Ulf Schoefisch: Bank should be keeping more in reserve

Ulf Schoefisch

Changes to the inflation target and monetary policy operating rules over the past decade were intended to give the Reserve Bank of New Zealand extra flexibility in maintaining low inflation without putting undue pressure on the economy.

The extended growth period over the past few years has put the policy framework and the RBNZ's operating skills to the test. Regrettably, the results have been far from satisfactory. The productive sector of the economy is yet again being subjected to the adverse effects of excessively tight monetary conditions.

With global interest rates comparatively low, it is hardly surprising that the RBNZ's aggressive lifting of the cash rate over the past two years has caused the dollar to appreciate to levels that have eroded the profitability of many exporters and of those companies that compete with imports.

Low international yields meant that, even at 6 per cent, the domestic cash rate put significant upward pressure on the dollar. However, lifting the rate to 7.25 per cent late last year was evidence that the RBNZ had lost sight of the overall impact of its policy on the economy.

The RBNZ appears to underestimate not only the damage inflicted on the tradeables sector by the high dollar, but also the adverse effects of other "headwinds" for the economy:

* The lagged effects of past interest rate increases.

* The loss of spending power from high global oil prices.

* Falling construction activity on the back of weak net migration flows.

* Softening export commodity prices.

In early December, the RBNZ estimated cumulative GDP growth of 1.5 per cent during the third and fourth quarters of last year. Latest indicators suggest that the actual result will be close to zero. That means that the RBNZ continued to raise interest rates when the economy was already at a standstill and at risk of entering a recession.

Even though the RBNZ was well aware of the risks associated with further rate rises at the late stage of the economic cycle, this was overridden by concerns about the pace of household borrowing and the potential effect of continued strong domestic demand on inflation.

The RBNZ's repeated public statements about undesirably high household debt were designed to create a sense of inevitability of further rate rises.

However, while it is easy to agree that household debt has become a serious problem, the huge overvaluation of the dollar made it far from obvious that raising the cash rate to 7.25 per cent would be the right response.

It cannot seriously be argued that the RBNZ, facing the threat of rising inflation, simply had no choice.

Its mandate is effectively to keep underlying inflation in a 1 per cent to 3 per cent range, while headline CPI inflation is allowed to move outside that range under specific circumstances.

Despite the enormous rise in global oil prices, the headline CPI rose only 3.2 per cent in 2005. Subtracting the oil influence (reflected in petrol prices, air travel surcharges) and the rise in petrol taxes means that underlying inflation in 2005 was only around 2 per cent.

The recording of underlying inflation at the height of the economic cycle around the mid-point of the 1 per cent to 3 per cent target range rather than close to the top demonstrates that the RBNZ has not utilised the leeway provided by the policy framework. Policy has been too tight.

Of course, the RBNZ is supposed to operate policy in a forward-looking manner. Concerns about future wage inflation may partly explain the reluctance to utilise the full width of the inflation target range.

However, the labour market is already cooling and most companies have little pricing power as a result of slowing GDP growth.

The recent lift in wage inflation is largely being absorbed through lower profit margins. This process reflects the rebalancing of wage and profit shares within company income flows that typically occurs at the late stages of economic cycles. Trying to interfere with that adjustment through raising interest rates puts too much strain on the economy.

Moreover, the RBNZ's strong emphasis on the risks flowing from rising inflation expectations reinforces the retention of the systematic tight policy bias the present framework was meant to get rid of. Inflation expectations have proved a poor leading indicator of actual inflation and the RBNZ seems to be unduly worried about lasting flow-on effects from the rise in global oil prices.

TOO little weight is being given to the downward effect on inflation that arises from significantly reduced purchasing power in the domestic economy.

As a result of overly tight monetary conditions, the downturn will be deeper than necessary, inflation pressure will subside and the RBNZ will have to start cutting interest rates in a fairly aggressive way sooner than later. Since the tradeables sector has been weakened considerably, the economy will not have much to fall back on once domestic demand slows more markedly.

The present experience is similar to the mid-1990s when monetary policy was kept too tight for too long. The domestic economy was - unlike Australia - unable to cope with the fall-out from the Asian crisis and went into recession in 1998 after a sustained period of exchange rate overvaluation.

External competitiveness is critical for New Zealand as a trading nation. The RBNZ has to move away from operating policy in a way that, in regular intervals, causes significant harm to the most productive parts of industry.

For various reasons the New Zealand economy exhibits significant underlying volatility. In addition, the last few years have been influenced by a one-off structural shift to higher household debt levels and unusually low global interest rate levels.

While undoubtedly difficult to manage, the RBNZ should be able to deal with such challenges more efficiently than it has done. This can be achieved through allowing swings in underlying inflation that utilise the full width of the inflation target range during economic cycles. As a result, inflation would, at times, be slightly higher than desired but, given the competitive domestic economy, there is little reason to expect that inflation would remain "sticky" at the top end of the 1 per cent to 3 per cent range.

Allowing wider swings in inflation does not at all mean losing sight of the low inflation goal. However, it requires the operation of policy in a manner that recognises that the excessively rigid pursuit of the inflation goal has a lasting negative influence on key industries that have the potential to lift the economy to a higher underlying growth path.

The present monetary policy framework provides enough flexibility for a different approach but the RBNZ has yet to make the transition to a cool-headed central bank like the one operating across the Tasman.

* Ulf Schoefisch is an independent economic consultant.