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Inflation and maximum sustainable employment

Inflation and maximum sustainable employment are our dual mandated objectives for monetary policy.

Our dual mandate

Since the late 1980s, we have used monetary policy to achieve low and stable inflation. In 2018, an amendment to the Reserve Bank of New Zealand Act (1989) added supporting maximum sustainable employment to our mandate alongside inflation.

The Monetary Policy Committee (MPC) uses monetary policy to achieve this dual mandate, as set out in its remit.

Inflation

The current remit requires the MPC to keep inflation between 1% and 3% on average over the medium term, with a focus on keeping future average inflation near the 2% target midpoint.

Since inflation targeting was introduced in New Zealand, consumers price index (CPI) inflation has averaged around 2.2%. This compares with over 11% in the 1980s.

What is inflation?

Inflation occurs when prices of a range of goods and services rise on average. It means that money’s buying power is decreasing, although some wages may rise faster than inflation.

In general, inflation occurs when demand for goods and services in the economy is outpacing supply. This leads to widespread shortages of labour and materials. For example, when lots of people want to build a house, it becomes hard to source materials and construction workers, so building costs increase.

Businesses can charge higher prices for the same goods or services, as long as consumers are willing to pay more.

Inflation can also be caused by a rise in the price of imports, such as oil.

Explaining inflation

Former Chief Economist John McDermott explains how inflation is measured and how it affects everyday life. He also explains the importance of maintaining price stability.

3M:42s

Maximum sustainable employment

We interpret the term 'maximum sustainable employment' (MSE) or full employment to mean the level of employment at which the job market is tight, but not so tight that inflation is rising out of control.

More formally, we define MSE as the highest use of labour resources that can be sustained over time without creating a sustained acceleration in inflation.

When more people find jobs and fewer people are unemployed, employers tend to offer higher wages to fill their vacancies. If this happens nationwide, it generates wage inflation and eventually widespread inflation as businesses pass on the higher wage costs to the prices of goods and services.

When employment is at its maximum sustainable level, there will be low and stable inflation. However, if employment is above the maximum sustainable level for too long, it will eventually cause prices to rise more and more quickly, requiring the MPC to raise interest rates to keep inflation under control.

Maximum sustainable employment explained

Brandon from the Reserve Bank Economics team explains Maximum Sustainable Employment in clear and simple terms.

1m 46s

Monetary policy has relatively little influence over the level of MSE in the long run. Instead, how the level of MSE changes over time is largely determined by structural factors, such as:

  • how quickly employers can find the workers they need, or workers can find jobs they are able and willing to do
  • the skills in the labour force
  • incentives to work including after-tax wages and unemployment benefits
  • if workers can easily switch the type or location of work they do.

However, monetary policy does have some influence over how employment fluctuates around its maximum sustainable level. Therefore, the MPC tries to smooth economic and labour market cycles around full employment. It tries to ensure the economy and job market is neither running too hot with rapid wage and price inflation, nor too cool, with more people out of work.

Monetary policy is a blunt tool and impacts the economy with a time lag. This limited and inexact impact that monetary policy has on employment is why we are directed to support MSE, rather than achieve it outright.

See Box C in the May 2018 Monetary Policy Statement for more on defining MSE

Assessing maximum sustainable employment

Maximum sustainable employment cannot be seen in one single indicator so we use a range of indicators to assess it and work out where employment is, relative to that maximum sustainable level over time.

The headline unemployment rate is the most commonly used labour market statistic, but it is only one measure of many that we use to gain a full understanding of what is happening in New Zealand’s labour market. We also consider the:

  • non-accelerating inflation rate of unemployment (NAIRU) – how low unemployment can go before wage inflation rises
  • unemployment rates of youth (15 to 24 years), females, males, Māori and Pasifika
  • underemployment and underutilisation rates – indicators of slack in the job market
  • average hours worked gap – if people are working more hours than they would typically
  • medium-term unemployment rate – an indicator of how many people are out of work for longer periods
  • job-finding and job-quitting (separation) rates
  • vacancy-unemployment ratio
  • labour measures from the Quarterly Survey of Business Opinion (QSBO); for example, the difficulty of finding skilled and unskilled workers.

Tightness of the labour market

Labour market scatter graph
Note: the left axis represents the lowest level for each indicator since March 2000, and the right axis represents the highest level since March 2000. The red dots represent the level that each indicator was at when New Zealand was last judged to be at maximum sustainable employment.