Reserve Bank Governor Alan Bollard used his annual speech to Canterbury employers yesterday for a vigorous defence of inflation targeting and a floating dollar.
Labour has formally withdrawn from the longstanding bipartisan support for the monetary policy framework and its leader Phil Goff said again on Thursday that reform was needed for the sake of the productive sector.
"A volatile and often over-valued exchange rate, and interest rates that are often among the highest in the developed world, indicate that current monetary policy is not serving New Zealand well," he said.
But Bollard said the inflation targeting framework for monetary policy had achieved over the past 20 years what it was designed to achieve, price stability, in the face of such shocks as the commodity and house price booms of the middle of the last decade.
Then, faced with the greatest global financial crisis in generations, the bank had been able to cut the official cash rate by nearly 6 percentage points.
"We were able to provide this degree of support because the inflation targeting framework allowed for a flexible response and inflation expectations were well anchored," he said.
Alternative frameworks, particularly those which target the exchange rate in some way, would not have provided the same flexibility. "The New Zealand dollar has fallen by over 10 per cent against the Australian dollar since 2006, a period in which Australia experienced an unprecedented minerals boom and very strong growth," Bollard said.
"If our currency had been pegged to the Australian dollar, New Zealand's exchange rate to the rest of the world would have been higher, interest rates would have risen three times already, and our recession would probably have been deeper."
Alternatively, if it had been pegged to the US dollar over the past decade, interest rates would have been lower for longer in 2003 and 2004, exacerbating the housing boom.
"Some of the challenges of a currency union can now be seen in Euro area economies such as Ireland, Greece and Spain, where monetary policy settings have been unable to lean against unsustainable domestic booms, or against the deep recessions that followed," Bollard said.
Singapore is sometimes pointed to as a country which has managed to achieve both low inflation and a stable currency (though not over the past two years).
But Bollard cited special factors which made that possible: Singapore's trade flows are very large relative to the size of its economy, it has a high level of domestic savings and foreign exchange reserves, and a toolbox of supplementary instruments, including capital controls.
Looking ahead Bollard said the difficulty of the Reserve Bank's task would depend in part on how the major economies managed the delicate balancing act of exiting from their very stimulatory monetary and fiscal policy settings.
"How deftly this process of normalisation is handled will be crucial to whether the global economy recovers in a balanced way, and how stable recovery is likely to be in New Zealand.
"If US monetary policy settings remain too easy for too long, and if exchange rates in China and the big surplus economies remain low even in the face of a dramatically improved economic outlook, we will risk facing conditions similar to those during the years leading up to the crisis: abundant global liquidity searching for returns in the wrong places, feeding unsustainable asset booms and growing economic imbalances," he said.
"Against this is the risk of a slower, more fragile recovery."