Inflation fixation to blame, say experts

By Brian Fallow

BERL economists urge Reserve Bank to relax policies influencing inflation

The present woes of the financial sector are to some extent a consequence of monetary policy's inflation fixation, according to economic forecasters BERL.

BERL economists Kel Sanderson and Ganesh Nana, appearing before Parliament's finance and expenditure select committee yesterday, argued that a vicious circle of unintended and undesirable consequences arose from the current approach.

When the Reserve Bank forecasts inflation to be above its target band it raises interest rates to levels higher than the average overseas. That attracts foreign funds into New Zealand, increasing the domestic money supply, BERL says.

With a deregulated financial sector and competition in the mortgage market, this increased money supply enables a rise in house prices and pushes money into sub-prime lending, reducing the soundness of the financial sector.

It also causes wide fluctuations in the exchange rate, hurting the tradeables sector.

Higher house prices reduce the affordability of housing, but they also increase household consumption among those who already own houses and see their wealth go up.

The Reserve Bank sees that increase in consumption as threatening further inflation, and the cycle continues.

But it could not continue indefinitely, Sanderson said. At some point the market would find some element of the situation unacceptable - such as the exchange rate or the current account deficit - and withhold funds.

Nana called for a more relaxed attitude towards inflation.

What really were the costs of the difference between 3 per cent inflation and 3.5 per cent, he asked, compared with the costs of under-investment in the productive base of the economy?

NZ Shareholders Association chairman Bruce Sheppard said high interest rates and a volatile exchange rate discouraged investment and had a direct and deleterious effect on productivity.

The official cash rate at 8.25 per cent is the same as Indonesia's.

"Why is New Zealand as risky as Indonesia? When did we last have a revolution and shoot our leaders," he said.

"Maybe we should do it soon."

The Reserve Bank Act's primary objective of price stability was appropriate for its time - the late 1980s.

"We had just had 20 years of stagflation. Now we have declining productivity, and outflow of skilled migrants and we are slipping down the international wealth tables," Sheppard said. "That is not going to change soon unless we address capital formation, increased New Zealand ownership and therefore savings, and the efficient deployment of those savings."

High interest rates crowded out investment in equities, but the latter was more effective in growing the economy, he said.

Professor Viv Hall from Victoria University, who served for 10 years on the Reserve Bank board, was in the "If it ain't broke, don't fix it" camp.

He had yet to see a suggested supplementary instrument that the bank might be given that he would recommend.

Tax measures such as a capital gains tax should only be considered in the context of the efficiency and fairness of the tax system.

"Don't kid yourselves that they will be a significant help for monetary policy."

NEEDING A FIX

*The finance select committee's inquiry into monetary policy began its public hearings yesterday.

*BERL economists linked the woes of the finance company sector to the "fixation" with inflation.

*The Shareholders Association's Bruce Sheppard queried why the risk premium in interest rates should be at third-world levels.

*Victoria University's Viv Hall counselled against the quest for a quick fix.

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