Interest rates could rise dramatically if the Government were to override the Reserve Bank's inflation target, former governor Don Brash says.
Finance Minister Michael Cullen this week raised the possibility of invoking a Reserve Bank Act provision, which has never been used, which lets the Government override one of its central provisions, that the objective of monetary policy is price stability.
Brash, who was one of the architects of the legislation and governor for 14 years, said to do that would compromise the bank's operational independence. "That is why I think it would have quite a dramatic effect on interest rates," he said.
"If the override provision is used then almost by definition he is either saying he is comfortable with a bit more inflation, and potentially quite a lot more inflation, or he is saying in his judgment Alan Bollard has it wrong and he is misjudging the inflationary pressures."
The latter would be "rather extraordinary".
"Alan has his critics but he has staff beavering away trying to assess inflationary pressures," Brash said.
If instead Cullen was saying he was willing to tolerate a bit more inflation that would have profound implications for international confidence in the New Zealand regime, and push up the risk premium in longer-term interest rates.
"What we could see is, yes, a lower exchange rate [but also] quite substantially higher interest rates."
Cullen might have been hoping that reminding the markets he has the statutory power to override might produce some hesitation in the exchange rate.
"But the quickest way of getting the exchange rate down is to make it unambiguously clear that the Reserve Bank will do whatever it takes to get domestic inflation under control," Brash said.
"Although it won't please too many people to hear it, until he does get on top of domestic inflation the exchange rate is going to remain firm."
The director of the New Zealand Institute of Economic Research, Brent Layton, was also critical of Cullen's comments.
"If you wished to undermine the credibility of the bank as a controller of inflation and inflation expectations it's hard to think of anything that would do so more effectively than for the Minister of Finance ... to remind us that he can change the rules."
The bank itself had already put some of its credibility at risk by intervening in the foreign exchange market.
"The currency has continued to go up so that risk has ... materialised."
The Chambers of Commerce called for the monetary policy framework to be left alone.
"As well as being crucial for maintaining international competitiveness, low inflation is also the best way to maintain low interest rates and exchange rates in the medium term," Charles Finny, chief executive of the Wellington chamber, said.
* Suspending price stability as the target of monetary policy would raise the risk premium in longer-term New Zealand interest rates, warns Don Brash.
* It would undermine the Reserve Bank's credibility, warns NZIER director Brent Layton.
* And it addresses the symptoms and not the causes of the pressure on interest rates and the dollar, says the Chambers of Commerce.