Just when it was going to raise interest rates on 18 August, the Reserve Bank of New Zealand bailed out. And rightly so.

Just hours before the bank was set to pull the trigger, and become the first central bank in the Western world to start raising cash rates from the rock-bottom levels of recent years, along came a new COVID outbreak and another national lockdown. It would have been mad to start hiking rates when businesses were putting up their shutters again.

But it made its future hiking intentions clear. And sure enough, it followed through on 6 October with a 0.25% rate increase and the promise of more to come, stating “further removal of monetary policy stimulus is expected over time”.

Its Monetary Policy Committee reasoned that “Employment is expected to remain at around its maximum sustainable level”, meaning that “rising capacity pressures would feed through into inflation”. So it was time to squish the pressures before they got out of hand.

The Reserve Bank’s own projections see its target official cash rate at about 1.5% in a year’s time, up from today’s 0.5%, and heading further north to about 2% in 2023. And people are fine with that.

While the outlook is murkier than usual, as best as the futures market can tell another 0.25% rate rise still looks on the cards by the end of this year, with something like three or four more hikes in 2022.

And it does seem obvious, doesn’t it? If you’re not going to raise rock-bottom interest rates when unemployment is only 4.0% and inflation is 3.3%, when the heck will you?

And yet, there’s something nigglesome about it. It’s not quite a slam dunk.

The numbers don’t tell the whole story

For one thing, the 4% unemployment rate isn’t as solid as it looks. Yes, the business surveys are showing incandescent levels of labour shortage, but that’s partly because the borders are closed and there’s nobody to pick the fruit, and partly because New Zealand had an unexpectedly robust V-shaped rebound out of the 2020 lockdown. You couldn’t get a waiter for your restaurant for quids. It’s not clear how long that unusually strong hiring demand is going to last. Nor do we know what domestic and global damage the latest COVID-19 outbreak will inflict.

And for another, the 3.3% inflation rate isn’t as frightening as it looks. Everyone knows there’s a good deal of short-term supply chain disruption and other transient stuff in the number. It’s true that even if you strip out the statistical noise, inflation is genuinely somewhat higher than it was: the graph shows two indicators of ‘underlying’ inflation, hopefully not too affected by shortages of computer chips. Both have been rising for some time, and both were about 2% before the latest lockdown.

Graph: Underlying inflation in NZ (click image to enlarge)

But the global experience of the past decade has been that inflation occasionally looks like perking up, but never actually does. Is it any different this time round? And without being finger-pokey about it (if I were in their boots, I’d probably have done it, too), New Zealand’s Reserve Bank has form when it comes to prematurely hiking rates; raising them in 2014 but unwinding in 2015.

The path of least economic pain

So, is the Reserve Bank right to be thinking of a series of rate increases? Let’s see where its own ‘least regrets’ approach takes us. Faced with a choice, pick the one that will cause you least pain if it goes pear-shaped.

The potential downside to doing nothing (or very little) is the risk that the inflation genie flies out of the bag, and genies tend to be difficult things to catch and put back. At the back of your mind will also be the thought that indefinitely low interest rates risk inflating ever bigger asset bubbles, and that part of a central banker’s job is maintaining financial market stability.

The downside to a series of hikes is knee-capping any repeat of a 2020-style recovery out of COVID, especially if borders stay closed and international tourism and education remain crippled. And also at the back of your mind will be the awkward fact that other central banks with similar issues are still sitting on their hands. What are they seeing that you aren’t?

Accidentally allow too much inflation? Accidentally knacker the economy? What would you choose?

Is masterful inactivity the right choice?

For mine, I’d pursue a policy of masterful inactivity. For one thing, I’m not sure that in these very uncertain conditions I’ve got enough information to make a decent decision. Would it really hurt to let things go a while longer and see where we actually find ourselves?

“For mine, I’d pursue a policy of masterful inactivity… Would it really hurt to let things go a while longer and see where we actually find ourselves?”

Pushed harder – and central bankers are paid to make forward-looking tough calls, even in the fog – then I’d still hold off for now.

I’d regret unemployment more than I’d regret inflation, for two reasons. One is I have some sympathy with the US Fed’s position, which is that a bit of above-target inflation isn’t the end of the world after such a prolonged period of below-target outcomes. The other is that I doubt if a short period of above 2% inflation is going to make a big difference to people’s longer-term expectations. I don’t think I’d be wrestling with runaway wage/price spirals for years to come.

At the risk of invidious trans-Tasman comparisons, the Reserve Bank of Australia (RBA) might be onto something with its “wait for the whites of its eyes” approach to inflation. It reckons it will be 2024 before the labour market will be genuinely robust enough for it to have to do anything. The financial markets think that’s a bit too laid back, and that the RBA will get off its chuff in 2023.

But maybe the RBA is right. In today’s markets, maybe the best plan is don’t just do something, sit there.

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