Finance Minister says new clause intended to better anchor inflation expectations

Three changes to the policy targets agreement between the governor of the Reserve Bank and the Government are only minor, says Minister of Finance Bill English.

The agreement is, in effect, the job description of new governor Graeme Wheeler. It defines and gives content to his statutory obligation, enshrined in the Reserve Bank Act, to achieve and maintain stability in the general level of prices.

That target is still defined as keeping inflation, as measured by the consumers' price index, between 1 and 3 per cent on average over the medium term.

But a new clause which reads "with a focus on keeping future average inflation near the 2 per cent target mid-point" has been added.


Outgoing governor Alan Bollard used all the flexibility his policy target agreement (PTA) gave him. Inflation has been above the top of his target band for nearly four of his 10 years, and average CPI inflation over his term has been 2.6 per cent. The change might be seen as a desire to lower that.

Westpac chief economist Dominick Stephens interpreted the change as tightening the definition of price stability. But English said the additional language was simply intended to better anchor inflation expec-tations. Surveyed inflation expectations have been closer to 3 per cent than 2 per cent most of the time in recent years.

"It doesn't signal tighter policy," English said. Nor did it imply policy had been too loose or that the bank too slow to respond to the housing boom, he said.

A second change is adding of asset prices to the range of prices the bank is required to monitor.

As it already keeps a close eye on house prices in particular, the new language may not require much change in its behaviour in practice. English said it demonstrated an understanding around the world from the global financial crisis that central banks probably could have taken more notice of the sharp rises in house prices.

"There was a view that asset prices didn't matter quite so much. Now we're familiar with the economic destruction that can arise when asset prices rise too fast then crash."

Thirdly, the governor, while pursuing his primary price stability objective, is now required to "have regard to the efficiency and soundness of the financial system" as well as the existing injun-ction to "seek to avoid unnecessary instability in output, interest rates and the exchange rate".

Financial stability is already a major focus of the Reserve Bank's activities. English said the PTA's stronger focus on stability made it clearer that it might be appropriate to use monetary policy to lean against the build-up of financial imbalances, if the Reserve Bank believed this could prevent a sharper economic cycle in future.

Work on developing macro-prudential tools would continue, he said.

The Reserve Bank was working out how to use them. "It is not straightforward.

"If you are going to use more tools, you have to work out who are the decision- makers, what are the criteria by which they are going to make decisions, in a framework that is somewhat similar to inflation targeting.

"That has got quite some way to go yet."

Wheeler emphasises that macro-prudential policy tools should be separate from, but complementary to, monetary policy. "The primary purpose of such tools will remain to promote stability of the financial system."