For the past two-and-a-half years, it seems, (to borrow one of Paul Keating’s more famous phrases) every galah in every pet shop has been squawking about the cost of living.

And with good reason.

After almost 30 years of low and stable inflation – including five years when inflation was actually lower than the RBA’s target of 2–3% per annum – inflation (as measured by the consumer price index) shot up to 7.8% over the year to the December quarter of 2022, the highest in 33 years. Likewise in New Zealand, inflation jumped to 7.3% over the year to the June quarter of 2022.

The experiences in New Zealand and Australia weren’t unique. Almost every ‘advanced’ economy – even Japan, which had grappled with deflation for most of the last three decades – and most ‘developing’ economies, with the conspicuous exception of China, experienced a surge in inflation as they emerged from the COVID-19 pandemic. 

A perfect storm

There were some common global factors behind this surge in inflation. In particular, governments around the world threw large amounts of cash at households during the pandemic, as part of their attempts to stave off deep recessions – which households used to buy things to use in, or improve, the homes that they were forced to stay in for extended periods.

At the same time, supply chains for a wide range of goods, including the items that many households wanted to buy (such as electrical appliances and devices, furniture and motor vehicles) were disrupted by COVID. And so were common modes of transportation for goods – in particular, container shipping. So, increased demand collided with reduced supply – resulting, as it always does, in a surge in costs and prices.

Then, in the early months of 2022, there was a surge in the global prices of energy, fertilisers and food commodities, triggered by Russia’s invasion of Ukraine – which were promptly passed on to consumers around the world. In New Zealand and Australia, these were reflected in higher prices for petrol, electricity and natural gas, and a range of food items.

Additionally, in many countries employers found it very difficult to find the workers they needed to resume full operations as economies re-opened. In some cases – particularly in the US and the UK, and also in New Zealand, although less so in Australia – employers began offering higher wages to retain or attract staff. Like other sources of cost increases, businesses discovered that in an environment where demand exceeded supply, they could pass on these salary costs in the form of higher prices without fearing that they would lose market share, because their competitors were doing the same thing.

The housing factor

The worldwide surge in the prices of goods has since abated. In New Zealand, it’s come down from 9% to 4.7%. In Australia, goods price inflation has come down from a peak of 9.6% over the year to the 2022 September quarter to 3.8% over the year to December 2023.

But services price inflation – which is mainly driven by domestic rather than global factors – has been a different story.

In New Zealand, the services inflation rate peaked at 6.1% in the June quarter last year, before falling to 4.7% in the December quarter. In Australia, the annual rate of services price inflation peaked at 6.3% in the September quarter last year, falling to 4.6% in the December quarter.

One of the principal drivers of services inflation on both sides of the Tasman has been housing costs. In Australia, the CPI measure of housing inflation peaked at 10.7% in the final quarter of 2022. By the final quarter of last year it was still running at 6.1%. In New Zealand, housing and household utilities inflation peaked at 8.0% in the December quarter of 2022. It had declined to only 4.8% by the end of 2023.

Pictured: Skyrocketing inflation and soaring property costs have produced a housing crisis in Australia and New Zealand, forcing some people, including Queenstown seasonal worker Merlin Traçable, to live in their vehicles. Image credit: eyevine.

Then, the squeeze

In response to this surge in inflation, central banks around the world have lifted interest rates sharply – more rapidly, in most cases, than at any time in the past 30 years and in some cases the fastest in 40 years. The RBNZ raised its cash rate to 5.5% – the largest increase of any ‘advanced’ economy, while the RBA raised its cash rate to 4.35% (which was one of the smallest increases of any ‘advanced’ economy central bank). The RBA’s interest rate hikes were a particular shock to those borrowers who had taken at face value the RBA’s repeated assurances that interest rates would remain at their record low of 0.1% “until 2024 at the earliest”.

The combination of sharply higher interest rates, falling real wages (because wages have risen at a slower rate than prices) and higher income tax payments has resulted in a squeeze on household incomes.

In New Zealand, real per capita household disposable income fell by 2.4% between the March quarter of 2021 and the September quarter of 2023. That’s much less than in Australia – but because business investment and exports have been much weaker than in Australia, New Zealand has experienced a ‘technical recession’, with the economy shrinking in three of the past four quarters.

In Australia, real per capita household disposable income has fallen by 9.1% since the September quarter of 2021, to its lowest level in more than six years. That’s a larger decline than occurred in any of Australia’s five recessions in the past 63 years. Australia avoided having its sixth recession in that period thanks to the strongest population growth in 50 years, combined with continued growth in business investment, public spending and exports.

What next?

Although inflation is now clearly on the way down in both countries, it is still too high for either the RBNZ or the RBA to contemplate cutting interest rates any time soon.

It’s not necessary for inflation to be back within stated target ranges (1–3% for the RBNZ and 2–3% for the RBA) before starting rate cuts. However, both banks need to be more confident than they are presently that inflation will be back within the target range within a reasonable period – and that it will stay there – in order to begin unwinding their previous rate hikes.

In Australia, at least, the RBA will also be conscious that households will be getting the equivalent – in terms of the impact on aggregate household cash flows – of two 25 basis point reductions in interest rates, in the form of personal income tax cuts, on 1 July this year.

And, if the National-led coalition government in New Zealand cuts income taxes this year – as it foreshadowed during last year’s election campaign – then that may have some impact on the timing of the RBNZ’s first move.

In hindsight…

Were there any alternatives to raising interest rates sharply in order to deal with the surge in inflation?

Well, yes. In decades gone by, governments in both Australia and New Zealand used to respond to unacceptably high inflation by raising taxes, rather than interest rates, in order to dampen growth in aggregate demand and bring it into line with aggregate supply. Arguably, that was fairer than raising interest rates. But raising taxes requires legislation, which takes time – and which in Australia might not get through the senate. It also requires politicians to accept responsibility for decisions that make a lot of people worse off – something that they are nowadays much more reluctant to do than in previous eras.

So, ultimately, the responsibility for dealing with inflation rests with ‘independent central banks’ – not just in New Zealand and Australia, but the world over.

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