Inflation target at 2% risks overheated economy, BNZ says

Inflation target at 2% risks overheated economy, says BNZ

By Pattrick Smellie

March 27 (BusinessDesk) - Targeting 2 percent annual inflation could force the Reserve Bank of New Zealand to cut interest rates too sharply and overheat the economy, says Bank of New Zealand, which suggests current low global inflation rates mean the local target is "unreasonably high in the current climate."

"We wonder if the target band should be lowered from its current one to three percent or, in the least, that its lower reaches be tolerated as the 'new normal' for the foreseeable future," writes senior economist Craig Ebert.

The annual inflation rate has been below 2 percent since September 2011, and clocked in at 0.8 percent in calendar 2014. Although that partly reflected the unexp-ected plunge in global oil prices, it prompted questions about the RBNZ's requirement to hit 2 percent average annual inflation over the medium term. The RBNZ also signalled in its March 12 monetary policy statement that it was reassessing whether inflation expectations had shifted downwards, potentially justifying a lower inflation target.

"To try to keep achieving the existing Consumers' Price Index target, in this environment, is tantamount to saying we need to over-egg the domestic economy and its internal inflation, in order to hit a precise CPI inflation number as agreed to under the old order.

"Might the better response be to accept the foreign-sourced deflation while trying to keep the local economy on an even keel, such that the headline CPI, overall, runs on the lower side for as long as it does?"

This "might suggest" a 1 percent annual inflation rate target, although BNZ says it is "not exactly forecasting" a change to the negotiated target inflation rate, which is enshrined in a formal Policy Targets Agreement between the government and the central bank.

While inflation persists in parts of the economy, especially Auckland house prices, BNZ argues that inflation for finished goods has been lagging, reflecting the impact of ongoing spare capacity in the global economy following the global financial crisis, internet-enabled global price competition, falling prices for new technology, and falling international trade tariffs, "the consequences of which tend to backwash into New Zealand's CPI in a downward fashion."

It suggests the RBNZ should accept the benefits to the New Zealand economy of falling global prices rather than reacting to low inflation as "any sign that the domestic economic is faltering and in need of economic stimulus."

Such stimulus could cause "all manner of economic and financial distortions (if it hasn't already) in the vain attempt of driving CPI inflation up a bit. We have to ask: is this arithmetic gone mad?"

A lower inflation target "would tend to affirm a lower inflation premium in nominal interest rates, but it would also take pressure off the RBNZ to keep cutting interest rates with the primary aim of boosting annual CPI back up to 2 percent, come what may. While the lack of Official Cash Rate cuts might be seen to support the New Zealand dollar, it might prevent over-heating in the real economy, and less house price inflation, than otherwise. A relatively lower CPI inflation target would tend to take the pressure off New Zealand's exchange rate in real terms," the BNZ note says.

It comes at a time when the Canterbury-based Employers and Manufacturers - perennial supporters of a weaker dollar to boost export competitiveness - is again calling for action to lower the kiwi, which has been climbing against the US, Australian and other currencies since last week's signals from the US Federal Reserve that expected US interest rate hikes may be later this year than the mid-year timing previously expected.

In its fortnightly Strategist publication, BNZ also paints an alternative scenario to its expectation that the Official Cash Rate won't fall from 3.5 percent this year.

“What if global deflationary risks dominate this year, as US data continue to disappoint and commodity prices fail to find a base," the note says. "In this scenario, the Fed delays rate hikes and German long yields remain near zero. US 10-year yields end 2015 closer to 1.5 percent than 2.5 percent. In this scenario we also assume the RBNZ cuts the OCR to 3 percent."

(BusinessDesk)

© Scoop Media