New Zealand small and medium businesses have been put on notice over pricing strategies, as one of the nation’s top economic advisers warns their behavior may inadvertently keep inflation persistently high.
In a speech to the business community, Reserve Bank of New Zealand Chief Economist Paul Conway says if companies are too quick to pass on temporary cost increases, inflation could become embedded in the economy and be harder for the central bank to control.
The warning comes as tensions again rise in the Middle East, forcing oil prices into the spotlight once more. It also follows NZIER Quarterly Survey of Business Opinion data that suggests businesses are struggling to absorb lingering cost increases caused by the crisis and are raising prices in response.
How Business Owners Developed An Inflation Mindset
The Reserve Bank’s focus now extends beyond the cost of goods to the psychology of the business owners setting the prices. Conway notes it has been a tumultuous period for business leaders as they have been forced to navigate volatility associated with COVID, the Ukraine War, and now the closure of the Strait of Hormuz.
The Reserve Bank forecasts inflation will have reached 4.2 per cent in the three months to June and 4.3 per cent for the current quarter.
“A key risk for monetary policy currently is that after a prolonged period of inflation above 2 per cent, businesses and households expect higher inflation to persist,” Conway explains.
This creates a cycle where the anticipation of inflation actively generates it. “When firms can pass on higher costs more easily, inflation becomes more persistent,” Conway says.
He points out that while few business owners worry about inflation when the CPI is low, it’s at the forefront of people’s minds when the numbers are high. With inflation having sat above the target 1-3 per cent range for 14 out of 25 quarters since 2020, Conway says he’s ‘pretty sure people are paying close attention to it now.’
The NZIER survey reveals that although confidence has risen since the announcement of the Iran ceasefire, inflation still has businesses under pressure. The proportion of companies experiencing higher input costs has passed 50 per cent in the June quarter, up from 37 per cent, and 41 per cent are passing on higher costs to customers and clients.
Businesses Are Quicker To Raise Prices But Slow To Cut
Reserve Bank research has revealed a shift in price-setting behaviour among modern business owners. Firms are now more likely to increase costs in relation to temporary shocks than they were in the past, although prices are increasing by smaller amounts.
Conway also says an asymmetry has emerged in price movements: “New Zealand businesses have become more likely to increase prices when costs increase, and less likely to cut them when costs fall.” This imbalance leads to inflation becoming embedded, he explains, and is most prevalent in the services sector.
He says 90 per cent of businesses cite higher labour and input costs as the key driver of price rises, with increased input costs more likely to prompt quick action. He notes that technology has allowed businesses to raise prices and track competitors much more quickly than they could in the past.
“This reinforces the importance of keeping inflation expectations anchored,” he says – in other words, ensuring business owners trust that inflation will return to the target 1-3 per cent band, so they do not feel pressured into pre-emptive price hikes. “If businesses expect cost pressures to persist or other businesses to increase their prices, they are more likely to raise their own prices, helping spread inflation through the economy,” he says.
The Tool For Fighting Inflation Is Higher Interest Rates
If wary and ‘unanchored’ small and medium business continue to pass along cost increases out of habit, Conway says the Reserve Bank may be forced to deploy ‘monetary policy’ to fight inflation. This means increasing the official cash rate, which would impact SMEs in other ways – ensuring borrowing costs remain higher for longer and slowing consumer spending as household budgets tighten.
The longer the inflation cycle lasts, the harder it is to break, he says, considering interest rates are a blunt instrument. “When expectations become embedded in price-setting behaviour, bringing inflation back to target becomes much more difficult and costly.”
The Reserve Bank wants business owners to trust its official projection that inflation will fall steadily over the next year and move back towards 2 per cent by mid-2027, and hold the line on pricing as a result.
“If expectations stay anchored, the economy will absorb this shock at lower cost,” he says. But he notes that even if some businesses want to keep raising prices, many will no longer have a choice. Slower consumer spending has created ‘excess capacity’ in the economy, meaning there is now more supply and staff available than there are active buyers. Because customers are scarce, businesses that raise prices risk losing remaining clients to competitors.
This dynamic is already playing out in the building sector, where a drop in construction demand is stripping firms of pricing power and forcing them to cut their prices to win contracts even as costs rise.
Reading between the lines, the suggestion appears to be that instead of implementing automatic price increases during economic shocks, business owners should evaluate their pricing structures on a case-by-case basis, and consider optimising internal costs as a first response.
While appealing to business owners, Conway notes that the job of taming inflation does not lie with them alone. He says the government also influences inflation by setting its own prices for public services, fees, and state tariffs.
