The Governor of the Reserve Bank is tasked with controlling inflation. He has a number of tools at his disposal for doing this but the most important is his credibility. The fine print of the September monetary statement from the bank indicates this credibility is under strain.

According to the Reserve Bank, inflation will fall back to 2 per cent early next year. Surveys of businesspeople, however, show they expect inflation to be running at 3 per cent.

At the time this Monetary Statement was being prepared, the 2011 Nobel Prize in Economics was announced. Thomas Sargent and Christopher Sims were awarded this honour in part for their work on mathematical models of inflationary expectations and, it transpires, there is a New Zealand link.

In the 1950s, New Zealand economist Bill Phillips discovered that periods of high inflation coincided with periods of low unemployment. The government of the day could reduce unemployment by printing money.


Throughout the 1960s, business owners were tricked by rising prices into thinking there was a rise in demand. They increased investment and hired staff. A little inflation was a politically palatable price for a reduction in unpopular unemployment.

By the 1970s, the citizenry got wise. Sargent and his contemporaries demonstrated that people were only tricked by an unexpected increase in inflation and, more importantly for Sargent's Nobel Prize, he developed a way to model this mathematically.

Promises by governments to be good were not credible because people know that governments care more about unemployment than small amounts of inflation. This is why, in 1989, New Zealand led the way by creating a Reserve Bank free of political interference and put the stern, inflation-obsessed Don Brash at the helm.

Sargent and Sims also demonstrated that once people understand a process they form better expectations.

This is why the Reserve Bank is wrong to dismiss high inflation expectations as people being confused over the recent GST increase and "... influenced by the current high level of headline inflation, even when giving quite long-dated inflation predictions".

Respondents to the Reserve Bank survey were clear. They expected monetary conditions to tighten and interest rates to rise in the next 12 months; they just do not believe that this will be enough to tame inflation.

The temptation to inflate away New Zealand's sovereign debt, a possible collapse in the dollar leading to a rise in the cost of imports, or a stronger-than-expected economic recovery butting heads with the economy's capacity constraints, will all cause inflation.

Simple grey-haired business people know these things now even if the highly-trained teenagers Alan Bollard relies on do not.

Sargent and Sims won a Nobel Prize for working this out. Old age and treachery, as the saying goes.