Peter Lyons: How we go about inflation

5:30 AM Wednesday Feb 6, 2013

I pity manufacturers in New Zealand. They are the collateral damage of our narrow approach to controlling inflation.

The issue is not about controlling inflation but how we go about it.

Policy debates on technical economic issues in New Zealand tend to be limited in participation and frequency. Yet this debate involves concrete outcomes being played out each night on television in the closure of firms and mounting job losses.

The Reserve Bank is mandated to keep inflation between 1-3 per cent. It uses short-term interest rates to control demand in the economy to achieve this target. If it is worried about inflation, it ramps up interest rates. This reduces borrowing and spending so firms are unlikely to increase their prices. If firms are struggling to sell their products then workers are unlikely to demand higher wages, fearing unemployment.

Higher short-term interest rates also attract overseas funds to the higher rates of return in New Zealand. This pushes up the value of the New Zealand dollar against other currencies.

An artificially high exchange rate makes it difficult for New Zealand firms to compete with overseas products either here or abroad. Most New Zealand exporters are price takers, so are unable to raise their prices to compensate for a higher New Zealand dollar. Profits slump and firms either fold or relocate overseas.

Since the global financial crisis, many countries have effectively resorted to printing money and have lowered their short-term interest rates to virtually zero to try to stimulate their economies. Their currencies have slumped against the kiwi.

The approach of the Reserve Bank has been to lower short-term interest rates to record levels. The problem is that they are still above those of many of our trading partners. It invites an inflow of hot money seeking a safe haven and higher returns.

The effect has been the New Zealand dollar has remained strong or appreciated against most other currencies making it very difficult for our producers to compete.

An artificially high New Zealand dollar effectively subsidises importers at the expense of our exporters.

The Opposition-led inquiry into manufacturing is missing the point. The problem is not about controlling inflation. It is about the need to increase the tool box of the Reserve Bank and to do it urgently. Our inflation rate is currently 0.9 per cent. This suggests a very fragile economy.

The main contributor to inflation at present is the housing market, particularly in Auckland. The Reserve Bank is reluctant to reduce interest rates further for fear of fuelling this market. This is the fundamental problem that has plagued our approach to controlling inflation over the past decade.

We have sacrificed our productive sectors in order to quell inflation in our non-productive sectors, particularly housing.

This is because of the bluntness of the instrument we have used. Using short-term interest rates to control inflation is like performing open heart surgery with a spade. It has led to a severely distorted economy.

We need a lower exchange rate to rebalance our economy in favour of exports but the fear of igniting housing inflation prevents such a move. So our economy continues to limp along. It resembles a malformed, lop-sided beast with half its body bloated by debt and the other half withering away with neglect.

The Reserve Bank is finally starting to acknowledge the need to target housing inflation directly through the use of specific tools. These could involve direct controls on loan-to-value ratios or stricter capital requirements for banks to reduce mortgage lending. It is puzzling why this hasn't happened before. The likely answer is that the economists at the Reserve Bank simply could not believe such a thing as an asset bubble can occur.

In their world of efficient markets, rational individuals make perfectly informed decisions unaffected by the actions of others. There is no such thing as herd behaviour or asset bubbles. Or maybe the bank is just fearful of collapsing the inflated house of cards on which our economy has been built over the past decade.

Peter Lyons teaches economics at St Peter's College in Epsom and is the author of several economic texts.