Don’t Rule Out an OCR Rise
New Reserve Bank Governor Anna Breman would’ve been hoping for a less eventful backdrop to just her third Monetary Policy Committee meeting scheduled for 8th April. Instead, the US and Israel’s reckless barbarism in the Middle East has thrown the global economy into a rapid tailspin of stagflation, with New Zealand’s already sluggish economic recovery now facing surging oil prices, uncertain fuel supplies, severely disrupted trade flows, and all the domestic economic disruption which inevitably follows.
The problem for the RBNZ’s Monetary Policy Committee (MPC) is that this crisis is new and constantly evolving. Their decisions are made with a view to the medium term—at least 6 months away—as changes to monetary policy settings now will take some time to have an impact. It is highly uncertain what will happen next week, let alone what will be facing the country in a few months time.
February’s Monetary Policy Statement indicated that committee members were balancing the upward pressure on inflation from households’ and firms’ inflation expectations against the dampening effect from low economic output. The supply shock now hitting us will be certain to lift CPI sharply when the next figures are released by Statistics NZ on 21st April, but it’s unknown whether the simultaneous hit to economic activity will balance that upward pressure. As indicated by Breman in her recent speech on the conflict, the RBNZ can do little about the inflation already arriving. Instead, what will concern the MPC will be the impact of a prolonged conflict further lifting inflation expectations, and this feeding through to firms’ pricing decisions and embedding inflation. If this occurs, Breman has been clear that the response will be to raise rates. The problem is, they won’t know for sure whether it happens until it’s too late for monetary policy to prevent it.
Money markets have recently priced in earlier rate hikes than previously expected, and all major banks have increased their rates accordingly. Unless something very unexpected happens, the OCR is going up. It’s just a question of when: now or later? Economists in New Zealand are almost universally of the view that the RBNZ will not lift the OCR until later this year. To take just one of many similar examples, BNZ economists have said that Breman’s speech indicates there will not be a “knee jerk reaction” to the initial inflation shock. These readings overlook the key conclusions of Breman’s speech, as well as important recent history.
Yes, Breman noted the risks of acting too soon, but she also said that the most important goal of monetary policy was to ensure that inflation spikes do not become embedded in the economy.
Getting this judgement right is key to avoiding reacting too early to near-term inflation pressures that monetary policy can do little about – or reacting too late if above-target inflation becomes embedded in the economy. Most importantly, monetary policy can and should ensure that a temporary inflation spike does not turn into enduring inflationary pressures. The Committee will be vigilant to this risk.
Breman reiterates here that monetary policy does not respond to the immediate conditions that it cannot control. But inflation shocks become embedded, so the theory goes, when firms and households determine that the upward pressure will stick around, and so firms raise prices and households raise wage demands. Surveys on inflation expectations give the Reserve Bank an indication of the size of this risk, and how large they determine it to be will drive their OCR decision. The quality of this data and how conclusive it is will be important, but there will also be some recent history on the committee’s mind.
The central bank faced a somewhat similar trade-off in mid 2021 when Covid-19 related supply chain bottlenecks lifted inflation. At the time, RBNZ viewed this inflation as “transitory” and held off increasing the OCR. Paul Conway, RBNZ Chief Economist, authored a report in September last year arguing that, in hindsight, this was an error, and the committee were too slow to raise the OCR. Conway now sits on the MPC following his appointment in 2022 and it would be consistent with his report if he were to push for an immediate raise to the OCR in response to the current oil crisis.
There is a key difference in economic conditions though - in 2021 there was a smaller output gap and lower unemployment. This will be a consideration for two reasons: firstly, the view of the MPC will be that this contributed significantly to the resulting inflation; and secondly, the risk that an increased OCR now will impact the economic recovery. However, Conway also pointed out in 2025 following his report that the RBNZ no longer have a mandate to “maintain maximum sustainable employment”, so medium term inflation should take precedence over any fears of slowing economic growth, under the bank’s renewed solitary focus on inflation.
The Reserve Bank of Australia have also recently taken a hawkish turn, raising their cash rate in March immediately following the inflation shock. There was a remarkably similar post-Covid response and regretful sentiment from the RBA to that expressed by Conway. An additional hike has been strongly foregrounded for their next meeting.
None of this is to say that hawkish central bank responses to this shock are sensible. In fact, the last thing the economy needs right now is less investment and fewer jobs. And of course there exists a broader critique of the prevailing, often unquestioned, orthodoxy around monetary policy management of the economy. But that’s a topic for another piece. For today, it’s crucial to simply understand that, just because the central bank have said they cannot do anything about the current inflation we’re experiencing, it doesn’t mean they won’t raise the OCR now in an attempt to prevent it becoming embedded. Given the refreshed personnel on the Monetary Policy Committee since the Post-Covid inflation wave and the regrets from that period, they just might pull the trigger.
Philip is a 1/200 co-founder and analyst following political economy & foreign affairs