I’m feeling bearish about the economic impact of the RBNZ’s position on increasing the OCR.
The OCR is typically increased to reduce the economy’s propensity to spend money (AKA reduce demand) to cool an overheated economy, but also to put the central bank in a position where they can drop the OCR to stimulate demand in future, as required.
Inflation is a key indicator (and cause for concern) of an overheated economy; hence the RBNZ has started on the path of OCR increases to cool the inflation before it creates instability in the economy.
However I do not believe that OCR increases are the right tool to reduce inflation in this case, and I believe that OCR increases may actually harm the economy.
I say this because while increasing the OCR is a great way to keep price increases in check that result from a flourishing economy, that’s not what’s happening here. Instead we have a performant economy that is threatened by high prices due to supply issues.
The difference is subtle until you consider a supply and demand diagram.
If we consider a supply and demand diagram, we can see that as an economy performs well, participants have an increased propensity to buy (increased demand) and this pushes up prices. In this scenario, increasing the OCR is a great way to keep demand in check by presenting buyers with a more preferable alternative of a higher ROI for their money in the bank and reducing their debt levels. The below supply and demand diagram illustrates an increase in demand due to a flourishing economy.
Unfortunately our economy isn’t suffering from increasing prices due to increased demand (much). By far the greatest pressure on prices is due to a lack of supply caused by COVID related logistics issues and other supply constraints (lack of lorry drivers, shipping queues at ports, labour shortages, semiconductor shortages, etc.). This is represented in the below demand and supply diagram, which depicts the effects of a reduction in supply.
Let’s have a look at what happens when the OCR is increased to reduce demand along with the already reduced supply.
As we can see from the above diagram, when the OCR is used to tackle price increases from a reduction in supply, one of two things can happen:
- The demand isn’t reduced enough, resulting in high prices and lower quantities traded
- The demand is reduced (at least) enough to match prices before supply decreases, resulting in larger drop in quantities traded
In both scenarios we see a drop in trade and most likely this won’t fix the inflation problem (at least not without significantly damaging the economy). A drop in trade means a poor economy, job losses, business closures / contractions, etc.
I would argue that as the economy isn’t overheating and is performant, that minimal interference is appropriate. Also, as a lack of supply is causing price increases and the government can’t fix the lack of supply (I won’t discuss policies that could help remedy this situation right now), we’ll just have to try to cope with the increases in prices for now and suffer the consequences (which could mean permanently higher prices in some industries).
Finally, I will leave you with a definition of poverty, where poverty is described as people not having things (lack of supply) and not being able to afford things (high prices).
