Inflation is the right target for monetary policy, says Reserve Bank governor Graeme Wheeler, and has served the country well over the past 25 years.
But there were a lot of things monetary policy couldn't do, he said in a speech yesterday. They included improving the economy's long-term growth rate, alleviating an overvalued exchange rate, lowering long-term interest rates and doing much more than buy time when the housing market gets out of balance.
Inflation was a hidden tax, he said, affecting most severely those with fixed incomes and holders of cash rather than inflation-protected assets.
"Price stability cannot by itself resolve concerns about inequality but it does reduce the insidious toll that inflation exacts on the more vulnerable and less financially sophisticated," Wheeler said.
The Reserve Bank remained firmly of the view that price stability was the most important contribution monetary policy could make to promoting efficiency and the long-run growth of incomes, output and employment.
Preserving the purchasing power of the currency enabled producers and consumers to plan with greater certainty for longer periods and respond to relative price changes that would otherwise be obscured during times of high inflation.
"Price stability also reduces the inflation risk premium in interest rates, facilitates long-term borrowing, lending and contracting, and reduces the need for speculative investments designed to protect against inflation risks."
In the 20 years before the Reserve Bank Act gave the bank its price stability mandate, annual economic growth averaged 2.2 per cent and inflation swung wildly around an average of 11.4 per cent. Since 1990 growth averaged 2.3 per cent and inflation 2.6 per cent.
Wheeler also said past attempts to give the exchange rate more weight in monetary policy decisions tended to generate more interest rate volatility, with little lasting effect on the real exchange rate.
"Instead, the appropriate policy response often lies elsewhere - for example, through measures to improve domestic saving, boost competitiveness and raise the growth rate of potential output."
Central banks operating floating exchange rate regimes, particularly in smaller countries, were significantly constrained in their ability to run independent monetary policies, Wheeler said, as in an era of integrated global capital markets long-term interest rates were highly correlated across countries.
"They can influence short-term rates but cannot set their own long-term rates. Instead, international investor activity has a greater influence over long-term rates. We see this at present.
"The Reserve Bank raised short-term rates during the period March to July 2014 but longer-term mortgage rates have fallen, as a result of the decline in long rates in the major economies."
Nor could the Reserve Bank deliver desired social outcomes in the housing market.
It could only hope to influence the demand for mortgage lending and the availability of credit, and buy time for the housing supply to increase. That supply response required other issues to be addressed such as the approval procedures around land use and building consents, the tax treatment of savings and of investment in real estate, and ways to increase productivity and reduce costs in the building sector, he said.
Meanwhile, an environment of low interest rates, rising leverage, aggressive competition among lending institutions, and a widespread search for yield by investors usually translated quickly into rising asset prices.
The Reserve Bank's loan-to-value ratio curbs, introduced for financial stability purposes, had also reduced consumer price inflation pressures by the equivalent of a 25 to 50 basis points rise in the official cash rate, Wheeler said, "enabling the bank to delay tightening interest rates, and reducing the incentive for further capital inflows into the New Zealand dollar in search of higher returns".