Labour should not take its eyes off the target

BY STEPHEN KIRCHNER
Last updated 08:06 21/12/2009

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Abandoning inflation control is a recipe for disaster, writes Stephen Kirchner.

OPINION: When New Zealand introduced inflation targeting with the passage of the Reserve Bank of New Zealand Act in 1989, it began a revolution in central bank governance that was to sweep the world during the 1990s.

The innovative monetary policy reforms were all the more remarkable for being introduced by the Labour Party, which at the time recognised the central importance of price stability to prosperity.

Twenty years later, and back in opposition, Labour has now rejected the monetary policy framework it pioneered. In a speech to Federated Farmers, Labour leader Phil Goff announced "the end of the consensus around the policy targets and tools of the Reserve Bank".

Mr Goff says he will continue to respect the independence of the Reserve Bank, but he no longer supports its primary focus on price stability, saying "the battle against inflation is no longer New Zealand's sole or overriding policy objective".

Labour has not said what alternative targets and tools it would adopt instead of the existing inflation target, but maintains the current policy framework is "not well designed to produce a stable and competitive exchange rate, nor to keep interest rates as low as possible".

Mr Goff says New Zealand needs a stronger focus on economic growth and export performance. The clear implication of his remarks is that Labour wants to use easier monetary policy to cheapen New Zealand's currency and devalue its way to stronger growth and exports.

The highly cyclical New Zealand dollar has always been a sore point for exporters and it is no coincidence that Mr Goff made his announcement before a Federated Farmers conference. As a small and open economy with a large traded goods sector dominated by the export of commodities such as dairy, the exchange rate has an important influence on economic activity.

The cyclical fluctuations in the dollar play an important role in insulating the economy against external shocks, not least during the recent global financial crisis. When demand weakens in the rest of the world, the Kiwi dollar depreciates, making exports more competitive.

When external demand is strong, the currency rises, moderating export prices in New Zealand dollar terms and restraining import price inflation. The floating exchange rate thus smoothes external demand and economic activity, making the Reserve Bank's job of controlling inflation much easier.

Many exporters resent the role of monetary policy and the exchange rate in moderating New Zealand's economic cycle. They see their competitiveness being sacrificed on the altar of inflation control, arguing that they bear too much of the burden of economic adjustment.

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But this is not a flaw of the inflation targeting framework. It is precisely how it is meant to work. The exchange rate is an important channel by which the Reserve Bank's changes in official interest rates are transmitted to the rest of the economy.

The idea that New Zealand can ignore inflation and grow faster through easy money and a lower exchange rate is a tempting, but short-sighted view. It ignores the fact that higher domestic prices would ultimately undermine rather than promote international competitiveness. Economic growth and export success must ultimately be built on real factors such as productivity growth, not easy money and exchange rate depreciation.

The Reserve Bank's primary focus on inflation recognises that monetary policy needs to be based on a single instrument and policy objective. Pursuing multiple objectives with multiple instruments, as Labour now suggests, is a recipe for incoherent policy and poor economic performance such as New Zealand experienced before its path-breaking reforms of the 1980s.

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It would also undermine the transparency and accountability that were important objectives of the Reserve Bank of New Zealand Act. Under the current framework, the governor of the Reserve Bank is personally accountable for realising the inflation target under a policy targets agreement with the finance minister. Sustained breaches of the inflation target can result in the non-executive members of the Reserve Bank board recommending dismissal of the governor to the minister. This is no idle threat, but it would be difficult, if not impossible, to hold the governor accountable for achieving multiple objectives instead of a clearly defined inflation target.

Since the first PTA was entered into in 1990, the inflation target has been progressively watered down. Most notably, the inflation target has been relaxed from 0-2 per cent to 1-3 per cent and given a medium-term focus, so there is now greater tolerance of short-term breaches.

Recent PTAs have also paid lip-service to reducing volatility in output and the exchange rate, but these objectives have always been made explicitly subordinate to the inflation target.

Labour now proposes to abandon inflation targeting altogether. It might be tempting to dismiss this as populist politics, but it would be complacent to assume that a future Labour government would not make good on its promise.

Foreign exchange markets have already factored in the risk, with the New Zealand dollar exchange rate falling sharply in response to Labour's announcement. It seems Phil Goff is already getting his way.

Dr Stephen Kirchner is a research fellow at the Centre for Independent Studies, an Australian-based think tank.

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