Bernard Hickey: How to thrash a dead horse

Reserve Bank Governor Graeme Wheeler is holding firm on interest rates. Photo / Mark Mitchell

Performance reviews are never fun and they're often more complicated than they should be.

Right now our pioneering Reserve Bank is having an awkward time explaining to its boss, Finance Minister Bill English, why it is missing its one and only economic performance target of keeping annual inflation in the Consumer Price Index (CPI) around 2 per cent over the medium term.

This performance review is important for all New Zealanders, and not just because millions of borrowers and savers depend on the bank's Official Cash Rate for their levels of disposable income.

It is increasingly deciding how wealthy we are because ever lower interest rates are helping to pump up asset values and house prices.

It is also important because New Zealand was the first to adopt this style of strict inflation targeting in 1990 and it has since been copied in many other parts of the world.

But now inflation is so low, or negative in some places, there are plenty of doubts about whether inflation targeting works at the bottom end of the spectrum.

Central banks have kept cutting interest rates to zero and below to try to get inflation back up again.

But this is beginning to look like thrashing of dead horses.

So this performance review is turning into quite a piece of performance art in an economic policy sense. Many people are watching to see how it turns out, and the early signs are not good.

Over the past couple of weeks this virtual review has led to a lot of uncomfortable shifting in seats because the pressure is mounting.

First, new data showed surprisingly little inflation in the economy last year and other central banks signalled even looser monetary policy to try to perk up inflation in their countries.

By not cutting interest rates, our Reserve Bank is effectively allowing a tightening of monetary policy here through our exchange rate. This hit home last week when dairy prices fell more than 15 per cent but the exchange rate rose US 2 cents to over US 66 cents.

Second, Governor Graeme Wheeler came out all guns blazing with his side of the story on why he was not meeting the target.

He wanted to interpret his performance agreement flexibly so he didn't have to cut interest rates.

He blamed the oil price slump and argued that inflation was higher than the headline number. He pointed to the bank's measure of "core" inflation, something most other economists can't fathom. He has also wondered aloud whether more rate cuts would benefit the real economy beyond house prices.

Effectively, he invented a new set of lower and wider goal posts and suggested using a round ball instead of an oval ball to kick the points.

The trouble is New Zealanders don't experience this new goal post - core inflation. For now, the boss is accepting Wheeler's reasoning. English agreed the Governor needed more time and that inflation below 1 per cent was acceptable.

This week the IMF said the Reserve Bank and the Government should be ready to tighten its LVR restrictions and further reduce the tax incentives for property investment. That would be one way for Wheeler and English to complete their performance review with a new set of action points.