Governor defends flexible inflation targeting regime; sticks with MPS view of another 35 bps of OCR cuts; says holding OCR would push up NZ$; but says more aggressive cuts would not lower NZ$ much and would worsen housing imbalances

By Bernard Hickey

Reserve Bank Governor Graeme Wheeler has used a speech on monetary policy to push back at those suggesting the central bank should either abandon inflation targeting or cut the Official Cash Rate more aggressively to lower the New Zealand dollar and get CPI inflation back up into the bank’s 1-3% target band.

The Governor, who is under pressure to lift CPI inflation from its current 0.4% level to his 2% midpoint target, said more aggressive cuts would worsen imbalances in the economy and housing market, while not cutting again would lift the New Zealand dollar and risked creating a downward spiral in inflation expectations.

Wheeler said flexible inflation targeting remained the most appropriate framework, as long as the bank retained flexibility.

He said the scope and influence of monetary policy in small open economies was heavily constrained by developments outside their borders.

“Nearly 10 years on from the Global Financial Crisis, economies face a difficult global economic and financial climate, with below-trend growth despite unprecedented monetary stimulus, declining merchandise trade and rising protectionism, very low inflation and interest rates, and high asset prices presenting financial stability risks,” Wheeler said. 

“Many of these issues have complex structural elements that are unlikely to fully self-correct as global growth recovers,” he said.

Wheeler said there was a “range of views” about what monetary policy could achieve and how it should be operated.

“In New Zealand, these include a view that flexible inflation targeting is no longer an appropriate framework for conducting monetary policy,” he said.

Wheeler said flexible inflation targeting remained the most appropriate framework for conducting monetary policy in New Zealand, “provided sufficient flexibility is allowed to accommodate the frequent and often severe impact of external shocks, the most important contribution monetary policy can make to promoting efficiency and the long-run growth of incomes, output and employment is the pursuit of price stability.”

‘Changing target would damage credibility’

“There is nothing sacrosanct about what particular inflation band or target should be adopted as a measure of price stability. However, changing a target when times become tougher reduces the incentives on central banks to achieve earlier agreed goals. It could damage the central bank’s credibility – particularly if a perception develops that the central bank will continually seek to respecify goals,” Wheeler said.

“The Bank also encounters a view that it should not lower interest rates, because current strong economic growth makes interest rate cuts unwarranted and undesirable. However, if financial markets believe that the Bank is content with below-target inflation, they would conclude that the easing process is over and proceed to bid the exchange rate up, perhaps substantially,” he said.

“The TWI exchange rate is already at a high level based on the Bank’s models. A sizeable appreciation would further squeeze incomes in the tradables sector, and drive tradables inflation lower for longer, thereby lowering overall headline inflation.”

‘Risk of self-perpetuating spiral of falling inflation expectations’

Wheeler said low headline inflation could also bring down inflation expectations in a self-perpetuating spiral.

“If inflation expectations fall too far, it can be very difficult to raise them back up. In such a situation, even further cuts in interest rates would be needed to stimulate economic activity and increase inflationary pressures,” he said.

Wheeler said there was a third view that the Bank should rapidly lower interest rates to bring inflation quickly back to the 2% mid-point of the inflation band.

“However, an aggressive monetary policy that is seen as exacerbating imbalances in the economy would not be regarded as sustainable, and would not deliver the exchange rate relief being sought. Rapid ongoing decreases in interest rates would likely result in an unsustainable surge in growth, capacity bottlenecks, and further inflame an already seriously overheating property market,” he said.

“It would use up much of the Bank’s capacity to respond to the likely boom/bust situation that would follow, and place the Reserve Bank in a situation similar to many other central banks of having limited room to respond to future economic or financial shocks.”

‘We still see another 35 bps of cuts’

Wheeler referred to the bank’s August 11 Monetary Policy Statement in the speech, which included forecasts for another 35 basis points of cuts in the Official Cash Rate on top of the 25 basis point cut to 2.0% on August 11.

“The key rationale for cutting the OCR in August was to lower the risk of a further decline in short-term inflation expectations. Our present judgement is that the current interest rate track, involving an expected 35 basis points of further interest rate cuts, balances a number of risks weighing on the economy, while generating an increase in CPI inflation back towards the mid-point of the 1 to 3 percent target range,” he said.

“We remain committed to the inflation goals in the Policy Targets Agreement. We do not believe that the outlook and balance of risks warrants a position of no policy change, nor a position of rapid easings. If the emerging information and risks unfold in a manner that warrants a change in our judgements, we will modify our policy settings and outlook.”