silver bullet to curb inflation in this turbulent time. It can only be effective when it aligns with fiscal policy, which is hard to accomplish at this unprecedented critical time.
On 22 February, the Reserve Bank of New Zealand (RBNZ) increased the Official Cash Rate (OCR) by 50 basis points, to 4.75 percent, to try and curb inflation. The RBNZ has hiked the OCR by 375 basis points since February 2022. The RBNZ has a target of keeping inflation between one and three percent, but inflation is at its highest level in recent history. In the December quarter of last year, it reached 7.2 percent. How effective is the OCR in combatting inflation during this turbulent time?
USA policy rate
In February, the United States of America (USA) increased its policy rate to 4.65 percent, which suggests that New Zealand may increase its OCR again in April to align with the USA policy rate. Historically, New Zealand’s OCR has always been much higher than the USA Policy rate. However, a higher USA policy rate implies an expensive US dollar which translates to a depreciation of the NZ dollar. This weak exchange rate means higher costs for imports, and that will result in a deterioration in both the trade balance and the terms of trade as New Zealand’s merchandise imports are higher than exports. The NZ trade GDP ratio is almost 50 percent, which means high import costs will likely galvanise high inflation.
Public expenditure on disaster recovery
The devastating floods and cyclone that recently hit the North Island will require additional funding to help the economy recover, to increase supply-side capacity, and also for infrastructure development. This signals that public expenditure will increase. This expansionary fiscal policy may stimulate inflation again, even while the RBNZ struggles to tame roaring inflation through monetary policy. In addition, the government has decided to increase the minimum wage rate by seven percent from 1 April 2023. This may have a further impact on the increasing price level.
Overall, this indicates that contractionary monetary policy will not significantly, or quickly, tame inflation in Aotearoa New Zealand, even though inflation is decreasing slowly overseas. Monetary policy has a ‘lag period’ that needs a couple of months to impact aggregate demand and the price level.
Limited policy options
Contractionary fiscal policy is critical to curbing inflation, but it could have negative impacts on economic growth and employment. A sustainable increase in supply-side capacity is the key to controlling inflation in the long-run. The key areas to invest in to increase supply-side capacity are resilient supply chains, digital trade, innovation, and sustainable development. Fiscal support should therefore be better targeted at those most affected by elevated food and energy prices, and public expenditure should be tightened carefully.