Reserve Bank's new target divides economists

By BRIAN FALLOW economics editor

As widely expected, the policy targets agreement between the Government and new Reserve Bank Governor, Dr Alan Bollard, has been amended to require him to keep inflation in a 1 to 3 per cent band "on average over the medium term".

Reaction among market economists divided into three camps.

Deutsche Bank and HSBC, who think monetary policy has been on the tight side over the years, welcomed what they see as a move to a more mainstream target and an accompanying mandate for the bank to be less heavy-footed in implementing policy.

The Bank of New Zealand and National Bank see it as a cosmetic move endorsing changes the Reserve Bank has already made in practice, and therefore see no reason for inflation or interest rates to be any different than they would have been under the former agreement.

ANZ and Westpac see it as likely to push inflation, inflationary expectations and interest rates all higher, to no purpose.

Finance Minister Michael Cullen said raising the target band from 0-3 per cent to 1-3 per cent "partly reflects actual outcomes over recent years".

Inflation had averaged 1.9 per cent over the past 10 years and 2 per cent over the past five years.

"It also reflects more common overseas practice and a range of research that stresses the danger of getting into, or close to, a deflationary position and the difficulty sometimes of getting out of that kind of position," said Cullen.

The more important change was the move to a medium-term focus, he said.

"The message is the need for a somewhat more flexible management of monetary policy."

Bollard said: "I would expect the medium term to be long enough to allow us to look through the business cycle.

"That is not a tightly defined, mechanical thing and it will to a large extent be up to the board of the bank ... what the medium term is, because they, as before, will be required to monitor the performance of the governor."

The BNZ's head of market economics, Stephen Toplis, said the acknowledgment that the target was a medium-term objective only represented what the central bank had been doing anyway.

WestpacTrust chief economist Adrian Orr said the change weakened the governor's accountability and risked denting the credibility of the bank's reputation for caging inflation.

Inflation and expectations had consistently been higher than the mid-point of the target range, he said.

Raising the mid-point risked higher inflation and interest rates, which would erode savings and lead to a misallocation of resources, said Orr.

National's finance spokesman, former bank governor Don Brash, said: "The unavoidable conclusion is that the minister wants the new governor to deliver a higher average rate of inflation. This will do nothing for faster economic growth and will inevitably lead to higher interest rates."

Both Bollard and Cullen say average inflation should be no higher under the new agreement.

National Bank chief economist John McDermott said that was plausible and there was no reason for interest rates to be higher over the longer term.

Deutsche Bank chief economist Ulf Schoefisch expected core inflation to rise a quarter to half a percentage point. While that would raise interest rates longer-term, it would be offset by lower short-term rates (including those driving floating mortgage rates).

The markets might also see a more mainstream policy target as likely to make the Reserve Bank less jumpy, Schoefisch said.

ANZ chief economist David Drage said the higher mid-point and, particularly, the medium-term focus would allow the Reserve Bank more flexibility to see how the present global uncertainty played out, even though inflation was already close to the 3 per cent upper limit.

He expected the bank to hold the official cash rate for the rest of the year.

"But in the longer term the change is likely to enshrine the upward movement in average inflation that has occurred over the past couple of years to around 2.5 per cent, and this softening of the target is not without risks of inflation expectations over and above that."

Business NZ chief executive Simon Carlaw welcomed the medium-term approach but said no one would benefit from the inevitable return to the higher inflation and interest rates.

Bollard said the agreement represented an evolution.

"The bank has done a huge job in getting inflation down from very big figures over the past decade and a half. Expectations about prices are very well-anchored now and I expect them to stay well-anchored."

Full text: Policy Targets Agreement