Brian Fallow: Still fighting the same fire

We are in the worst-of-both-worlds stage of the economic cycle, with high inflation and feeble growth, and we seem to be stuck there.

Inflation is running at 4 per cent and has been above 3 per cent for a year. The Reserve Bank warns us to expect another year of inflation outside its target band of 1 to 3 per cent. Meanwhile gross domestic product growth slowed to 2.2 per cent in the year to March 2006, little more than half its average 3.9 per cent pace over the previous six years. Consensus growth forecasts for the current March year and the next one are 1.3 and 2.4 per cent respectively.

But a good 18 months into what looks like an elongated period of below-par growth we have a policy interest rate of 7.25 per cent and gubernatorial warnings from Alan Bollard that it may go higher yet.

As Bank of New Zealand chief economist Tony Alexander puts it, 2 1/2 years after Bollard started tightening he is still fighting the same fire.

What, or whom, should we blame for this high inflation?

The official line from the central bank is that it is the oil shock - the biggest since the Iranian revolution in 1979 - which hit before the economy had time to purge the inflationary pressures that had built up over a long period of unsustainably fast growth.

"Our analysis is that most of the kick-up in inflation over the past year has been oil-related," Bollard told Parliament's finance and expenditure select committee last Thursday.

"Most of the increase in inflation" is not of course the same as "most of the increase in prices". Even with energy and fuel excluded, the consumers price index would have risen 2.7 per cent in the latest June year.

Higher oil prices have a double effect. In the short term they push up prices directly. But they also raise the medium-term inflation risk, by way of higher inflation expectations. The risk is that such expectations become self-fulfilling as people seek to pass on the higher inflation they experience to their employers or their customers.

Inflation expectations in the Reserve Bank's quarterly survey are now running at a worrying 3.5 per cent on a year-ahead view, though it may take a little comfort from the fact that respondents expect inflation to be back under 3 per cent two years out, though only just.

New Zealand is of course not the only country to have experienced an oil shock. Inflation is at 4 per cent in Australia and the United States too. They don't seem to be panicking.

Across the OECD as a whole annual inflation in July was 3.1 per cent, up from 2.5 per cent a year earlier.

The Reserve Bank's problem - and its problems quickly become ours - is that this rise in global prices for oil, and other commodities, has come at a time when the economy's resources are stretched tight by those six years of near 4 per cent growth. The unemployment rate at 3.6 per cent is the lowest for 20 years.

Granted all of that, the suspicion remains that some of the current 4 per cent inflation rate has to be laid at the door of too loose a monetary policy two years ago.

Bollard was tightening then, first to take back "insurance easings" of the year before, then to lean against emerging inflation pressures.

But the tightening stretched over two years with wait-and-see pauses and a counter-productive statement saying that was probably it, when it wasn't.

With the benefit of hindsight the conclusion might be that a swifter, steeper tightening track would have been more effective.

Bollard reminded the MPs last week that the policy targets agreement (PTA), which in effect is his job description, was "written to allow CPI inflation to go outside the band without having to screw down the economy in a way where arguably we could get it back in very soon but only by doing damage to the economy. Ultimately history and the board of the Reserve Bank will judge whether we have done that successfully. It's too early to do that for sure yet."

The PTA specifies the policy target as keeping "future inflation outcomes between 1 and 3 per cent on average over the medium term".

Whether the key word is "future" or "outcomes" probably depends on whether you are the Governor, making decisions with your eyes fixed on a medium-term horizon, or the board, judging his performance.

"We interpret this as requiring CPI inflation to be comfortably within the 1 to 3 per cent band over the second half of a three-year forecasting horizon," Bollard said.

The bank's latest forecasts have inflation back below 3 per cent by the end of next year, but still averaging 2.6 per cent in the second half of 2008.

Does that count as "comfortably"?

History suggests not.

Two years ago the bank's forecast for inflation two years ahead was 2.75 per cent. The outcome will be more like 4 per cent.

A year ago the bank's two-year forecast was 2.5 per cent. That now looks optimistic.

It is not that the bank is no good at inflation forecasting. Its record is better than the private sector's. But it leaves itself too little margin for error. It seems content to aim not for the bull's eye, the target's midpoint of 2 per cent, but for somewhere below the top. And for the past year it has missed the target altogether.

Bollard might argue that he is using the leeway he has been given by the amended PTA, intended to "give growth a go".

But that would raise the question whether former Governor Don Brash was right, and Finance Minister Michael Cullen was wrong, about the wisdom of loosening the PTA four years ago.

There is yet another, more troubling explanation of our high inflation rate.

It is that structural changes in the economy have weakened the effectiveness of the bank's instrument, the official cash rate.

If the borrow-and-spend behaviour of the household sector is the seat of the inflationary problem, how does the central bank get at it?

Borrowers' preference for fixed mortgage rates and globalisation of the funding of banks' mortgage books have silted up that channel, not altogether but very substantially.

And the shift to a permanently tighter labour market than in the past has so far limited the extent to which pain has been transmitted from businesses to households.

What that leaves, unfortunately, is the exchange rate and an export-led hard landing instead of an export-led recovery. That would do the trick.

"One despairs for export growth long-term in New Zealand," says Alexander, "because the Reserve Bank will have to continue to rely for its monetary policy restraint on the New Zealand dollar being pushed to overvalued levels."

Maybe it is time to send out another search party to look for a supplementary monetary policy instrument.