Reserve board says Bollard on track

The board of the Reserve Bank has endorsed Governor Alan Bollard's handling of monetary policy even though inflation is forecast to be above his target band of 1 to 3 per cent for two years.

The directors' comments in the bank's annual report released yesterday focus on the bank's monetary policy performance, in contrast to much more cursory consideration in the previous three years' reports.

They conclude that the medium-term path for inflation has been, and is projected to be, consistent with the requirements of the policy targets agreement between the Governor and the Minister of Finance.

But they warn that "care must nevertheless be taken to ensure the rate of inflation is reduced in such a manner that higher inflation expectations do not become entrenched".

The agreement signed when Bollard took over as Governor in September 2002 requires him to "keep future CPI inflation outcomes between 1 per cent and 3 per cent on average over the medium term".

It does not define medium term but the bank has said, most recently last month, that it interprets the agreement as requiring inflation to be comfortably within the 1 to 3 per cent target band over the second half of a three-year forecasting horizon.

The board backs that interpretation. But the directors note that over the past three June years inflation has averaged 3.1 per cent a year. However, only in the last of those years has inflation climbed above the target band.

And the bank's September monetary policy statement forecasts inflation, currently 4 per cent, not to fall back below 3 per cent until late next year, by which time it will have been outside the target band for two straight years.

A faster reduction in inflation would require much tighter monetary conditions in the short term, but the directors consider that would be inconsistent with another provision of the agreement that requires the Governor to avoid "unnecessary instability in output, interest rates and the exchange rate".

Bollard has come in for criticism this year because of the length of time inflation has been and is forecast to be above the 1 per cent to 3 per cent target band.

The directors say New Zealand is not alone in experiencing inflation pressures, especially from international oil prices which almost doubled in the two years to June.

Australia's inflation rate is also 4 per cent, the United States' 3.8 per cent and the OECD average for August was 3 per cent.

"Nevertheless the bank cannot be complacent," they say, noting that even excluding the effects of energy, inflation is running at 2.7 per cent.

"The bank is placing downward pressure on inflation through its maintenance of short-term interest rates that remain high by developed country standards and which continue to feed through into longer-term interest rates, for example into fixed mortgage rates."

They also consider whether Bollard should have tightened more aggressively in the past to prevent an inflationary surge.

That has to be judged in terms of the expectations at the time past monetary policy calls were made, and how reasonable those expectations were.

The directors say they are satisfied the bank uses a wide range of information in making its projections, and that its forecasts tend to be more accurate than the private sector consensus.