Inflation goal for shake-up

By BRIAN FALLOW economics editor

Any day now, Finance Minister Dr Michael Cullen and Reserve Bank Governor-designate Dr Alan Bollard will conclude a new policy targets agreement - the bank's riding instructions.

It is widely expected that they will change the inflation target band to 1 to 3 per cent, from the 0 to 3 per cent range which has applied since 1996.

They may also make it explicit that this is a medium-term objective.

About the only thing that can be said with any certainty about this is that it will either improve the situation, leave it much the same or make it worse.

All three views have their adherents. Time will tell who is right.

The optimistic view, reduced to a slogan, is that such a change to the policy targets agreement (PTA) tells the bank to go easy and give growth a chance.

At the stage in an economic cycle when resources are stretched and demand is outstripping the capacity to supply, the desirable response is that businesses invest.

The aim is a virtuous circle of expanding capacity, higher productivity and incomes, and more demand.

But the risk is that businesses reach for the price-sticker gun rather than the cheque book, rationing their output by raising their prices.

The charge against the bank is that it has been too quick to assume the inflation response would predominate and so has pre-empted investment and growth by hiking interest rates too hard and too soon.

Belabouring the bank during the election campaign, Cullen said the bank's position was that the only response to an output gap problem (where demand is outstripping supply) was an inflationary one.

"Of course you won't see an investment response, because people will be scared off. If you are an exporter and your understanding is that as soon as the economy starts growing reasonably strongly you are going to face a very substantial appreciation against the Australian dollar, then you won't engage in new investment. You will be very risk-averse."

That meant the bank's position would be a self-fulfilling prophecy.

From this viewpoint, it hardly matters whether this analysis is fair to the bank.

It is the perception among firms that counts. And it is the perception - that the bank will always take away the punch bowl just when the party is getting going - that has to change.

Deutsche Bank chief economist Ulf Schoefisch says that moving to a 1 to 3 per cent target would constitute an excellent compromise between the need for change and the desire to minimise potential adverse reaction to changes in the monetary policy framework.

He says the 0 to 3 per cent target's mid-point of 1.5 per cent is fairly ambitious by international standards.

In practice, the 0 to 1 per cent part of the existing range has long been considered a no-go zone on the grounds that it effectively constitutes deflation.

The reason is an acknowledged "measurement bias" in the consumers price index, arising from such things as the difficulty of adjusting for improvements over time in the quality of goods in the CPI basket. The result is that "price stability" probably means about 1 per cent growth in the CPI, rather than zero.

Schoefisch says a 1 to 3 per cent target range would still be wide enough to avoid the need for the sort of qualification that a narrower target such as Australia's 2 to 3 per cent requires, namely that the target is to be achieved on average over the cycle, a period very difficult to define.

"Moving to a 2 to 3 per cent range would change the nature of the 3 per cent top of the range from a relatively hard edge to a soft edge."

That would be a more significant change and risk an adverse reaction from the financial markets and business community, whose leaders had expressed a preference for only minimal changes.

The second, cynical, view is that the sort of changes envisaged to the PTA do no more than insist that the bank do what it has been doing anyway.

Moving to a 1 to 3 per cent target would only entrench a change in the bank's approach to monetary policy that has already been evident over the past few years.

WestpacTrust chief economist Adrian Orr points to the things that would not change: There would still be an independent central bank with a single decision maker. Price stability would still be the key goal of monetary policy and there would still be a target range.

And the bank's eternal dilemma would remain: how to strike the right balance between the short-term risk of retarding economic growth on the one hand and the longer-term risk of eroding confidence in the low inflation environment on the other.

The bank has been pretty flexible since it went to an official cash rate regime in March 1999, Orr says.

Since the PTA was amended three years ago, requiring the bank to run policy more flexibly to avoid instability in output, interest rates and the exchange rate, inflation has averaged nearly 2.9 per cent.

Since the target range was widened from 0 to 2 per cent to 0 to 3 per cent in late 1996, inflation has averaged 2 per cent. Orr says that is the mid-point of a 1 to 3 per cent range, so the bank should not change its behaviour.

Bank of New Zealand chief economist Tony Alexander thinks a new PTA will make little difference.

"At the same time that we have this changing of the guard at the Reserve Bank and a change in the PTA, we also have a change in the fundamentals, to a lack of capacity."

Under-investment in plant and machinery, and in key infrastructure like roads, will combine with skill shortages and emerging tightness in the electricity market.

"So there are these capacity pressures which say to me that the job is not necessarily going to get all that much easier. It still means that, once you get growth threatening to go above 3 per cent for a while, you will face higher interest rates until capacity catches up," Alexander said.

The third, pessimistic, view is that raising the mid-point of the target range represents further backsliding from the intention of the Reserve Bank Act, to no good end.

It will mean higher inflation, higher inflation expectations and higher nominal interest rates. That will increase the cost of capital - a perverse outcome if you are trying to encourage investment.

Business Roundtable executive director Roger Kerr said that when the Reserve Bank Act was brought in there was discussion of what the "right" level of inflation was.

"The conclusion was that stable prices was the correct goal and there was no argument for any higher level of inflation."

Getting inflation down from very high levels involved economic costs - no question. But having achieved a credible low inflation regime, the costs of maintaining a trend inflation rate of 1 per cent are no greater than maintaining a trend rate of, say, 4 per cent, Kerr contends.

"At various times in the cycle you will just have to squeeze to the same degree. When activity is building up and inflation is climbing above 4 per cent, the bank will have to lean against it, and when it looks like dipping below 4 per cent, it will have to ease. It will be performing exactly the same if it is operating around a 1 per cent goal."

If inflation were to average 2.5 per cent for 10 years, prices would be 28 per cent higher at the end of the decade than the beginning. How is that price stability, which is what the act requires, asks Kerr.

For Adrian Orr, the shift to a higher inflation target is not scary in itself, but the expectations behind it are.

"That is where I get nervous. If people think this is the way to higher growth, they are going to be disappointed. So what is their next move? Try 2 to 4 per cent or 3 to 6? If they are more upset next time round, will they go after the independence of the bank, or give it multiple targets?"

* In Forum tomorrow: Former Reserve Bank Governor Don Brash and Waikato University vice-chancellor Bryan Gould on inflation and the bank's response.

What the agreement says

The present policy targets agreement, signed in December 1999 by Michael Cullen and Don Brash, includes the following provisions:The Reserve Bank "shall formulate and implement monetary policy with the intention of maintaining a stable general level of prices, so that monetary policy can make its maximum contribution to sustainable economic growth, employment and development opportunities within the New Zealand economy."

"The policy target shall be 12-monthly increases in the consumers price index of between 0 and 3 per cent."

When inflation is outside the target range, or expected to be, the bank must explain why, and what measures it has taken, or plans to take, to get inflation back within the target range.

The bank must "implement monetary policy in a sustainable, consistent and transparent manner and shall seek to avoid unnecessary instability in output, interest rates and the exchange rate."