Has Reserve Bank joined real world?

By Fran O'Sullivan

O'Sullivan on…

I'm still waiting for Reserve Bank governor Don Brash to take The Economist magazine to task.

If Brash is to be consistent, he must give the prestigious magazine a similar serve to that he recently dished out to New Zealand news media for failing to understand the abandoned "monetary conditions index" (MCI).

When the Reserve Bank moved away from its Ouija board approach to managing monetary policy last month to targeting a simple cash rate, there were muted cheers from the financial sector.

Many had often wondered why New Zealand's central bank had persisted for two years in using an arcane index as a de facto policy instrument. Others were too caught up in the game of divining whether or not the central bank would use its next "Wednesday window" to comment on current monetary conditions, to give serious thought as to why New Zealand's economy had turned turtle in such a short time.

The MCI in all reality was always too hard. It was out of step with best international practice, prone to misinterpretation and, more importantly, took a lot of valuable intellectual grunt away from the real task of making profits in difficult times.

But there was nothing from the Reserve Bank in last week's Economist to rebut its recent charge that New Zealand - "one of the most open and efficient economies in the world" - had come unstuck during 1998 because of monetary mistakes.

In its March 6 issue, The Economist blamed the Reserve Bank's policy of using a monetary conditions index for the double digit interest rates which crushed domestic demand last year - just as the Asian crisis was beginning to seriously affect regional economies.

The magazine in effect laid the blame for the 1998 recession at the Reserve Bank's door - contrasting New Zealand's recessionary plunge with the resilient growth which neighbouring Australia continued to enjoy despite the Asian knockon.

As The Economist pointed out, New Zealand had been widely held up as an economic model for more than a decade - and lauded by many, not least the magazine. In fact, its economics editor used to be so entranced with the "New Zealand Experiment" that she would on a regular basis fly economy class to this country to check progress.

When the Reserve Bank closed its Wednesday window, assistant governor David Archer explained, "on reflection, the risks of misinterpretation, either of using the window to make a comment, or being silent with the window open, are too great."

In Auckland, speaking to various business audiences, Brash has laid the blame for the financial markets' failure to respond appropriately to the use of the MCI on the unsophisticated analysis by local news media. The financial wires - journalists from agencies such as Reuters, AP, Dow Jones, Bloomberg and the New Zealand Press Association - came in for opprobrium. Their failure to read the fineprint and the qualifications surrounding monetary policy statements and the workings of the MCI was largely the reason why it had to be abandoned in favour of simple cash targets.

The claim is pure sophistry. If financial journalists are so lacking in intelligence that they constantly get it wrong, it should not have taken the Reserve Bank two years to realise it was being wrong-footed and to toss the index out. The claim was also nonsense as financial markets received the same data as journalists.

As the Australian Financial Review put it when the Reserve Bank changed tack - it had finally "joined the real world."

Now the Ouija board has been dumped and the bank's open market operations - known in the trade as "open-mouthed operations" - cut back, the Reserve Bank has returned to its usual bogey boy of inflation.

On Wednesday, financial markets were surprised when Brash said the bank had set its first official cash rate at 4.5 per cent - 25 basis points above the highest level most pundits were expecting.

While the domestic economy was now recovering relatively robustly, Brash warned it would be some time before the slack built up in the economy over the last year or so had been used up, so downward pressure on inflation would continue for a while yet.

Back in Pavlov mode, Brash indicated the central bank might once again have to take action if New Zealanders spurred a debt-fuelled boom in the housing market.

The Reserve Bank's approach is doubly rich when much international focus is still on the risk of deflation - not its opposite. Indeed, Brash's old fans at The Economist have been warning that good central banks have to also keep in mind that deflation can be more damaging than inflation. And that monetary policy in the rich world, taken as a whole, looks dangerously tight.

In reality, the New Zealand economy would benefit most if the Reserve Bank simply went into "closed mouth operation" mode.

Brash's change of stance on monetary policy - while welcome - is an admission of failure and ought to be read as such by all in business. His soft-option of blaming local news media should be taken for the intellectual cop-out it is.