Our Reserve Bank is rightly proud of being the first independent central bank in the world to focus solely on achieving a targeted inflation rate.

It became a model that 30 other central banks have adopted. The scourge of high inflation in the 1970s and 1980s was tamed and consumers and employers alike became confident inflation would be around 2-3 per cent over the long run.

They felt happy about investing and employing people in the knowledge that inflation would not take off. The Reserve Bank set the Official Cash Rate, its only tool, at a rate that ensured the economy ran as fast as it could without generating inflation higher than about 2-3 per cent.

So why are all sorts of serious people going soft on the idea? No one thought inflation undershooting that 2-3 per cent level would be a problem, but it clearly is and not just in New Zealand.


Annual Consumer Price Index (CPI) inflation, the inflation rate the Reserve Bank has agreed to target, has been below 2 per cent since the September quarter of 2011. It has been below 1 per cent since the September quarter of 2014.

This week the Reserve Bank forecast CPI inflation would not get back to the 1 per cent lower bound until this December quarter and would not get back to 2 per cent until September quarter of 2018.

That would mean inflation will have been below the 1 per cent level for two years and below the 2 per cent midpoint for seven years.

The Reserve Bank is forecasting "future average inflation" at 1.6 per cent. That is a clear failure of one part of the target.

Some people are saying New Zealand should accept the Reserve Bank cannot get inflation back up into its target range. They argue that trying to hit the target is a waste of time when other central banks are creating US$150 billion ($208b) a month out of thin air to buy Government and corporate bonds, and where central banks for two thirds of the global economy have cut interest rates to 0.5 per cent or below.

That makes our OCR of 2 per cent look temptingly high to investors who already have US$13 trillion in bonds with negative yields, which means investors pay the Government to look after their money. Those investors are rushing to park their money in New Zealand dollars, which has made imports cheaper, which in turn is dragging even more inflation.

The Reserve Bank may be missing its target, but we shouldn't give up so easily.


The inflation targeting quitters say lower interest rates here and overseas are not boosting economic activity and are simply pumping up asset values - particularly property, stocks and bonds - that could go bust.

That may be true in places like Japan, the US and Europe, which have cut their rates to almost 0 per cent or below and have been printing money for eight years.

But our Reserve Bank still has 200 basis points up its sleeve and a 50 basis point cut this week would have substantially reduced the New Zealand dollar. Instead the bank gave a 25 basis point cut and promised just one more, which triggered a sharp rise in the currency to over 77.

That made a mockery yet again of Governor Graeme Wheeler's call for a lower currency and has made getting inflation back to 2 per cent much harder.

Wheeler also announced plans last month to limit rental property investors to having a 40 per cent deposit nationwide, and is preparing debt-to-income limits that could reduce demand from highly leveraged buyers.

So why didn't he take action to achieve his one target - to do his one job?

Wheeler said he couldn't control half of CPI inflation, which came from overseas, and he was worried that if he cut harder that would leave him less ammunition to deal with a bigger crisis in future.

That decision is costing exporters. The Reserve Bank forecast this week that the economy was essentially at full employment, but that's not what Treasury estimated last week. It said the rate of unemployment was closer to 4 per cent, which is well below the current rate of 5.2 per cent and which meant there was room to cut rates.

A higher-than-necessary currency is also acting as a handbrake on exports and the productivity and real wage growth that goes with it. It means the Government is failing to reach one of its major targets of lifting the share of exports in the economy from 30 per cent to 40 per cent by 2025.

There are real costs to giving up on inflation targeting. People don't get jobs and exporters don't grow sales or wages. There is also a risk wage and price setters will stop believing that inflation is steady around 2 per cent. Inflation expectations have been dropping from 2 per cent to under 2 per cent over the past 18 months and risk creating a dangerous self-fulfilling prophecy of ever-lower prices and inflation.

The Reserve Bank may be missing its target, but we shouldn't give up so easily just because it is hard to hit.