By Bernard Hickey
Our Reserve Bank is rightly proud of being the first independent central bank in the world to focus solely on targeting an inflation rate and achieving it.
It became a model for the world that 30 other central banks have adopted. The great scourge of high inflation in the 1970s and 1980s was tamed and both consumers and employers alike became confident that inflation would be around 2-3% over the long run. They became confident about investing and employing people in the knowledge that inflation would not take off. The Reserve Bank set the Official Cash Rate, its only tool, at a rate that ensured the economy ran as fast as it could without generating inflation higher than around 2-3%.
Inflation targeting is a good thing, so why are all sorts of very serious people going all soft on the idea? No one thought that inflation undershooting that 2-3% level would be a problem, but it clearly is now, and not just in New Zealand.
Annual Consumer Price Index (CPI) inflation, which is the inflation rate the Reserve Bank has agreed to target, has been below the 2% mid-point of the bank’s 1-3% target range since the September quarter of 2011. It has been below the 1% lower bound of that range since the September quarter of 2014.
Governor Graeme Wheeler specifically agreed with Finance Minister Bill English in September 2012 to target ‘future average inflation’ at the 2% mid-point of that range over the medium term. This week the Reserve Bank forecast CPI inflation would not get back to the 1% lower bound of that range until the December quarter of 2016 and would not get back to 2% until the September quarter of 2018. Assuming the Reserve Bank’s latest forecast is right — and it has wrongly forecast a return to target for four years — then that means inflation will have been below the 1% level for two years and below the 2% midpoint for seven years.
The Reserve Bank is itself forecasting ‘future average inflation’ at 1.6%. That is a clear failure of one part of the target and you could debate whether seven years counts as the ‘medium term’. That sounds like long term to most people.
Some people are saying New Zealand should just give up on the idea and just accept the Reserve Bank cannot get inflation back up into its target range. They argue that trying to hit the target is a waste of time in a world where other central banks are creating US$150 billion a month out of thin air to buy government and corporate bonds, and where central banks for two thirds of the global economy have cut interest rates to 0.5% or below. That makes our OCR of 2.0% look temptingly high to investors who already have US$13 trillion in bonds with negative yields, which means investors pay the Government to look after their money. Those investors are rushing to park their money in New Zealand dollars, which has pushed it up and made imports cheaper, which in turn is dragging even more inflation.
The inflation targeting quitters say lower interest rates here and overseas are not actually boosting real economic activity much and are simply pumping up asset values — particularly property, stocks and bonds — to dangerously high levels that could go bust with painful consequences.
That may be true in places like Japan, the United States and Europe, which have cut their rates to almost 0% or below and have been printing money for much of the last eight years.
But that’s not the case here. The Reserve Bank still has 200 basis points of cuts up its sleeve and a 50 basis point cut this week, along with forecasts of more cuts, would have substantially reduced the New Zealand dollar. Instead Governor Wheeler delivered only one 25 basis point cut and promised just one more cut, which triggered a sharp rise in the currency to over 77 on the Trade Weighted Index. That made a mockery yet again of the Mr Wheeler’s call for a lower currency and has made his task of getting inflation back to 2% that much harder.
Mr Wheeler also had given himself some breathing room to cut more substantially without further inflating the fast-rising housing market. He announced plans last month to limit rental property investors to having a 40% deposit nationwide, and is preparing debt to income multiple limits that could substantially reduce demand from highly leveraged buyers. The banks are helping too by not passing all the cuts on to mortgage borrowers.
So why didn’t he take action to achieve his one target — to do his one job?
Mr Wheeler said he couldn’t control half of CPI inflation, which came from overseas, and he was worried that if he cut harder that would leave him less ammunition to deal with a bigger crisis in future.
The trouble is that decision is costing exporters and hurting people who would otherwise get jobs without that extra stimulus. The Reserve Bank forecast this week that the economy was already essentially at full employment, but that’s not what Treasury estimated last week. It said the full employment rate of unemployment was closer to 4.0%, which is well below the current rate of 5.2% and which meant there was room to cut rates without generating more inflation pressures.
A higher-than-necessary currency is also acting as a handbrake on New Zealand’s aspirations to increase exports and obtain all the productivity and real wage growth that goes with it. It means the Government is failing to reach one of its major targets of lifting the share of the economy producing exports from 30% to 40% by 2025.
There are real costs to just giving up on inflation targeting. People don’t get jobs and exporters don’t grow sales or wages. There is also a risk wage and price setters will stop believing that inflation is steady around 2%. Inflation expectations have been dropping from 2-3% to under 2% over the last 18 months and risk creating a dangerous self-fulfilling prophecy of ever-lower prices and inflation. The Reserve Bank should have gotten ahead of the curve and front-loaded its cuts to arrest that slide in expectations.
The Reserve Bank may be missing its target, but we shouldn’t give up so easily on the target just because it is hard to hit.
A version of this piece has also appeared in the Herald on Sunday. It is here with permission.