By BRIAN FALLOW
Reserve Bank Governor Dr Don Brash surprised nobody by leaving interest rates steady yesterday.
But he surprised everybody by talking of the risk of stagflation when appearing before Parliament's finance and expenditure committee.
The New Zealand dollar, which had already been sold down in tandem with the aussie after the Reserve Bank of Australia defied market expectations by also leaving interest rates alone, briefly dropped below 40USc after Dr Brash's comments.
Stagflation - the combination of weak or negative growth and high inflation - was one of three alternative scenarios for the economy Dr Brash sketched when he appeared before the committee. He would not rate their relative probability.
Market economists scrambled to explain that he would not have been talking about a return to the situation between the first oil shock in 1973 and the mid-1980s, with double-digit inflation and growth in the 1 to 2 per cent range.
"What he would be talking about here is a much more moderate version of stagflation where you are stuck at 3 to 4 per cent inflation caused by wage and price expectations blowing out, and the Reserve Bank has to fight to rein that in," said ANZ Bank chief economist Bernard Hodgetts.
"Still it's significant in the current environment where the growth indicators are continuing to disappoint, that they are genuinely considering it as a possibility, even if they are not putting a high weight on it at this point."
Dr Brash made it clear that he would raise interest rates if he saw signs of stagflation.
And in an effort to reassure the markets that interest rates were a two-way bet, he said: "Equally we are saying that if the economy looks weaker than it does now and if business confidence is very weak and inflation pressures look like abating sharply, then we might well have to reduce interest rates."
Economists interpreted the comment as a repeat of his warning two months ago against the inevitable coming jump in headline inflation to well above 3 per cent, due to high world oil prices and the weak dollar, fuelling generalised and systemic inflation. The former could be "looked through," the latter would require a policy response.
WestpacTrust chief economist Adrian Orr said: "What everyone is struggling with and what the Reserve Bank is going to have to provide a reasonable steer on, is just how long they are prepared to accept inflation outside their 0 to 3 per cent target range. How much will just correct itself, and how much extra work is there for the bank to do?
"The important comment there was that beyond this series of one-off events they think inflation remains firmly between 0 and 3 per cent. That means at this stage they themselves do not think they have a hell of a lot of work to do [by more interest rate rises] - albeit at the risk of that stagflation scenario," Mr Orr said.
Dr Brash emphasised that his warning was directed not just at wage-setters but at price-setters generally.
"What I am talking about is not price increases which are the direct consequence of the exchange rate fall or the international oil price increase, but rather attempts by businesses to re-establish margins, or attempts by businesses to push up prices because they are under pressure from staff to get wage increases which exceed productivity increases."
He added: "At this point I don't think we have seen that and I don't think we have got evidence to suggest that's about to happen."
Alarm bells ring over stagflation
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