Balancing inflation and growth

By PETER LYONS*

Michael Cullen's attack on the rigidity of monetary policy warrants further debate. While his comments were politically motivated, the key point is important. Is the adherence to a target of 0 to 3 per cent inflation (and, in particular, the midpoint of this target) curtailing economic growth?

New Zealand has operated a politically autonomous monetary policy since the introduction of the Reserve Bank Act in 1989. The main aim of the act was to make the control of inflation the main role of the Reserve Bank. The establishment of a policy target agreement initially required the bank to keep the level of inflation between 0 and 2 per cent. This was later amended to 0 and 3 per cent.

There is little doubt that the Reserve Bank has been successful in achieving its goal. It has also been successful in squeezing inflationary expectations out of the national mindset. This is perhaps evidenced by the restraint displayed by many trades unions in wage claims in line with reduced inflationary expectations.

It is also evidenced by the difficulty that many teachers encounter in teaching about inflation. Students have never experienced excessive inflation. They find it difficult to visualise a situation of double-digit inflation, such as New Zealand experienced throughout much of the 1980s.

New Zealand was one of the first countries to introduce a transparent monetary policy with an explicit target range for inflation. There has been periodic criticism of this mechanism but little widespread debate about the costs and benefits of operating monetary policy this way.

While recognition must be given to the role of the Reserve Bank, there have been a number of other structural changes in the economy over the past 15 years that have also helped to reduce inflationary pressures.

A return to the wage-price spirals of the 1970s and 1980s is less likely because of the nature and extent of these changes. The removal of trade barriers and widespread deregulation in many industries have increased competitive pressures that act as a restraint on inflation. Labour market reforms have also reduced union influence and militancy. The proliferation of individual contracts and the casualisation of many jobs have reduced collective pressure for wage increases.

But the key change has been in people's mindsets, in the removal of inflationary expectations, and this can be largely attributed to the Reserve Bank. Inflationary expectations are the fuel on which inflation feeds. If people expect price levels to rise, the situation becomes self-perpetuating.

Wage demands chase price rises, which, in turn, chase wage demands. This is the main fear of adopting too relaxed an approach to monetary policy. Central bankers refer to it as letting the inflationary genie out of the bottle.

The perceived advantage of having an explicit inflation target is providing transparency and a degree of certainty. It removes the necessity of allowing for variable and high levels of inflation in making financial decisions.

While there is general consensus that high levels of inflation are damaging and distorting to an economy, there is little consensus about the optimal level.

One of the key distortions caused by high levels of inflation in New Zealand was on saving and investment decisions. Savings and investment are a cornerstone of growth. High levels of inflation act as a disincentive to savings and distort investment patterns towards speculative activities.

So is the policy target acting as a straitjacket on growth? Sometimes it appears the economy is like a runner with his legs tied together. Every time the pace of growth increases, interest rates are raised to restrict growth and dampen potential price level increases.

The difficulty is in determining the level of economic growth that can be sustained without causing inflationary pressure. Economists generally use the non-inflation accelerating unemployment rate to determine this. If unemployment levels fall below this rate, it puts upwards pressure on wage and price levels.

Any critique of monetary policy must examine a number of questions. Is having an explicit inflation target worthwhile? Should the target range be extended or abolished? How accurate are the Reserve Bank's estimates of maximum non-inflationary growth? How much inflation is too much?

Economic forecasting is renowned for its inaccuracy. This was evident in the United States during the late 1990s when unemployment levels dropped to historical lows without the appearance of expected inflationary pressures. This led to questioning of the concept of the non-inflation accelerating unemployment rate.

The US Federal Reserve seems to have a more pragmatic but just as effective approach to targeting inflation than its New Zealand counterpart. It retains autonomy without being bound to an explicit inflation target.

The use of the consumer price index to measure inflation is also not without its flaws. The development and refining of economic statistics is not a glamorous part of the subject. Consequently it fails to get the attention it deserves, given the important policy decisions that are based on many of the statistics produced.

The CPI tends, on average, to overstate the rate of inflation because of its inability to rapidly allow for changes in spending patterns and product qualities and types. For example, an increase in the price of electricity will cause consumers to fairly quickly either reduce consumption or substitute other fuels.

The weighting of electricity in compiling the statistics will remain unchanged. The effect on the rise in the price of electricity on the cost of living of an average household is, therefore, difficult to determine accurately.

It could also be argued that higher interest rates as a result of tight monetary policy inhibit the growth of productive capacity in the economy. This is because borrowing is more expensive and firms' profits are lower because of higher debt servicing costs.

This leads to a catch-22 situation. The lack of growth in productive capacity requires a tightening of monetary policy whenever the economy heats up. The higher interest rates then restrict growth in productive capacity.

A more relaxed approach to monetary policy will not create or guarantee higher economic growth. An overly restrictive approach can, however, limit growth.

Economics is not an exact science. It has more than its fair share of dogma and paradigms. The medicine dished out in the late 1980s and early 1990s to quash inflationary expectations was probably necessary.

But it is time for a re-evaluation of the costs and benefits of monetary policy as it is operated at present.

* Peter Lyons, an economics teacher, is studying for a Masters of International Studies at Otago University.