Bollard: Betting a bob each way

By BRIAN FALLOW

Alan Bollard's first monetary policy statement puts one in mind of Buridan's ass.

Buridan, a medieval philosopher, illustrated the notion that nothing happens except for a sufficient reason by saying that a donkey placed equidistant between two equal piles of hay would have no more reason to go for the one on the left than the one on the right and would therefore starve.

The Reserve Bank's statement this week projected no change in short-term interest rates for the next two years.

Not that the bank expects that to happen. It is its way of telling us that right now the case for the next move in interest rates to be down looks just as strong as the case for the next move to be up. Neither pile of hay is more tempting than the other.

The net effect is a neutral statement, with nary a wiggle in the projected track for interest rates to give the financial markets a steer.

Eventually, Bollard will have to choose.

But "eventually" may be a bit longer under the new policy targets agreement (the governor's contract with the Government) than it was for his predecessor, Don Brash.

The agreement has been amended to require the governor to deliver price stability (now defined as inflation between 1 and 3 per cent) "on average over the medium term".

Explaining what he takes the change to mean, Bollard talks a lot about comfort.

"It gives us a bit more room when we look at where our comfort zone might be around inflation," he told a press conference on Wednesday.

"We are not saying we are looking to move inflation back to the mid-point of the [1 to 3 per cent] zone. But we have our views about where the comfortable areas of the zone are.

"We would not be comfortable if we had inflation just sitting on the edge of it. The way the agreement has been rewritten gives us a little bit more flexibility, more comfort that the inflation track in the monetary policy statement is comfortably within that zone."

And in a bid to explain the phrase "medium term", the bank says: "In typical circumstances we will give most of our attention to the outlook for CPI inflation over the next three or so years.

"Our goal ... will be to ensure that, in the absence of significant unforeseen events, inflation will be back within the target range in the latter half of that three-year period."

This is a more distant horizon than the 18 months to two years the bank has talked of in the past.

But is it practicable? Some economists, including Deutsche Bank's Ulf Schoefisch, think not.

Three years ago, he says, when the US stockmarket bubble had yet to burst, and the Word Trade Centre still stood, the outlook was very different from the present reality.

A study of forecasting error, commissioned by Bollard when he headed the Treasury, found that on average economists' forecasts of growth two years ahead were out by about 1.5 percentage points.

So the bank's current forecast that growth two years from now will be about 2.5 per cent means we can be reasonably sure it will be somewhere between 1 and 4 per cent. The margin of error around a three-year view would be wider still.

Bollard is at pains to emphasise that the extra flexibility in his mandate leaves the essential policy framework intact.

The primary objective of price stability has not changed at all, he says, and the top of the target ranges is still 3 per cent.

The bank's ability to be more flexible is conditional. For one thing, it depends on the public's continuing confidence in low inflation.

"If inflation looks likely to move well outside the target range or persist outside the target range for a prolonged period, then to maintain that confidence monetary policy reactions will still need to be strongly assertive."

The agreement calls on the governor to avoid unnecessary instability in output (economic growth), exchange rates and interest rates.

"That could mean a predilection to keep rates on hold if we can," Bollard said.

"But it could also at times actually mean we would move and move decisively in order to ensure that output does not move around more than it might otherwise need to.

"I'm talking about flexibility and about growth and productivity. I'm talking about stability. But we don't want to fool ourselves. We don't have any new instruments to do that. And we are talking about a complex economy that more than ever responds to overseas events, not domestically generated ones."

Do people expect too much of the Reserve Bank and monetary policy?

"I think people generally understand monetary policy on its own does not promote growth. In my view, if it is incorrectly applied it can inhibit growth. It should be setting the background environment to businesses to get on with their job investing and households to get on with their job of working and consuming."

When Brash became governor 14 year ago, his task was to tame virulent and endemic inflation.

"I don't want to see any of that work go out the window," said Bollard. "I can only operate in a context where inflation expectations are really well anchored."

It seems to be a case of so far so good on that score. Despite annual inflation rates averaging 2.9 per cent over the past two years, inflation expectations do not appear to be significantly different from levels observed over a longer period, the bank says.

The theme of continuity is likely to feature strongly as Bollard sets about talking to business audiences about how he interprets the change to the policy targets agreement.

"Because it is a change."

Some market economists, however, remain to be convinced it will be much of a change in practice.

Westpac chief economist Adrian Orr detects business as usual beneath the semantics.

National Bank chief economist John McDermott finds the talk of comfort zones "fuzzy".

"They are just saying they don't want to be near the edge [of the 1 to 3 per cent target range] but they are not allowed to say they are targeting the mid-point."

Schoefisch says it will not be clear how much of a change this is "until we get into a situation where things are stress tested."

ANZ Bank chief economist David Drage thinks the change is already apparent in the neutral stance of the latest statement: "Under the old regime, they would have had a tightening bias."