Meeting of minds on inflation target

By Brian Fallow

Between the lines


Incoming Finance Minister Michael Cullen meets Reserve Bank Governor Don Brash next week to discuss amending the Policy Targets Agreement.

If that is all the two men have to discuss, it should not take long. The convergence in their positions is remarkable.

Even though the briefing paper with which the bank greeted the new Government yesterday says it is not proposing any amendments to the targets, the document is heavy with the kinder, gentler, more flexible approach the bank has been emphasising for some time.

The change to the agreement three years ago which widened the inflation target band to 0 to 3 per cent was a major and constructive change.

The new language which Dr Cullen wants to write into the agreement will mark a further step towards a more flexible approach to monetary policy, but in reality it only reflects changes the bank has already made.

As this column has commented before, there are two ways of reading that: Either Dr Cullen, seeing which way the bank is moving spontaneously, wants to claim some credit for it.

Or Dr Brash, seeing which way the political wind is blowing, has positioned the bank ahead of it.

Probably it is a bit of both.

Labour's policy, reaffirmed by Dr Cullen yesterday, is to maintain the inflation target range at 0 to 3 per cent, and to amend the agreement to ensure the bank, in meeting that target, pays appropriate attention to minimising adverse impacts on the real economy, including excessive appreciation of the New Zealand dollar.

That does not mean, Dr Cullen has stressed, targeting the exchange rate as well as inflation.

The briefing paper contains the remarkable observation that "even where policy is consistently directed at keeping inflation within the 0 to 3 per cent range, annual consumer price inflation outcomes can be expected to fall outside that range about 20 per cent of the time or in other words about one year in five. We think this strikes an appropriate balance between the need for flexibility in the framework and the need to anchor inflation expectations, which requires that inflation not breach the target too frequently."

No wonder Dr Cullen, for his part, "is satisfied the bank has been moving to a less aggressive approach."

The test for this more relaxed approach may not be long in coming, however.

Deutsche Bank chief economist Ulf Schoefisch, for one, believes Dr Brash is already underestimating mounting inflationary pressures.

Mr Schoefisch thinks the Reserve Bank will have to tighten policy significantly more and faster than it has indicated. He forecasts mortgage rates will rise between 1.5 and 2 percentage points over the next 12 months and the dollar will rise 10 per cent to reach 56USc by the end of next year.

Whether Dr Brash's new riding instructions take the edge off that only time will tell.