Bollard using unreliable forecasts, economist says

Alan Bollard. Photo / Mark Mitchell

The way the Reserve Bank arrives at its interest rate decisions is fundamentally flawed, says economist Rodney Dickens.

In the second of a three-part critique of the current monetary policy framework, Dickens says the bank relies on unreliable forecasts of economic growth and when the governor reacts - belatedly - to the evidence the forecasts were wrong it has the effect of amplifying the economic cycle rather than moderating it.

It takes about a year for changes in the official cash rate to impact fully on economic growth and about another year for the impact on growth to filter through to inflation.

But the fundamental problem with using forecasting models when making interest rate decisions is that as representations of reality they are too simplistic to be much good, especially looking two years out, Dickens says.

In addition there is the ever-present risk of external shocks, especially for an economy as small and open as ours.

"Plus there is an overwhelming tendency for people to feed them their preconceptions," he said.

"Whether it is economic forecasting or business forecasting, when firms do their budgets, the over-riding factor is what people would like to see happen."

Dickens, the managing director of Strategic Risk Analysis, points to how wide of the mark the bank's forecasts were last year on the strength of which governor Alan Bollard raised the OCR twice in the middle of the year when, it turned out, the economy was already struggling.

It was not alone. The Treasury admitted last March that most of its downward revision to the growth outlook was not the result of the quakes, but to its having over-estimated the vigour of the recovery.

Bollard waited a "long, long time" before reversing those interest rate hikes in March this year, Dickens said.

"They weren't just a bit reactive. They were phenomenally slow to respond. The history of the bank is that it is not only reactive but very slow to react. So by the time they do react what caused the problem is just about over and they are just creating the next upturn or downturn," he said.

"In my assessment the Reserve Bank's overly optimistic economic growth forecasts played a significant part in the bank being extremely slow to realise the economy was struggling to grow at all in 2010."

In particular, Dickens believes forecasters generally underestimated the effect of the well-flagged changes to the tax treatment of investment property last year, which he reckons were equivalent to a 1 percentage point rise in interest rates.

If so it is somewhat ironic, as the Reserve Bank had been advocating tax changes in that area for years.

Last week Dickens accused the bank of setting the economy up for a boom/bust cycle by "experimenting" with low interest rates in 2003 and 2004.

They learned not to make the same mistake again, he said yesterday, but they were making the opposite mistake this time around.