Research by Treasury economists has highlighted the effect of government spending and low interest rates on New Zealand’s continued high inflation.
The research comes as Stats NZ is about to release its latest consumer price index (CPI) inflation figures on Thursday – with inflation now at 7.2 per cent.
In a recent note, Treasury economists attempted to untangle the supply and demand components of the inflation spike we are experiencing. The economists looked at spending and inflation data and created models to see which parts of that inflation were driven by demand and which parts were driven by supply.
The study was the work of Treasury economists, but did not represent official Treasury opinion.
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There is a very important political issue at stake: the main 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 have gone too far in stimulating the pandemic-hit economy and causing unacceptable inflation, while the government wants to clear its debt by pointing to the fact that most economies experiencing high inflation.
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This research suggests that the opposition has a point.
The study found that “demand and supply factors that the model can account for have contributed roughly equally to annual inflation over the past year, although different models provide different estimates.”
While supply and demand contributed roughly equally to inflation, they did not always contribute equally.
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When inflation first started to rise beyond the 1-3 percent range the Reserve Bank targeted in 2021, it was driven largely by demand thanks to government spending, the Reserve Bank and New Zealand’s then-hot housing market.
“The rise in inflation from 2021 was initially demand driven by stimulative monetary and fiscal policies and rapidly rising house prices fueling economic activity,” the report said.
Demand inflation lingered and has since contributed about 2 percentage points to New Zealand’s 6 plus percent inflation.
Unfortunately, demand inflation was accompanied by supply inflation, which itself contributed about 2 percentage points. This was due to several factors, such as the war in Ukraine, labor shortages and broken supply chains.
“[F]from the second half of 2021 supply-side factors drove inflation to continue to accelerate. Contributions from supply and demand drivers have remained relatively stable in 2022,” Treasury said.
The report calculated that supply and demand factors each contributed to about one-third of inflation, with the remaining third to unknown factors.
National Party finance spokeswoman Nicola Willis said the report undercuts the “idea that inflation is a visitor from overseas and global forces”.
“Yes, global supply factors have had an impact on New Zealand, but there have been domestic issues,” she said.
Willis said Labor had become “too used to pushing the spend button”.
Prime Minister Chris Hipkins had recently challenged politicians who promised to reduce inflation by cutting what they would actually cut, noting that a material impact on the rate of inflation would require fairly large cuts.
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Willis said she would not give numbers on what National would do, but she said future national budgets would not have “the level of higher spending that Labor has become accustomed to”.
“I’m not going to give you a specific number today, but what I think we’ll do in our first budget is a combination of reallocating some spending and we’ll reallocate some infrastructure spending,” Willis said. She added that there would still be some areas where spending would increase. The party has pledged to increase spending on health and education.
Willis noted that building materials were a major driver of inflation, and said National would soon have policies on the matter.
“We still have highly vertically integrated supply chains. There are still real questions for us about whether builders are getting a fair price for their materials,” she said,
“We’re looking at what it takes to make sure we have fair prices,” she said.
The government’s contribution to inflation may already be declining. December GDP figures showed that central government consumption fell by 2.8 percent in the December quarter and by 1 percent in September.
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The fiscal impulse, which measures the effect of government spending on demand, also shows that spending is becoming a net drag. The current forecast is that government spending as a share of the economy will fall to about 30 percent – the long-term average.
The Treasury report noted that New Zealand experienced less supply-side inflation than other countries such as the United States and Australia.
In the US, supply-side inflation accounted for 60 percent of total annual inflation.
“The comparable experience in New Zealand likely reflects the global nature of some of the supply-side shocks that have occurred during the pandemic.
“However, the lower impact of supply-side shocks may reflect the fact that New Zealand is better insulated from any 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’s pressure on both sides, but mostly the continued level of the demand component.”
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“In hindsight everyone knows we did too much, but beyond that I think what comes out a lot more is that when it was clear we were doing too much, we didn’t back down easily,” said Olsen.
He said the government had clearly indicated that it would cut spending and re-prioritize existing spending to fund new things rather than increasing spending levels.
