The answer: Yes, if that’s the price we have to pay to bring down inflationary pressures and re-establish stable price expectations.

The November 2022 Monetary Policy Statement was one for the history books: the first 75 basis point (bp) increase to the official cash rate (OCR) in New Zealand’s monetary policy history. Perhaps as monumental was that the size of an increase took the cumulative OCR increase to 400 basis points since the tightening cycle started in October 2021. But the increase came with the Reserve Bank’s strongest warning yet: inflation is too high, and a recession is necessary to curb aggregate demand and get inflation back under control.

Despite well-founded concerns that the Reserve Bank may have just overcooked its response, the unprecedented rise was the right call.

What choice did they have?

• Inflation remains persistent, pervasive, and problematic, with the consumers price index up 2.2% in the September quarter, resulting in annual inflation of 7.2% – far worse than expected.
• Labour market outcomes remain considerably stronger than expected too, with private sector wage growth at 8.6%pa – even above the Reserve Bank’s large forecast of 8.3%pa.
• Inflation expectations rose strongly too, with inflation in two years expected to be 3.62% – the highest reading since 1991.

Taking these indicators together, the Reserve Bank had to go big, no matter the consequences. The messaging from the Reserve Bank was important too – it had to commit to doing whatever it takes to get inflation under control, as well as clearly outlining the process towards a recession, to jolt households’ and businesses’ mindsets away from expecting high inflation to continue. In our view, it achieved both.

Such action comes at a cost. The Reserve Bank now expects the New Zealand economy to enter a four-quarter (12 month) recession, with a 1% reduction in GDP. By comparison, GDP fell 2.7% during the Global Financial Crisis. That outcome is the Reserve Bank’s view of the necessary cost to get aggregate demand low enough to stop large price rises in their tracks.

The transmission path from higher interest rates to lower inflation is as follows.

1. Higher interest rates cause people to save more and spend less. Mortgage repayments are higher, leaving less disposable income for other consumption.
2. More saving and less spending mean weaker sales and less revenue for businesses.
3. Less revenue across the economy means businesses need to compete harder for the fewer sales available. One way of competing is on price, so firms start to limit price increases, lest they lose market share at a time when sales are already shrinking.
4. Lower sales and lower revenue mean there’s not as much work to be undertaken, so businesses start to reduce their workforces, raising the unemployment rate.

Although theoretically this method works to reduce inflation, it’s by no means a walk in the park. With inflation out of control, there are tough, painful choices to wrestle the genie back into the bottle.

Importantly, the method outlined above sees the unemployment rate rise. But rising unemployment does not inherently curb inflation, and no one is going to be jumping for joy as the unemployment rate rises. Instead, rising unemployment is a by-product of the method taken to get inflation under control, and provides a signal that businesses are changing their operations in the face of the pressures they face. Importantly, higher unemployment and more slack in the labour market should also lead to slower wage inflation, lessening one of the major cost pressures being experienced by businesses at the moment.

That’s not to say we should embrace a higher unemployment rate. In terms of tools, the Reserve Bank has an indiscriminate bulldozer at its disposal, but the government has a surgical scalpel to support those people hardest hit by job losses and an economic downturn. Carefully wielding that scalpel will enable the government to support people who lose their jobs to retrain and move into new roles, for example. Nevertheless, the government also needs to be more cautious in its spending to avoid adding further fuel to the inflation fire, which could lead to even larger interest rate increases and, therefore, more upward pressure on the unemployment rate.

A key surprise in the Monetary Policy Statement was that the Monetary Policy Committee chose between a 75bp and a 100bp increase. We’d noted the possibility of a 100bp increase before the announcement too, although most expectations were for a toss-up between a 50bp and 75bp rise. Given how seriously the Committee considered a 100bp increase, we’re surprised it didn’t just bite the bullet and go for the larger move.

If you know where you need to get to, there’s a strong argument for getting there as fast as possible – especially when you’ve already admitted you’re behind schedule. Because the Bank has been too slow to react to accelerating inflation the real, inflation-adjusted, OCR is now deeply negative, and according to the Bank’s forecasts, it will stay that way until the end of 2023 (see Chart 1).

That negative real OCR matters: it implies that interest rate settings remain considerably expansionary once people factor inflation into their thinking, and so it risks keeping spending high and savings low for too long. Such trends have already contributed to an un-anchoring of inflation expectations, which makes quelling inflation even more difficult.

Adding to the case for a larger interest rate rise now is the fact that the Reserve Bank doesn’t meet for another three months, so a bigger increase would have provided greater insurance against unexpected strong inflation heading into 2023.

The Bank will argue that taking more considered steps is important to not causing disruption in the economy and avoiding unpredictable shifts. Against this view, we’d argue that persistent and pervasive inflation, and a lack of belief that the Bank can get inflation under control, is itself disruptive and causes unpredictability, gazumping a more conservative approach to OCR increases.

There is a still a difficult and uncertain path ahead, both for the OCR and the economy more generally. That’s not unusual, given the considerable changes in the expected OCR track over the last three years (see Chart 2).

We can see several scenarios playing out, some more likely (in our view) than others.

1. At present, our central forecast is for the OCR to peak at 5.75% in mid-2023, following an orderly wind-down in OCR hikes. This scenario sees a 75bp rise in February, a 50bp rise in April, and a 25bp rise in May, before increases cease.
2. Around this central forecast, we think the risks to the OCR lie on the upside, which would see inflation remaining too hot, and more work needed to knock pricing pressures over. An additional 50bp or 25bp increase, or both, would take the OCR to 6% or as high as 6.5%.
3. We can envisage, but for now think is unlikely, that economic activity domestically and globally rapidly shifts enough to swiftly change inflationary pressures. This outcome could see the OCR peak lower, with fewer increases (in both magnitude and number) needed in 2023.

These three scenarios were our immediate reaction upon reading the November 2022 MPS, and we’d implicitly discounted one further option as implausible. However, the more we’ve reviewed the Statement and the Bank’s conversations publicly, the more we think Option 4 is still possible:

• The Reserve Bank could choose to abruptly stop hiking the OCR altogether, after either a further 50bp or 75bp increase in 2023.

We had always assumed, given the Bank’s ongoing focus on “considered” steps, that a moderation in policy steps would be needed to end the tightening cycle. In other words, if 25bp moves are normal, 50bp moves are large, and 75bp moves are massive, the Bank would need to progressively scale back its increases to get to a zero-change action. However, we now think it’s possible the Bank instead judges each review on its merits and abandons any view of considered steps further.

Finally, it’s worth reflecting that the considerable lift in the OCR peak to 5.5% by the Bank might be as much a signalling exercise as a proper forecast. The 75bp increase in November wasn’t a surprise – the fact that the Bank raised its peak OCR more than anyone was expecting was a surprise.

It’s reasonable to think that the Bank might not have to raise the OCR to 5.5% to get inflation under control, but that publishing that forecast track clear had a shock factor that will help the Bank achieve its aims without having to follow through.

However, given how persistent and pervasive inflation has been so far, we’d be reluctant to call the Bank’s bluff and bet against significant further increases to the OCR in the new year.