$350 boost fuels inflation

Households will spend their cost of living payments, pushing prices up further,

One of the most discussed parts of Budget 2022 is the cost of living payment. If you earned less than $70,000 last tax year and you are not eligible for the winter energy payment, you are entitled to the $350 cost of living payment, which will be made via three monthly instalments from August 1.

The Government estimates that

2.1 million people are eligible for this payment, with the overall costs estimated to be $814m. However, there may be more of a price to pay.

The cost of living payment programme is likely to add to aggregate demand and put upward pressure on prices, either increasing inflation or preventing it from falling faster.

These types of one-off payments are typically used to stimulate an economy in a recession and not to redistribute. For example, the George W Bush administration used tax rebates to stimulate the United States economy in 2001. Everyone received US$300-$600 (a total of $38 billion).

In 2008, the Obama administration spent $100b on so-called ‘‘economic stimulus payments’’ during the global financial crisis. A single individual would receive $300-$600, plus $300 for each child.

What happens if aggregate supply in an economy is low and aggregate demand is high? Prices go up and we have inflation. What happens if we further increase aggregate demand? Prices will go up more.

Now the Government will spend NZ$814m. . Will this lead to more inflation? The answer depends on the effect of these payments. Will households save more, or spend more and add to aggregate demand?

Research has shown the 2001 spending programme in the US led households to spend about two-thirds of the payment on non-durable consumption in the quarter in which the rebates were received. In response to the 2008 spending programme, households spent between 12 and 30% of the payment on non-durable expenditures during the period the payments were received.

Additionally, purchase of durable goods increased (mainly new vehicles), such that overall spending amounted to 50-90% of total payments in the quarter of receipt.

You might think it would be different these days, because of Covid-19.

The Trump administration spent $300b in 2020 on a one-off ‘‘economic impact payment’’ programme (about $1200 per adult and $500 per child). Spending increased by 3-16% on non-durable goods and services during the three-month period in which payments were made.

Recall, though, that this was intended to act as an insurance against job loss and occurred during a time when the ability to spend was low (because of lockdowns) and uncertainty was high.

Another insight from research is that spending increases are especially large in households with low levels of wealth and income. Households with low wealth levels spent 20-30% of the economic impact payment, highlighting the role of targeting spending programmes.

We know the spending rate in the US is higher than in other countries, so we would expect smaller impacts here in New Zealand.

For the sake of the argument, let us assume that 50% of the $814m will be consumed between August and October. This would be a significant economic stimulus (about 0.44% of annual GDP) and will likely add to aggregate demand.

In comparison, the US 2001 and 2008 spending programmes each increased demand by 1.3-2.3% in the quarter of the payments. These numbers ignore multiplier effects, which likely lead to underestimating the impact.

Importantly, these payments were made during a low-inflation environment. In the current high-inflation environment, people expect that prices will increase further in the future and, hence, pull spending forward, which further increases prices.

Therefore, the impact is likely larger than what research has found in a recession and what my rough calculations predict.

Overall, the basic lesson economists have learned, but the Government ignores, is: do not try to use fiscal policy to deal with inflation – leave it to monetary policy, even if there is an election.

This holds especially true if aggregate supply is low and aggregate demand is high.

Spending increases are especially large in households with low levels of wealth and income. Dennis Wesselbaum, above