Monetary policy is bust, so why are we still banking on it?

Price rises are no longer the Reserve Bank's biggest concern, with inflation stubbornly low.

Price rises are no longer the Reserve Bank's biggest concern, with inflation stubbornly low.

OPINION: A bit of whistling in the dark, a touch of goalpost-shifting and a ritual burning of straw men have all been tried.

But nothing can hide the fact that something is broken in our monetary policy regime, and that the Government is in open denial.

When your central bank is aiming for an average 2 per cent inflation rate, has agreed to keep consumer price inflation within a 1-3 per cent band and has instead missed the targets for years and "achieved" a 0.1 per cent outcome then something - either the target, the policy targets agreement or the legislation controlling the central bank itself - is crying out for a tune up.

It is not as if there were insufficient criticism of the regime on the way here, mainly over the disconnects between the inflation target, the preferred level of the dollar and the impact of lower rates on the booming Auckland housing market. 

But now the problem is more fundamental; the prime tool of monetary policy, cuts to the Official Cash Rate, cannot achieve the target - and the central bank appears reluctant to try, leaving New Zealand with a de facto tighter monetary policy than other countries.

Finance Minister Bill English has conceded the obvious: "No-one ever thought it would be used to try and lift inflation, and central banks that have tried to lift inflation have found that pretty difficult." But he sees no reason to change.

It's a strange logic. Satisfied the current tools won't do the job, the Govenrment has decided to stick to the same tools - and the same job.

In the meantime we have seen some fancy foot work from English and the bank.

The first shimmy, going back a year or more, was (and I paraphrase) that missing the target was okay providing the efforts you took were credible and you forecast that you would reach the target over the next 18 months or so.

There was also a time when inflationary expectations were as important as inflaiton itself, but now they have refused to play ball too.

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Then, when the target was repeatedly missed and the long range forecasts were drifting away from the mark, there was the shift in emphasis to the bank's own "core inflation" measure - a metric outside the policy targets agreement as well as outside the ability of most analysts to forecast. That has been accompanied by Governor Graeme Wheeler's rejection of a "mechanistic" approach that would see low inflation immediately trigger a cut to interest rate, currently at 2.5 per cent. It is hard to find any sophisticated analysts in the area who has made such a "mechanistic" call, but hey! Straw men have no say over what goes into their stuffing. 

Worldwide, bottom-feeding central bank interest rates have failed to lift inflation, just as RBNZ rate cuts have had little impact so far here.

Obviously the world has changed a lot since the legislative bones of the current Reserve Bank regime were put in place in 1989 with the aim of curbing inflation (cue: a repeat of English's quote above).

The most obvious recent shift has been in the way we buy and sell, what we buy and sell, and generally the supply side of world economies.

Globalisation, aided and abetted by internet technology. has opened the world at the consumer level, allowing buyers to source from almost anywhere the best goods at the best price.

Then there is the cheap and falling cost of the technology itself. (There was once a learned discussion among economists about the impact of falling computer prices and rising capacity on the measurement of inflation - a debate that has now been dwarfed by more recent changes.) 

All else being equal, it is no surprise that under the influence of the supply side and consumer-driven boost to competition that inflation is going to take a pounding. And that's before you take into account the long run impact of new oil and gas resources, greater energy efficiency and the impact of cheaper and more readily available renewables.

So tell us again why we still think it is a good idea to stay wedded to an inflation-busting model predicated on pushing up interest rates to limit demand? Or why we think no change is needed to monetary policy and that - in the teeth of the evidence - the model can push up inflation as easily as it could curb it?

Does it matter if the economy is robust and growth is not flagging badly?

Well no, unless you think the credibility of monetary policy is important. The longer the inflation number is badly astray of the bank's target the less credible is the target, the bank and the regime it operates under. And credibility is a central bank's main currency. Debase it at your peril.

Monetary policy is never finished. It should be reviewed and revised regularly. And the appropriate policy is never the same for every country and at every time in history, as Harvard monetary policy expert Professor Jeffrey Frankel has said

It is not as if there are no options. Winston Peters and Labour have suggested a suite of ideas over the years, the most interesting (but now late and lamented) being Labour's 2014 suggestion of a focus on inflation in tandem with the external balance. Another was the suggestion of a a nominal GDP target, floated by NZIER last year.

It's hard to imagine a better time to consider other options than now, when the current regime is effectively in abeyance. 

 - Stuff


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