Why we’re doomed to hold interest rates too high for too long - Liam Dann

Inflation is slowing but interest rate pain will continue for months to come. Photo/123RF

OPINION

We’re going to overdo the inflation fight, keep interest rates too high for too long and cause more economic pain than is necessary.

Which is a bummer.

It’s not the Reserve Bank’s fault. It’s par for the course with modern monetary policy. The Bank has to get the annual inflation rate back into a 1-3 per cent band.

Unfortunately, the data it has to use to prove it has done that is woefully outdated.

In the economy that we are experiencing right now, we have theoretically already achieved that target.

Of course, the annual inflation rate is 4.7 per cent. But that is based on what we experienced in 2023 and pumped up by high inflation early last year.

The latest data we have came out last month, the inflation rate for the last quarter of 2023 was just 0.5 per cent.

If we annualise that rate forward, we are already at 2 per cent.

Unfortunately, economists aren’t allowed to look at the most recent data and extrapolate — even if that would more accurately reflect our lived experience.

I understand why it works that way. It would be dangerous to set policy based on assumptions. You need to deal with hard facts.

But if, say, you are struggling to keep your business afloat or pay your mortgage or face redundancy, it must be galling that the conventions of the monetary policy mean the RBNZ can offer you no respite.

It’s famously considered to be a poor workman who blames their tools, so the strongest defence you’ll hear from a central banker is that monetary policy is a blunt tool.

Central banks are forced to focus on the balance of risks with regard to policy swinging too far one way or the other.

When Covid first hit and the economy was locked down, the risk of loosening policy too much and causing inflation was deemed lesser than the risk of keeping things tight and allowing the economy to crash.

As inflation took hold the RBNZ had to pivot. The balance of risk shifted towards inflation becoming embedded as a long-term problem.

There’s been no shortage of debate about the choices it made. That’s a healthy part of the process.

I think that risk is shifting again. Others will remain more hawkish.

The orthodox view on inflation is that it is like a forest fire that will destroy an economy if left unchecked, so it is prudent to keep hosing it down until the last embers are extinguished.

You don’t want to undermine the sacrifices already been made to beat it by giving up too soon and letting it flare up.

Fair enough.

But my concern is a structural flaw that makes it near impossible for a central bank to pivot until the economic damage is done.

According to RBNZ’s own research, it can take 27 months for the full effect of higher rates to flow through to street level.

The RBNZ started lifting rates in October 2021. So the real pain of higher rates has only just begun. The impact of the last hike in May might not flow through to the economy until August 2025.

To recap, we are using an inflation figure that includes data already more than 12 months out of date to guide policy that won’t be fully felt through the economy for at least another year.

That’s blunt in the way doing brain surgery with a cricket bat is blunt.

New Zealand captain Kane Williamson wields a blunt instrument in New Zealand v Pakistan at Eden Park last month. Photo / Andrew Cornaga, Photosport

I’m not advocating a major overhaul of our monetary policy system. In my view, it is one of the few economic approaches that has been proven to work. It fits in the same category as democracy being the worst form of government except for all the others.

It did its job through Covid. We dropped interest rates, loosened the money supply and kept the economy humming. Now we’re tightening up and we’re going to get through the cycle without the acute trauma of the GFC or the chronic multi-decade malaise that began with the oil shocks in the 1970s.

What I am saying is that we could, and should, be doing much better at honing the resources the Reserve Bank has to guide its policy.

For starters, much bigger economies than ours manage to produce inflation data every month.

Why stop there? New Zealand once led the world in its approach to inflation targeting and monetary policy. We are a small economy. It should be easier to count things.

Given the electronic nature of almost all transactions and the advances in AI, surely we should be seeing great leaps and bounds in data collection.

If we put the right systems in place we could be seeing inflation in almost real time.

It was heartening to see Stats NZ new Selected Price Index — which now manages to measure around 45 per cent of household costs every month.

It is too little, too late for this economic cycle though. The agency is obviously at the limits of what it can do without some serious investment.

I know it’s a bad time to talk about funding government departments. We need new roads, another Auckland harbour crossing and more teachers, nurses and police officers.

But if you want to create wealth you need to invest in the getting fundamentals right.

It seems to me — given the huge impact inflation data has on our lives — that a relatively moderate investment in collecting it in a more timely fashion would deliver an outsized return to taxpayers.