KEY POINTS:
Alan Bollard faces a double dilemma.
The first arises from the fact that the economy is in the worst-of-both-worlds phase of the cycle, with growth feeble but inflation running strong. One says cut rates, the other says wait. But on top of that is a deeper issue raised
by Bernie Fraser. That's Bernie Fraser the former Reserve Bank of Australia Governor, not the ex-All Black.
What if these relentless rises in oil and food prices are structural and mark an extended period of transition from an era of cheap oil and cheap food to the opposite. If they are, Fraser says it would be wrong for the central bank to respond by pushing up interest rates - a mistake he compares to pre-Keynesian orthodoxy that Governments should respond to recessions by tightening their belts, which only made things worse. Fraser is reminding us that there is an important distinction between the kind of inflation which arises when demand in an economy outstrips its ability to supply, and the kind which arises from external price shocks such as we have seen in oil and food lately.
We have both kinds of inflation and over the past six months they have been about equally potent.
Higher interest rates are effective against the excess-demand variety, but ideally monetary policy should "look through" the imported cost-push kind as it reflects forces beyond its control.
If what is under way is a structural worldwide shift to higher fuel and food prices it would be futile to try to counter it through tighter monetary policy. But there is a catch. The caveat is that the central bank cannot ignore the effect on inflation expectations and therefore on price- and wage-setting behaviour. Remember the debilitating wage-price spiral of the 1970s?
Inflation has been only a whisker below 3 per cent, top of the target band, on average over the past three years.
It is expected to get worse before it gets better, with many economists forecasting something above 4 per cent later this year, and not to return to the target band until the year after next.
Little wonder inflation expectations have been rising relentlessly. And as the bank itself noted three months ago: "It is well recognised that reversing an increase in inflation expectations can be difficult and costly."
Whether New Zealand has to go through that painful process (again) will depend not on the Reserve Bank but on the choices businesses make over the year ahead.