Brian Fallow on the economy

Brian Fallow is the Herald's Economics Editor

Reserve Bank boss sets out plan to ensure inflation does not destroy recovery

By Brian Fallow

Reserve Bank Governor Graeme Wheeler with assistant governor  John McDermott (left) and deputy governor Grant Spencer. Photo / Mark Mitchell
Reserve Bank Governor Graeme Wheeler with assistant governor John McDermott (left) and deputy governor Grant Spencer. Photo / Mark Mitchell

Governor Graeme Wheeler dislikes the old line that it is the central banker's role to take away the punch bowl just as the party gets going.

"Don't forget the Reserve Bank spiked the punch bowl," he told MPs on the finance and expenditure select committee on Thursday.

Wheeler argued that the deep cut in interest rates to multi-decade lows when the global financial crisis hit had contributed mightily to the economic recovery.

The bank's task now was to ensure the recovery was not destroyed by inflation, he said.

At a press conference earlier on Thursday Wheeler enumerated the sorts of things that could derail the "strong and increasingly broad-based recovery".

"A major slowdown in world growth might do that, but the consensus forecast is that this is not likely to happen. The economy could slow dramatically if we had a sharp decline in the terms of trade [now at 40-year highs]. That doesn't seem likely. It looks likely to hold up there for quite some period.

"You could see reckless fiscal policy. But the Government is talking about balancing its books in 2014/15 and then running surpluses.

"And there could be a sharp fall in house prices. But what would trigger it?"

These things could stop a recovery but the chances were reasonably low, Wheeler said.

"But one thing that does stop recoveries in small open economies is inflation getting out of control. It starts to undermine the growth in real incomes. It starts undermining the competitiveness of the economy. And that's what we want to avoid. We want to move early. We want to contain inflation expectations and we want this recovery to go on for as long as possible."

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He was asked about the Opposition's plans to amend the Reserve Bank Act to broaden the objectives of monetary policy and whether that would lead to a lower interest rate cycle.

"No, we don't believe so," he said.

"There isn't a central bank in the world that I know of, certainly including this one, that doesn't think about the real economy, about the exchange rate and unemployment, when it is looking at monetary policy settings."

Wheeler is increasingly seen as a stitch-in-time sort of Governor.

He seems keenly aware of what, with the benefit of hindsight, looks like too timid and tardy an approach to monetary policy during the last cycle.

His predecessor Alan Bollard ended up having to stand on the brake pedal, pushing the official cash rate to 8.25 per cent by 2007, and mortgage rates back into double digits. It tipped the economy into recession even before the global financial crisis hit, not least because of the effect on the exchange rate and the tradeables sector.

The Reserve Bank estimates the economy has grown 3.3 per cent over the past year and is forecasting similar growth for the year ahead. But that is faster than the 2.5 per cent rate at which it reckons the economy's productive capacity is growing - reflecting fundamental factors like growth in the size of the labour force and in its productivity.

That rate of potential output growth is pretty good by international standards, Wheeler told the Herald, and the bank believes it will pick up to around 2.75 per cent in a couple of years, reflecting higher labour force participation and a surge of capital investment.

Growing at that sort of rate at the same time that Australia and the United States had also recovered and China was growing at around 7 per cent would make for "pretty attractive" medium-term prospects, he said. But in the meantime interest rates need to rise from the historic lows of the past five years to achieve some sort of balance between the demand and supply sides of the economy.

The monetary policy statement the Reserve Bank released on Thursday, and the Governor's comments, strongly signalled that the process of normalising interest rates will be front-loaded, with another three OCR increases pencilled in before September's election, though Wheeler says the timing of the election will have no bearing on the bank's decision-making.

However, there is considerable uncertainty about how households will respond to what will be the first significant tightening since 2007.

Household debt levels are high relative to incomes and nearly three-quarters of the mortgage debt is either at floating rates or fixed for less than a year. "We are just going to have to watch the data, the impact on households, and feel our way through this," Wheeler said.

No central bank could be confident about the lags with which interest rate changes work on the economy or expect surgical precision in its inflation targeting.

Wheeler has been clear that he is aiming for the 2 per cent mid-point of the target band rather than just being within the band, that is, below 3 per cent, on average over the medium term.

This reflects a subtle but important shift in his mandate from the Government, the policy targets agreement, compared with Bollard's from the previous Government.

"You would expect the rate of inflation to cycle around the mid-point. But we wouldn't want to see a large cycle around that inflation rate," he said, in a read-my-lips sort of way.

"Not at all."

- NZ Herald

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