Brian Fallow: Spills and thrills not part of policy targets

Is the Reserve Bank running monetary policy in a way that takes the economy on a rollercoaster ride, amplifying the output cycle, exacerbating the highs and lows?

If it is, it would be at odds with Governor Alan Bollard's job description, the policy targets agreement, which enjoins him in pursuing his primary objective of low inflation to "seek to avoid unnecessary instability in output".

The problem with magnifying booms and busts is, of course, the destruction of businesses and jobs that occurs during the busts.

Westpac chief economist Brendan O'Donovan says a prima facie case can be made that Bollard is running monetary policy pro-cyclically, setting short-term interest rates in response to current inflation when he is supposed to be proactive and focused on the medium-term outlook.

His counterpart at ANZ National Bank, Cameron Bagrie - counsel for the defence in this case - contends that, on the contrary, we are enjoying more stability in economic growth and employment, even if the price we pay is a bit of volatility in inflation and interest rates.

O'Donovan has argued for some time that the Reserve Bank is not forward-looking enough in running monetary policy.

Instead, there has been a disconcertingly close fit between rises and falls in the official cash rate over the past four years and rises and falls in the "headline" measure of inflation, the consumers price index.

By contrast in the pre-Bollard period, 1993 to 2001, there was only a weak relationship between the cash rate and concurrent headline inflation, but a strong correlation with non-tradeables inflation.

Non-tradeables inflation relates to those goods and services - just over half of the CPI basket - which are not subject to international competition and hostage to the exchange rate. Generally, they include sectors such as housing that are more influenced by interest rates.

If monetary policy is to be driven by current inflation, it makes more sense to focus on non-tradeables inflation than the headline measure.

With the benefit of 20:20 hindsight, O'Donovan said the interest rate cuts of 2003 were a mistake.

They were a precautionary response to a pretty scary-looking international environment, but the local context was that because the exchange rate was going up, headline inflation was only around 1.5 per cent.

Domestic, non-tradeables inflation on the other hand was high and accelerating under the influence of a big surge in net immigration and a housing boom. By cutting rates, the Reserve Bank further stoked the boom, creating more of an inflation problem down the track.

O'Donovan attributes the fact that inflation is now outside the Reserve Bank's target zone of 1 per cent to 3 per cent to that easing in 2003.

He reckons it takes 18 months to two years for changes in interest and exchange rates to impact on the real economy - investment and employment - and another six months before they have their main effect on inflation.

But just as the headline inflation rate in 2003 understated the underlying inflation pressures, the high rate now exaggerates the inflation problem.

"It is more than likely that once petrol and the currency have fallen out [of the annual rate], headline inflation will be getting close to 1 per cent."

O'Donovan says if the Reserve Bank is still driving monetary policy off the headline inflation rate we will then have the opposite problem. It will ease too far.

But is it fair to accuse the bank of allowing current inflation to "drive" its interest rate decisions?

O'Donovan acknowledges that even a close correlation between the OCR and the CPI does not in itself establish a causal connection between the two.

Might it be that the OCR is high because the bank has responded to inflationary pressures, which in turn have pushed the CPI up? Might they be two wheels driven by the same axle and crankshaft, rather than one driving the other?

But Westpac's indictment also cites the Reserve Bank's present rhetoric, in particular its concern about keeping a lid on inflation expectations.

"Expectations happen to be pretty much coincident with actual inflation outcomes. So if you say you are not going to alter policy until you see inflation expectations falling, in effect you are saying you will not alter policy until you see headline inflation falling."

The beauty of an open economy with good institutions, O'Donovan says, is that it is to a large extent self-correcting. Bollard should trust that more and be less heavy-footed.

But Bagrie is more inclined to cut the Governor some slack.

"Hindsight is a wonderful thing. Everybody, ourselves included, was telling the Reserve Bank in 2003 they needed to cut. We all fell into the same trap," he says.

"And, in the middle of last year, we all thought the bank could have ended the tightening cycle. With hindsight, it was not the case. We were underestimating the strength of the momentum in the economy and the persistence of the inflation dynamic."

Nor does he think the bank is wrong to be more concerned about inflation than growth right now.

It is a case of the lesser of two evils, of weighing the risk of recession against the risk of the inflation genie getting out of the bottle. The latter would do more damage in the longer-term.

In any case, Bagrie argues, volatility in interest rates has become the "sacrificial pawn" in the cause of ensuring a bit more stability in economic growth.

"The fact that we are seeing volatility in interest rates is not necessarily a bad thing, because that has allowed a lot more stability over the past four or five years on the output and employment front.

"It is the longest expansion New Zealand has had since the 1960s and output growth has been kept in a narrow band relative to where we have been over the previous 20 or 30 years."

He points to the rises and falls in fixed mortgage rates over the past six months - a period in which the official cash rate has been steady -as a case of the interest rate market responding as a shock absorber to economic developments.

"Late last year, we had strong data and fixed mortgage rates above 8 per cent. Early this year, the data softened and fixed mortgage rates came down closer to 7.5 per cent - a de facto easing. Since the end of March, the data has been stronger again, so fixed lending rates are back up to 7.8 and 7.9 per cent," he says.

"That's where the skill comes in terms of monetary policy. It's not about playing with the OCR lever. It's all about manipulating expectations and letting the yield curve do your easing and tightening for you."