A soft spot for a tough policy change

Annual average GDP growth is at a seven-yearlow, but economic forecasters appear to have broadly accepted the ReserveBank’s commitment to raising interest rates higher.   This combination suggeststo us that the Reserve Bank has explicitly grown less accepting of medium-terminflation pressure, and that it has largely convinced the market that anaggressive stance is necessary.

In justifying the "likely" need for arate increase in March, the Reserve Bank pointed to a "resurgent housingmarket" and a rebound in domestic demand.   Business confidence and consumerconfidence, which tend to be good leading indicators of activity, have bothimproved to multi-year highs.

However, the Reserve Bank could beaccused of cherry-picking the data.   Some of the "big" statistical measuresshow continuing weakness in the economy.   The economy grew at an annualisedrate of just 1.2% over the last two quarters, there was no employment growthover the same period, and despite a strong result in the December quarter,growth in retail activity has weakened substantially over the last year (inaccordance with the Bank’s intentions).   Crucially, headline inflation, andmeasures of core inflation, have both eased recently (see Graph 9.1).

Historically, there has been a stronglink between headline rates of inflation and contemporaneous interest ratedecisions.   This relationship is not purely reactionary – the Reserve Bank’sinflation forecasts emphasise the role of inflation expectations in determiningfuture inflation outcomes, and expectations are themselves conditioned oncurrent inflation levels.   But it does suggest that the Bank has tended tofocus more on short-term than medium-term inflation (despite its mandate forthe latter).

Graph 9.1

With that in mind, a decision to raiserates during a period of falling headline inflation would be highly abnormal(especially with a backdrop of weak economic growth).   It is somewhatsurprising, then, that this move has been met with a begrudging acceptance byfinancial markets.   In contrast, the Reserve Bank received sharp criticism whenit last raised interest rates in December 2005.

We take two things from this.   Firstly,it is clear that the consensus outlook for New Zealand has improved sharply –it is widely accepted that the economy is robust enough to raise rates withoutrisking a recession.  

Secondly, the Reserve Bank has toned upits communication skills.   With hindsight, it is clear that the last fourpolicy statements have built a consensus in favour of higher interest rates.  The Bank has shaped the discussion by concentrating on the bullish economicindicators, although an alternative and equally plausible campaign for easierpolicy could have been mounted by focusing on the indications of economicweakness.   Leading the market by the nose has allowed the Bank to moreeffectively shape interest rate expectations and thus the yield curve (see Graph9.2).

Graph 9.2

Why now?

To what aim has the Reserve Bank shiftedmarket opinion?   The best explanation for increasing rates now, even asheadline inflation is starting to ease, is that the Bank is putting a greateremphasis on the medium-term inflation risk (as revealed by the increasingnumber of references to "medium-term" in recent policy statements).  

With a starting point of uncomfortablyhigh inflation expectations and little spare capacity, the Bank knows that areacceleration in economic growth threatens to cement medium-term inflation ataround 3%pa.   This should be an unacceptable outcome for the Bank, given thattheir inflation target implies average inflation of 2%pa.   However, judging bythe Reserve Bank’s own forecasts of future inflation, their adherence to thatpolicy goal appears to have weakened substantially in recent years.[1]

It is highly problematic for the Bank totolerate medium-term inflation outcomes between 2.5% and 3%pa, as the Bank hasbeen forecasting for the last three years, while notionally committing to amedium-term upper limit on inflation of 3%pa.   With so little headroom tomanoeuvre, the Bank is forced to either be more tolerant of (inevitable)inflation outcomes above 3%pa, or to respond more aggressively to newinflationary threats.   Neither is an optimal policy approach.

Graph 9.3

Building the case now for a strongermedium-term focus is a convenient way of ignoring the short-term impact fromlower petrol prices, a rising dollar, and earlier economic weakness (thecombined effect will be to push headline inflation temporarily below 2%), whichwould normally create public pressure for interest rate cuts.

However, there can be little doubt thatthere is a genuine need for the Reserve Bank to reverse the trend towards everhigher rates of medium-term inflation.   With short-term economic indicators nowlooking more promising, the Reserve Bank may very well judge that the economyis fundamentally sound enough to bear a sustained push of tighter monetarypolicy with the aim of stamping out inflation.

[1] For further discussion of this point, see David Grimmond, "Does the Reserve Bank spend too much time looking in the rear-viewmirror?".

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