Thursday, 7 Apr 2022
View point: 
The Treasury

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Special Topic - Inflation and fiscal policy

Inflation has increased sharply and is becoming persistent. Monetary policy is the primary tool for addressing inflation, but fiscal policy can play a supporting role. This note briefly explores the interaction between rising inflation and fiscal policy.

Inflation rose sharply in 2021…

After remaining stubbornly low for a decade, Consumers Price Index (CPI) inflation rose 1.4% in the December quarter to be up 5.9% over 2021. Broadly, this is the result of:

  1. oil prices increasing sharply
  2. global supply chains unable to keep pace with a strong rebound in global demand
  3. strengthening domestic demand following the significant monetary and fiscal support in response to the pandemic
  4. COVID-19 hampering the domestic supply response to last year’s surge in demand, and
  5. the exchange rate remaining subdued. 

The Russia-Ukraine conflict is also driving up prices for oil and other commodities and is adding to inflation, although the Government’s fuel excise and public transport policies will provide a partial offset.

…and has become persistent

Although some of the initial drivers of inflation were temporary, it is now clear that inflation has become more broad-based and persistent. Prices are increasing across most expenditure groups and Reserve Bank measures of core inflation and inflation expectations are rising (Figure 1).

Higher wage growth will also feed into persistent inflation. Wages grew 2.6% in 2021, compared to inflation of almost 6%. In coming years, workers will look to make up for the real wage reduction. They will also have stronger bargaining power with the tighter labour market. Of course, how tight the labour market remains depends on demand for labour (which is expected to remain strong) as well as migration.

Figure 1: Persistent inflation

Figure 1: Persistent inflation

Source: Stats NZ, RBNZ

While domestic monetary and fiscal policy responses to COVID-19 put upward pressure on inflation…

In response to COVID-19, the Reserve Bank’s Monetary Policy Committee decided to reduce the Official Cash Rate (OCR) and use alternative monetary policy tools like Large-Scale Asset Purchases to provide additional stimulus. While it is difficult to quantify the impact of these decisions, low interest rates have clearly had an impact on some key areas. For example, low interest rates contributed to a sharp lift in house prices that stimulated consumer spending. An associated boom in construction activity contributed to a 16% increase in the price of building a new home in 2021. The non-housing parts of non-tradables inflation have also accelerated, and non-tradables inflation overall is now 5.3%, compared to an average of 2.5% in recent years.

Fiscal policy has also been very stimulatory over the past three years. At last year’s HYEFU, the Treasury’s estimate of the fiscal impulse (a simple measure of how much additional demand fiscal policy is directly adding into the economy) suggested that fiscal policy directly added an average of 2.4% to GDP growth over each of the fiscal years from 2019/20 to 2021/22 (Figure 2). The Treasury’s economic forecasting model, which also captures indirect effects of the fiscal impulse, tells a similar story. The real-world effects of additional spending are however highly uncertain and depend on various factors, including the composition and timing of spending. 

Figure 2: Fiscal impulse and fiscal balance

Figure 2: Fiscal impulse and fiscal balance

Source: The Treasury

…insufficient stimulus may have been worse.

Although fiscal stimulus has added to inflation, Treasury stands by the advice it gave at the onset of the pandemic to provide a strong fiscal response. The risks of providing too little stimulus could have been far worse than the risk of providing too much.

Monetary policy will be the main tool for reducing inflation …

In our assessment, bringing inflation back to 2% will require a significant tightening of monetary policy. Some recent drivers of inflation are temporary and will recede on their own, such as petrol price increases. However, there is also a more persistent inflation dynamic developing, and a monetary policy response will be required to reverse this. The Reserve Bank has already increased the OCR, and financial market pricing is pointing to an OCR of 3.5% by mid-2023.

…but fiscal policy can play a supportive role…

Tighter monetary policy should be the primary tool for containing inflation, but fiscal policy can play a supporting role. Fiscal policy is set to tighten over the years ahead, reducing demand the Government is adding into the economy and helping to contain inflation. Our HYEFU fiscal impulse estimates were negative over the coming years, in line with the fiscal balance moving from deficits to a small surplus. The key driver of this projected fiscal tightening was the winddown of COVID support schemes.

A further supporting role for fiscal policy is played by the automatic stabilisers. Tax revenues and transfers such as the unemployment benefit tend to work in the opposite direction to the economic cycle, meaning the Government contributes more to demand during economic slowdowns, while the fiscal impulse automatically falls during periods of strong demand.

…and can help determine how the costs are distributed.

The supply disruptions that are contributing to inflation at present will have real costs for the economy. We expect ongoing economic growth, but bringing demand-driven inflation down will inevitably involve cooling in some parts of the economy. Fiscal policy cannot alter these realities, but fiscal policy choices can help to determine how such costs are distributed through society.

Inflation will affect government revenue and expenditure.

Inflation impacts government spending and tax. Rising inflation increases the price of delivering government services, which will erode the purchasing power of existing departmental budgets. This means that greater government spending increases will be required to maintain a given level of service. Conversely, high inflation increases tax revenue via higher nominal economic activity. In addition, faster wage growth moves salary and wage earners into higher tax brackets and overall, tax increases as a share of GDP.