Inflation: the struggle for simplicity

Why the Reserve Bank must distinguish monetary inflation from supply shocks

This morning I heard Auckland Chamber of Commerce chief executive Simon Bridges describing the dire state of the Auckland economy. He put part of the blame on the Reserve Bank’s signal that interest rates may need to rise in response to increasing prices. His point was that the immediate cause of the latest price pressure was not excessive domestic demand, but a spike in fuel prices caused by disruption to Middle East oil supplies.

Bridges noted that, had the more doctrinaire members of the Bank’s monetary policy committee had their way when the latest OCR decision was announced on 27 May, the OCR would have gone up. That would have been a further blow to Auckland’s struggling economy. Fortunately, the Reserve Bank executives, supported by the Governor’s casting vote, were more pragmatic and in tune with reality. The OCR was left on hold.

Bridges was right to point the finger at the Reserve Bank. During my 26 years’ involvement in the governance of ASB Bank, I was often puzzled by the way economists made things more complex than they needed to be and often seemed blind to events happening outside New Zealand.

Economists are not alone in making difficult subjects opaquer than they need to be. Lawyers and law makers do it too. Tax law is the obvious example of complexity created by the government. The Income Tax Act 2007 runs to thousands of pages, is amended annually, and sits alongside a host of other legislation administered by Inland Revenue.

It is so long that the government legislation web site contains a warning: “Due to the size of this legislation, it can only be viewed in parts. This will affect CTRL+F searches, which will only search the part you are currently viewing. You can use the content search on the top right of the page to search content across the whole Act.”

Only specialists have any realistic prospect of navigating it with confidence. Even for them, it requires enormous effort.

In the field of law more generally, there are some who try to achieve a modicum of simplicity. One of these was Justice Robin Cooke, later Sir Robin, and later still Lord Cooke of Thorndon. Cooke is often criticized for judicial activism although as an activist he is not a patch on some of today’s judicial incumbents. As an intellect, Cooke towers above them. In 1986, Cooke presented a paper, “The Struggle for Simplicity in Administrative Law.” In it he explained that the essential function of judicial review is to ensure that decision-makers act in accordance with the law, fairly and reasonably.

I have borrowed my title from Cooke’s paper and applied it to the economic field of “inflation.” The use of that term is itself a way of disguising the truth. Inflation is not the result but one of the causes of increased prices. Understanding why prices increase, why the cost-of-living increases, is quite simple when all the jargon and the fancy mathematical equations are stripped out.

When a country creates more money than the economy has goods and services to buy, prices will rise. In other words, more money chasing the same amount of stuff leads to increased prices. Imagine an economy produces the same amount of goods as last year, but the money supply doubles. Prices will roughly double, because there’s twice as much money competing for the same goods.

In that example, it is inflation of the money supply producing the increased prices. That distinction matters because the same price increase may have very different causes. Treating all price increases as if they are caused by excessive demand is a serious policy error.

The converse is also true. If there are fewer goods and services to buy and the money supply stays the same, prices will rise. Imagine an economy produces half the goods as last year, but the money supply stays the same. Prices will roughly double, because there’s the same amount of money competing for half the goods.

During the serious mismanagement of the economy and monetary policy during the covid years, both factors were in play. The Reserve Bank greatly expanded the money supply, aiding the government to pump money into the economy. At the same time, the government shut down large parts of the economy for extended periods, reducing the production of goods and services.

There was a double whammy effect: more money with fewer goods and services. Both factors worked to increase prices. The severity of the impacts explains why the economy has taken so long to recover.

Simon Bridges was right to call out the RB’s academic economists. Resulting from the war in the Middle East, the supply of oil decreased. Consequently, prices of oil derivatives in NZ and elsewhere increased. Those increases flow through the economy. Because oil derivatives are essential inputs for many producers the increased prices increased production costs (as well as consumer prices) and therefore had the tendency to reduce production as well as to increase prices.

It can be seen, therefore, that in this case the problem is not increased money supply but decreased supply of goods. Increasing the OCR has no impact on the supply of goods. All it can do is constrain the money supply.

Reducing the money supply by increasing the OCR would constrain price increases up to a point. Interest rate increases take money from consumers and reduce demand. But an OCR increase can have no impact whatsoever on the price of oil derivatives which is a function of diminished supply of oil.

Another impact of an OCR increase, and I expect this is part of Simon Bridges’ concern, is that it also tends to strangle investment in the domestic economy, the economy’s ability to produce goods and services, and the economy’s ability to compensate somewhat for the reduction in the supply of oil products. In addition, Reserve Bank talk of the prospect of increasing interest rates reduces business confidence. Why would you try to increase production when you are being told to expect weaker demand for what you produce?

The lesson is not difficult. When prices rise because the money supply has been inflated, the Reserve Bank has a proper role in restraining it. But when prices rise because supply has been disrupted — especially in something as fundamental as oil — higher interest rates do not solve the problem. They merely spread the damage.

They suppress demand without fixing supply. They will not increase oil production. They will not lower international fuel prices. They will not make Auckland businesses more productive. They will, however, reduce spending, discourage investment, weaken confidence, and add another burden to an already struggling economy.

That is the danger Simon Bridges identified. The Reserve Bank must distinguish between monetary inflation and supply-driven price increases. If the Bank cannot do that, it becomes part of the problem. Competent policy begins with a simple question: are prices rising beca

use there is too much money, or because there are too few goods?