Interest rates are being used to try to control inflation in the economy, but what are the alternatives that could be used to tackle the problem?
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The Reserve Bank has been battling to get New Zealand’s rate of inflation down for coming up on two years.
The official cash rate (OCR) has lifted from a Covid low of 0.25 percent to 5.5 percent as the bank sought to reduce the amount of money New Zealanders had to spend – and push up prices.
That has taken interest rates with it, putting the squeeze on indebted households and borrowing businesses.
But did it have to be that way?
Economists say there are other options, but each come with their own pros and cons.
Here are some of them:
Tax
NZ Council of Trade Unions policy director and economist Craig Renney said tax could be another way to reduce demand in the economy.
That could be a tax on company profits, a tax on higher income-earners or a tax on something like luxury goods.
“If you believe companies are making excess profits then taxing those profits is a means of helping to withdraw that demand because those companies are then not distributing those profits to shareholders.”
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He said this would have a more guaranteed direct effect than OCR changes.
While banks might not choose to pass on a full increase or cut of the OCR to retail interest rates, a tax change would be felt completely.
“There’s a reason why most countries don’t head down that route, and that’s the political reason. People tend to like stability in the taxation system.”
Companies could also choose to shift their operations to different countries to avoid these taxes, he said.
“We saw that in the UK where there were various windfall taxes levied on energy providers during Covid, when energy prices were spiralling the government said ‘we won’t levy your windfall if you invest in the UK during this period of time’.
“We saw a lot of brought-forward investment, but how useful that was to the UK economy at any point in time is highly debatable.”
When Canada tried to tax luxury goods, such as boats, it increased the value of boats on the secondary market, and encouraged boat-building in places such as the northwest United States, where the tax did not apply, Renney said.
While the OCR reduced demand, it also increased incentives to save, which purely demand-reduction measures, such as taxes, did not, he said.
KiwiSaver tweaks
It has been suggested that the contribution rate to KiwiSaver could be adjusted so that in times when demand needed to be slowed, people were required to invest more in their own accounts.
“This helps to reduce the level of aggregate demand in the economy,” Renney said.
“You can move that around quite quickly in the same way you can with the OCR. The challenge there is that is only borne by the workers. Businesses don’t face that rate, unless you force employer contributions to match the increase.”
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It would also be less effective at reducing demand than an OCR hike, because the money would go to fund managers who then had to invest it, he said.
“It increases the investment capital that’s available in the country so it’s still increasing aggregate demand to an extent.”
It might also encourage people to structure themselves as companies to avoid it, and there would have to be changes to KiwiSaver to make the scheme compulsory, he said.
Regulatory changes to boost supply
University of Otago associate professor of economics Dennis Wesselbaum said sometimes regulatory changes to free up the supply side of the demand-supply equation would be most useful to lower inflation.
BNZ chief economist Mike Jones said that had been particularly helpful for the United States. “Part of that has been to do with what looks like a productivity boom in the US that we’re not seeing here.”
Often the exchange rate would play a bigger part in the transmission of monetary policy than it had this time, partly because tradeable inflation, which is influenced by international factors, had come down much faster than domestic price pressure, he said.
Target the source
Wesselbaum said an important consideration was what had caused the inflation.
If the government was printing money, stopping the source problem would be the most effective solution.
“But if you have the Chinese economy in trouble and that’s creating a recession you can probably do nothing about the source of the problem, interest rates are probably the best method you have to deal with that. It’s not a simple answer, it really depends on the underlying cause of the inflation.
“Generally speaking, unless it’s an inflation we’ve engineered somehow by doing some weird policy, interest rates will be the best tool.”
Change the target
Renney said there was also a “time-honoured tradition” of simply ignoring the target.
“Instead of saying we’re going to hit 2 percent, we say ‘the world has changed, it’s moved on, we have a range of challenges and we’re going to aim for 3 percent for a few years.
“That has the benefit of getting to interest rate reductions faster.
“There’s no science behind the 2 percent rate … central banks around the world have adopted that, but there’s not a huge amount of evidence to support a 2 percent rate, it’s just become a norm which is mad when you think about it.”
He said, if the Reserve Bank said it was going to accept inflation at 3 percent for a while, attention would then have to turn to whether credit rating agencies would be concerned, and how the banking sector would react.
Banks might decide not to move their interest rates if they needed a higher margin to cover a higher cost of capital, he said. Real assets would reduce in value faster because of the compound effect of years of 3 percent inflation rather than 2 percent.
But there had been talk in international circles about whether a 2 percent inflation target resulted in a lack of investment, he said.
“If we need interest rates at 5 percent to achieve a 2 percent inflation goal, could they be at 4.5 percent to achieve a 3 percent goal – how much more investment in climate change would then be possible, how much more investment in infrastructure would then be possible?”
Price controls
NZ Initiative chief economist Eric Crampton pointed to attempts in the 1970s by the government to directly control prices.
He said it was a poor alternative.
“That doesn’t reduce inflation, it just hides it for a while and at substantial cost.”
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