The era of monetary policy based on inflation targeting is drawing to a shuddering halt. But nobody seems to know what to replace it with

By David Hargreaves

Well, the Reserve Bank did its best today, but the New Zealand dollar didn’t seem to think it was good enough.

I have been critical in the recent past about our central bank sending some horribly mixed messages that have aggravated the situation regarding the currency.

The RBNZ now seems to have got its lines right, but it’s still not making a real difference.

At the moment the RBNZ seems to be trying to navigate a kind of ‘middle’ path, with interest rates that aren’t too low to completely boil the housing market, but ARE low enough to take the energy out of the dollar.

I think the reaction of the dollar today tells you that the mid course is not going to work.

A decision probably needs to be made right now either to simply leave interest rates where it is felt they should best be, or join the international race to the bottom – drop them to virtually zero – and see if that can fix the dollar.

But low interest rates have done nothing for the rest of the world.

The old theory of inflation targeting has it that low interest rates will feed into greater consumption, which will feed into economic growth, which will feed into inflation.

Post the 2008 GFC the theory has been broken and the extent to which it is completely broken is now stripped bare. The money that has been pumped into the global economy has in large part been diverted into fixed assets rather than consumption. So, asset price inflation is rampant, fuelled by debt, while economic growth still languishes.

I’m inclined to say that in this country we should completely throw away inflation targeting as the focus of monetary policy.

But the trouble is, if we do that, we could see a situation where the New Zealand dollar rises and rises to a point where our economy is completely stunted.

We are not there at the moment, largely due to the free immigration policy of this Government, which is pumping up overall rates of economic growth – although growth per capita is not rising by anything like as much.

The other alternative though, joining the race to the bottom, seems even more risky. You could drop interest rates all the way down, still find the dollar is elevated and in the meantime asset prices (in the New Zealand context that’s houses, houses and more houses) keep going through the roof. Something would presumably give at sometime and it could be messy.

So, I think we do need to be bold and say that for now we aren’t going to worry about inflation. But, of course there needs to be agreement with the Government that this is what would be done.

However, we are tiny.

Inevitably we are at the mercy of the global economy.

And it’s the global economy that needs a re-think.

What does become clear is that the global economic system has not really ‘recovered’ from 2008. The structural overall of financial markets and systems that was, it seemed, made necessary, by the GFC, didn’t happen.

More clever people than me need to get together and sort out this conundrum. It’s urgent. 

Inflation targeting is dead. But what to replace it with? For now, targeting growth would seem the answer. But how best to do that?

In the meantime, little old New Zealand needs to just ride it out as best we can.