Reserve Bank has too much room to wriggle
One of the disconcerting factors in theReserve Bank’s Monetary Policy Statement released earlier this month was theinclusion of forecasts for inflation excluding the effects of food and energyprices. Price rises from these two sources are responsible for more than halfof 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 trendsin world commodity prices that have pushed food and fuel costs up so rapidly,so at first glance, omitting these two components from the battle againstinflation appears perfectly reasonable. But it smacks of bad timing to embarkon such an exercise at precisely the time when these inflation sources are sostrongly at the forefront of the public’s mind. We’ve previously seen changesto the Reserve Bank’s inflation target that have strongly reflected theeconomic pressures of the day, and these amendments have generally meant thatmonetary policy has got progressively more lax.
The Reserve Bank governor has been givenan ever-increasing number of "get out of jail free" cards should he fail to dohis 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 ofkeeping inflation constant throughout the economic cycle. But now the PolicyTargets Agreements also includes the following wording.
- "On average" (translation: inflation doesn’t have to stay inside thetarget band, as long as its within the band more often than not)
- "Over the medium term" (translation: let’s ignore current inflationoutcomes and look at where inflation is forecast to be at some unspecified timein the future)
- "Seek to avoid unnecessary instability in output, interest rates andthe exchange rate" (translation: if you can’t find any other reasons, use thesefactors as justification for policy decisions that may have failed to keepinflation under control)
Now, even without any explicit mandatefrom the government, the Reserve Bank is hinting that it would like to targetsome subset of overall inflation instead of the headline CPI. Ourinterpretation is that achieving genuine price stability has simply got toodifficult 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 upthat suggestion.
We recognise the futility of the ReserveBank 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 NewZealanders are effectively forced to pay the world price for these goods. Thusalmost half the CPI is dictated by movements in world commodity prices, globalinflation trends, and exchange rate movements.
But it’s time to stop making excuses forour persistent domestic inflation problem. The non-tradable component of theCPI has averaged 4.1%pa over the last five years, and this inflation is drivenby factors that monetary and government policy can influence. Employment laws,compliance costs, and competition regulations all have a part to play inkeeping the trend in non-tradable inflation down. Monetary policy’s role is toinfluence inflation expectations, as well as providing any necessary "finetuning" throughout the economic cycle.
Following this year’s election, a new PolicyTargets Agreement will be signed between the government and the Reserve Bank. It represents an ideal opportunity to add some potency and focus back into theBank’s inflation control. Let’s forget about the tradable section of the CPI â€“it will add or subtract to headline inflation throughout the economic andexchange rate cycle, but it’s just a distraction. Mandate the Bank to targetnon-tradable inflation instead.
How should the Bank’s target bedescribed? We certainly don’t need a target band that only needs tobe hit on average over the medium term â€“ add those threecomponents together and it sounds like a great recipe for missing your targetmore often than not. Only one of these three elements is required, and webelieve the "medium term" is the best one to keep. Targeting inflation at somefuture point recognises that changes in monetary settings take time toinfluence 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 intrying to instantly rectify any unforeseen inflation problems, but can allowany policy changes it makes now to gradually affect inflation outcomes.
Implicit in the previous paragraph was aneed 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.