Monetary Policy Framework at Risk

Confusion Around Inflation Putting Monetary Policy Framework at Risk

Monetary policy is a hot topic right now. The Reserve Bank’s decision yesterday to raise the Official Cash Rate to 8.25% will ensure that it remains on the boil.

Inflation is economically and socially destructive. It hurts most those on fixed incomes with no assets. People like Chris Trotter who advocate a softer line on inflation seem to have no regard for its pervasive harms.

The passage of the Reserve Bank Act with its focus on keeping prices stable was one of the pillars of the post-1984 economic reforms. Combined with fiscal discipline and the freeing up of markets, it led to major productivity improvements, stronger economic growth and low inflation, without creating major exchange rate problems, for a decade or so from the early 1990s.

What has gone wrong? CPI inflation has been running at an average compounded rate of 2.7% since 2000, well above the Reserve Bank’s mandate to maintain price stability. Over a decade, that means roughly a 30% increase in the CPI – a far cry from a stable price level. At the same time, the exchange rate has climbed relentlessly, putting extreme pressure on many export industries.

Part of the answer lies with the Reserve Bank. In hindsight it misjudged monetary conditions in 2003 when it cut interest rates, and then moved too slowly to tighten monetary policy, with the result that inflation expectations have stayed high. The problem may well have been exacerbated by the increases in the inflation target range (currently 1-3%) in successive Policy Target Agreements.

In addition, the Reserve Bank has created major confusion with its misplaced focus on house price increases, consumer spending, and bank lending, its fruitless intervention in the foreign exchange market, and its misguided search for alternative mechanisms, such as tax policy changes, to curb inflation.

Inflation is not about increases in particular prices such as oil or housing. It is a sustained increase in the general level of prices (or, equivalently, a fall in the purchasing power of money). Hence the saying ‘inflation is too much money chasing too few goods’. With its existing mechanisms, which are similar to those of Australia and many other countries, the Reserve Bank has full control over the supply of money and hence over medium-term inflation.

By contrast, changes in tax rules (for example on housing) would only have one-off effects on prices, not on ongoing inflation.

Finance minister Michael Cullen seems not to understand the monetary origins of inflation either when he talks about the economy ‘overheating’ and the need for activity to ‘cool down’. The economy is hardly growing strongly: growth was only 2.2% in calendar 2005 and 1.5% in calendar 2006 and looks likely to remain subdued this year and next. By contrast, the Australian economy is currently growing at around 4% a year and inflation is well controlled.

Fast economic growth does not generate inflation nor does economic stagnation ease it, as we saw in the ‘stagflation’ period of the 1970s. Dr Cullen’s comments reflect Keynesian ‘demand pull’ and ’cost push’ views of inflation which have long since been discredited.

What has also gone wrong is that policies outside the Reserve Bank’s control have made its job harder. ‘Monetary policy needs mates’ to facilitate non-inflationary growth without creating pressures and imbalances within the economy.

One major source of difficulty has been the massive increase in government spending, up by $21 billion since 2000. This has pushed up costs and prices in the domestic economy and squeezed exporters. There is no way monetary policy can offset these effects.

Other cost-raising measures such as changes to employment law, business regulation, controls on building and land supply, large increases in local body rates and charges, as well as inefficient infrastructure, have compounded the problem.

Finally, there is the issue of ‘too few goods’. Labour productivity growth has halved from an annual rate of 2.7% in 1992-2000 to 1.3% in 2000-2006, putting additional pressure on interest rates and the exchange rate.

A parliamentary select committee is currently looking at this range of issues. Business and farming organisations have made submissions to it, stressing the importance of maintaining the current monetary framework and adopting a more balanced policy mix.

The best contribution monetary policy can make to growth is to keep prices stable; it cannot otherwise contribute to the economy’s long-run growth performance. New Zealand enjoyed years of strong growth and became one of the wealthiest countries in the world in the late 19th century and early 20th century at a time when the price level was essentially stable.

It is to be hoped that the committee helps clear up the current confusion around monetary policy and inflation and points to remedies to the current problems. Reining in the rate of growth of government spending would be the most effective immediate remedy.

Roger Kerr is the executive director of the New Zealand Business Roundtable.

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