Reserve Bank has too much room to wriggle
One of the disconcerting factors in the Reserve Bank’s Monetary Policy Statement released earlier this month was the inclusion of forecasts for inflation excluding the effects of food and energy prices. Price rises from these two sources are responsible for more than half of the lift in the CPI over the last year, so if we exclude these components, inflation looks much more respectable at just 1.6%pa.
The Bank can do little about the trends in world commodity prices that have pushed food and fuel costs up so rapidly, so at first glance, omitting these two components from the battle against inflation appears perfectly reasonable. But it smacks of bad timing to embark on such an exercise at precisely the time when these inflation sources are so strongly at the forefront of the public’s mind. We’ve previously seen changes to the Reserve Bank’s inflation target that have strongly reflected the economic pressures of the day, and these amendments have generally meant that monetary policy has got progressively more lax.
The Reserve Bank governor has been given an ever-increasing number of "get out of jail free" cards should he fail to do his job. The initial thinking behind having an inflation target band (1-3%pa), rather than a point target (eg 2%pa), was to recognise the impossibility of keeping inflation constant throughout the economic cycle. But now the Policy Targets Agreements also includes the following wording.
- "On average" (translation: inflation doesn’t have to stay inside the target band, as long as its within the band more often than not)
- "Over the medium term" (translation: let’s ignore current inflation outcomes and look at where inflation is forecast to be at some unspecified time in the future)
- "Seek to avoid unnecessary instability in output, interest rates and the exchange rate" (translation: if you can’t find any other reasons, use these factors as justification for policy decisions that may have failed to keep inflation under control)
Now, even without any explicit mandate from the government, the Reserve Bank is hinting that it would like to target some subset of overall inflation instead of the headline CPI. Our interpretation is that achieving genuine price stability has simply got too difficult for the Reserve Bank’s decision makers. The Bank’s own forecast, that headline inflation will still be at 3%pa by March 2010, tends to back up that suggestion.
We recognise the futility of the Reserve Bank trying to keep a tight rein on prices that it can do little about. Forty-four percent of the CPI is classified as "tradable", meaning that New Zealanders are effectively forced to pay the world price for these goods. Thus almost half the CPI is dictated by movements in world commodity prices, global inflation trends, and exchange rate movements.
But it’s time to stop making excuses for our persistent domestic inflation problem. The non-tradable component of the CPI has averaged 4.1%pa over the last five years, and this inflation is driven by factors that monetary and government policy can influence. Employment laws, compliance costs, and competition regulations all have a part to play in keeping the trend in non-tradable inflation down. Monetary policy’s role is to influence inflation expectations, as well as providing any necessary "finetuning" throughout the economic cycle.
Following this year’s election, a new Policy Targets Agreement will be signed between the government and the Reserve Bank. It represents an ideal opportunity to add some potency and focus back into the Bank’s inflation control. Let’s forget about the tradable section of the CPI – it will add or subtract to headline inflation throughout the economic and exchange rate cycle, but it’s just a distraction. Mandate the Bank to target non-tradable inflation instead.
How should the Bank’s target be described? We certainly don’t need a target band that only needs to be hit on average over the medium term – add those three components together and it sounds like a great recipe for missing your target more often than not. Only one of these three elements is required, and we believe the "medium term" is the best one to keep. Targeting inflation at some future point recognises that changes in monetary settings take time to influence inflation outcomes. Legislating that the inflation target will be "2%pa in two years’ time" means that the Bank does not need to get caught up in trying to instantly rectify any unforeseen inflation problems, but can allow any policy changes it makes now to gradually affect inflation outcomes.
Implicit in the previous paragraph was a need to make sure that the target horizon is well-defined, such as two years, rather than the extremely vague "medium term" that is currently in the wording. Transparency is a vital part of fighting inflation, so the clearer the wording, the better.